Federal employees are fortunate to be eligible to receive two types of retirement income upon retiring from federal service.
The first type is in the form of a guaranteed pension – either a CSRS annuity or a FERS annuity. As a defined benefit retirement plan, both the CSRS annuity and FERS annuity have a guaranteed income stream that continues throughout the life of the federal retiree. There is also some inflation protection in the form of an annual cost-living adjustment (COLA).
SEE ALSO: 10 Costly TSP and IRA Rollover Errors Federal Employees and Retirees Should Avoid
The second type is from the Thrift Savings Plan (TSP). Unlike a CSRS or FERS annuity, the TSP is classified as a defined contribution plan. As such, the TSP does not guarantee lifetime income for a federal retiree. In fact, a retiree’s TSP account could be depleted before the retires dies.
To prevent this from happening, there are certain actions TSP participants are advised to perform with their TSP accounts and to hopefully avoid certain mistakes when it comes to contributing to and investing in the TSP. Each TSP participant’s goal should be to maximize lifetime growth in the TSP, thereby preserving an employee’s TSP account throughout the TSP participant’s lifetime.
This column presents the actions TSP participants should perform and the biggest mistakes participants should avoid when it comes to their TSP accounts.
1. Opting out of the automatic TSP enrollment
Newly hired Federal employees are automatically enrolled in the TSP with 5 percent of their bi-weekly salary automatically deducted and contributed to the TSP starting with their first pay period in federal service. By contributing 5 percent of their salary, the employee receives from his or her agency a maximum TSP contribution match of 4 percent. A newly hired employee has the option to opt out of the automatic TSP enrollment.
Opting out of the TSP is a mistake on a newly hired employee’s part and not a prudent financial move. This is because the earlier an employee starts contributing to the TSP, the longer the TSP money has to grow, tax-deferred for the traditional TSP and tax-free for the Roth TSP.
2. Staying with the default TSP contribution level
Some FERS employees assume that the TSP’s 5 percent default contribution level will be sufficient to fund their retirement. According to most financial planners, a 5 percent employee contribution level (resulting in a FERS employee receiving a maximum 4 percent agency matching) together with an agency automatic 1 percent of gross pay contribution (resulting in a total annual 10 percent contribution level) is insufficient to fund a FERS employee’s future retirement.
In fact, Fidelity Investments recommends that individuals should aim to save at least 15 percent of their salary each year (divided between their contributions and employer matching contributions) for retirement. This means that FERS employees should save at a minimum 10 percent of their salaries each year resulting in saving 15 percent for the year.
SEE ALSO: TSP Maximum Contribution Limit
3. Investing too conservatively, particularly while a new employee and in mid-career
While some federal employees getting close to retirement may attempt to accelerate the growth of their TSP accounts (by having all of their TSP invested in the three TSP stock funds), many younger employees often fail to take advantage of the growth potential of the three TSP stock funds – the C, S, and I funds. Past performance (no guarantee of future investment return) has shown that stocks outperform all other types of investments over the long term more than 20 to 30 years which is the time period for an employee starting when the employee contributes to the TSP and continues through employee’s retirement.
A recommended rule of thumb for a moderately aggressive portfolio is to take one’s age and subtract it from 120. The resulting number is the percentage that ideally will be invested in stocks and /or stock funds (that is, the C, S, and I funds), as opposed to more conservative investment assets such as bonds and bond funds (that is, the F and G funds). An employee who is 35 years old should therefore ideally have at least 85 percent (120 -35) of their TSP portfolio invested in the C, S, and I TSP funds.
4. Not diversifying within the TSP
The TSP offers three stock funds – the C, S and I funds – and two bond funds – the F and G funds. In an attempt to keep their TSP portfolio simple, some employees may contribute to only one stock fund or to only one bond fund.
In doing so, the TSP participant’s investment portfolio lacks some diversification which is not recommended for a long-term investor. Having a balanced portfolio, a portfolio that includes stocks of diverse kinds, along with diverse types of bonds, helps to shield a TSP participant’s portfolio from market volatility.
5. “Choosing and forgetting” a life cycle (L) fund.
Life cycle or L funds do not get much respect because they try to apply a one-size fits all approach to retirement savings.
Many financial advisers are lukewarm on L funds but admit that L funds may have their place in the long-term retirement savings world, especially for novice investors. L funds are a good place to start investing and certainly a better alternative than not saving at all.
