The Federal Retirement Thrift Investment Board (FRTIB), which oversees the the Thrift Savings Plan (TSP), announced during their November 2024 meeting that they would begin allowing participants in the TSP to make in-plan Roth conversions beginning in 2026.
Many of my financial commandos out there will already know why having retirement assets in a Roth account is a big deal, but just in case I am going to review why Roth assets are important in this blog post and discuss how this change at the TSP will make life easier for millions of military service members, veterans and government employees.
Why are Roth Assets Important?
The first thing you need to know as a financial commando about Roth accounts is that they are important. Like most retirement accounts, Roth accounts provide you an opportunity to save and invest for retirement in a tax advantaged way. With Roth accounts the money is taxed as ordinary income when it is earned but is allowed to grow tax-free and be taken out in retirement without being taxed. This is different from traditional contributions to retirement plans in which contributions are made on a tax deferred basis and grow tax free until they are pulled out in retirement. When money is pulled out of a traditional retirement account it is then taxed as ordinary income. The choice between contributing money to a Roth account versus a traditional account is really just a choice about the timing of when you will pay taxes on the money earned in that year.
Theoretically, if your tax rate never changed throughout your life and your expenses stayed consistent every year in retirement too then there would never be an advantage found in contributing to Roth over traditional or vice-versa. Unfortunately, life isn't so simple. Since our tax rates do change throughout our life either because of changes in income or government policies we find that there is a relative advantage between contributing to Roth accounts versus traditional accounts. Mathematically, the greater your tax rate is in the year you earn your money versus the year you pull it out in retirement the more it makes sense to contribute to a traditional retirement account. Conversely, the lower your tax rate is relative to what it is in retirement the more it makes sense to contribute to a Roth retirement account.
We can't always predict what life has in store for us though. If we have already contributed large sums of money to traditional retirement accounts only to find ourselves in a low-income and low tax rate year we may want to execute a Roth conversion. During those years where your tax rate is exceptionally low it may make sense to convert some of your traditional retirement account funds into a Roth retirement account. Of course doing so would mean realizing more taxes in the year of that conversion than you would have realized without the conversion, but if planned well and executed properly, it may result in a lower lifetime tax bill. Why would you pass up the opportunity to pay taxes at the 22% rate now if all signs point to you paying 35% or more in retirement?
We should also realize the value of not spiking our taxable income during retirement because of one-time large expenses. The example I often share with my clients is that of the retired couple who needs to replace the roof on their home. A typical roof might cost tens of thousands of dollars. Assuming the roof costs $20,000 and you are in the 35% marginal tax bracket, that extra expense might cost you $7,000 in taxes for the privilege of accessing your money. However, if you had a good plan in place before retirement and had the opportunity you might have been able to contribute to a Roth account while your marginal tax rate was only 22%. Assuming a no-growth scenario, which is unlikely, than this one move could have saved you $2,600 on your lifetime tax bill.
Why are In-Plan Conversions Important?
Let's assume that you or your spouse is suddenly without work for part of the year. You expect your income to be much lower than usual and far below the rate you will pay in retirement. Since you are financial commandos, you have set aside emergency reserves and live off of significantly less than you earn in order to build wealth and live life on your own terms. As such, you view this as a wonderful opportunity to convert some of your TSP assets from traditional to Roth. You have met with your financial advisor and CPA, discussed making this conversion and made a plan, but that is when your financial advisor points out that the TSP doesn't let you make in-plan Roth conversions. As a result, to make a Roth conversion you would have to move your money out of the TSP and into another institution to convert those funds from a traditional retirement account to a Roth retirement account.
That is the way this will work until the change the TSP announced that permits in-plan Roth conversions takes effect in 2026.
In-plan Roth conversions are helpful because they allow you to keep more of your funds consolidated to one institution and a relatively good one at that. This is helpful for simplicity and efficiencies sake, but it is also helpful for TSP enrollees because of some of the unique attributes the TSP has. Among the benefits of having a TSP account are
- Relatively low-cost and high-quality funds.
- Access to the G-Fund which is unavailable outside of the TSP.
- Access to retirement funds without penalty after the age of 50 but before you are 59.5 years old if you are/were a public safety employee with 25 years or more of service.
These are benefits that can make a significant impact in a person's ability to retire when and how they want.
Is the TSP Preparing to Offer After-Tax Contributions?
Something that may go unnoticed by many, but not by this financial commando, is that the TSP implementing in-plan Roth conversion functionality is a necessary step to provide TSP participants the option to contribute to an after-tax account and automatically convert those funds into a Roth account. This financial maneuver is a regular occurrence for high earning employees in the private sector and is used widely among Fortune 100 companies as a tool for increased retirement savings. As such it helps those companies to attract and retain high quality talent. My guess is that the TSP is laying the groundwork to allow this same benefit to military and federal employees.
An example here may be helpful. At a typical large corporation once an individual maxes out their normal retirement contributions for the year ($23,000 for 2024) they may want to contribute to an after-tax retirement account. After-tax retirement accounts let you save for retirement by contributing money on an after-tax basis, letting the money grow tax-free but then the growth potion of the assets get taxed when it is pulled out in retirement. Clearly this leaves something to be desired. However, the IRS