Although L fund allocation is designed to change over time to more conservative funds (that is, the bond funds) as time goes on as an employee gets closer to his or her retirement date, a TSP participant’s personal tolerance for risk should still come into play. This is especially true if the TSP participant is getting close to retirement.
Over the years, the TSP has expanded the number of L funds available to TSP participants, going from five L funds to 10 L cycle funds (L lncome, L 2025, L 2030, L 2035, L 2040, L 2045, L 2050, L 2055, L 2060 and L2065).
SEE ALSO: What Are the Lifecycle Funds in the Thrift Savings Plan?
6. Panicking after the TSP’s inferior performance during a particular month or quarter
Switching from one TSP stock fund after that fund performs poorly during a particular month and switching to another TSP fund that performed well that same month or quarter sounds like a promising idea.
However, the likely result is that a TSP participant who performs such a move will end up “selling low” and “buying high,” the exact opposite of basic investing principles. The same is true when switching from the three TSP stock funds to the conservative TSP G fund.
During March 2020, when the stock market was in a downturn at the start of the COVID 19 pandemic, many TSP participants transferred their money out of the C, S and I funds and switched their money into the TSP G fund. One reason for this move given by these participants was to “stop the bleeding” in their TSP portfolios.
But many of these same TSP participants missed the start of the stock market recovery starting one month later in April 2020 and remained invested in the TSP G fund. Even if some of these participants got back into the C, S and I funds 3 to 6 months after the market started turning upward in the spring of 2020, they made out worse than those TSP participants who “stayed the course” and remained in the C. S and I funds throughout.
SEE ALSO: Latest TSP Fund Returns
7. Abandoning a 401(k)-retirement plan after leaving a job and entering federal service
With all of the upheaval that comes when switching from one employer to another, it can be understandable that a newly hired Federal employee may not be aware that an employer-sponsored qualified retirement plan (such as a 401(k) plan) that the employee previously participated can be directly transferred into the employee’s TSP account.
Leaving retirement fund assets in a 401(k) and not keeping track of those assets can have profound investment consequences. For example, the investment fund assets can change to the point that they no longer fit the owner’s investment goals.
8. Starting to contribute in mid-career to the TSP and trying to play “catch up”
Federal employees who start contributing to the TSP when they are in their 40s to early 50s will have a shorter time period to grow their TSP account by the time they want to retire and can no longer contribute to the TSP. Starting as early as possible when a TSP participant is first hired and maximizing one’s TSP contributions allows the TSP participant to take advantage of compounding investment returns and hopefully build the largest possible retirement nest egg over time.
SEE ALSO: TSP Catch-Up Contributions
9. Cashing out a traditional TSP account and/or Roth TSP
When first retired, cashing out one’s traditional TSP account via a lump sum withdrawal is not a wise investment move for several reasons. First, the withdrawn funds will be taxed at the TSP participant’s marginal (ordinary) income tax bracket.
If the participant has a sizeable traditional TSP account balance – for example, more than $500,000 -then withdrawing the entire account will result in the account being taxed at the highest federal marginal tax bracket (37 percent).
In addition, if the participant lives in a state with an income tax, then a substantial amount of state income taxes will have to be paid. This could be especially expensive if the TSP participant lives in a state with high income tax rates, such as California and New York. In addition, the withdrawal of the entire traditional TSP account results in the cessation of tax-deferred growth. Withdrawal of one’s entire Roth TSP account results in the cessation of tax-free growth.
10. Transferring your TSP to an IRA with high custodial and maintenance fees
There is no lack of financial planners and investment companies including banks, brokerages and insurance agencies who would like to have the opportunity of being the custodian of a TSP participant’s TSP account.
Many of these financial planners or investment companies suggest that the participant transfer their entire TSP account to an IRA (traditional TSP to a traditional IRA, Roth TSP to a Roth IRA) managed by them. But the essential information that most of these planners and companies do not fully explain to the TSP participant is the fees and expenses associated with the IRAs they want to manage.
The one fact that all TSP participants should be aware of is that the TSP likely has the lowest administrative fees of all current defined contribution plans. TSP participants pay no commissions or custodial fees with their TSP accounts.
The same cannot be said of IRAs as every IRA has an annual custodial fee. These commissions and fees take away from the gross investment return that many IRA owners think they are earning but in reality they are not.
SEE ALSO: 10 TSP and IRA Rollover Errors to Avoid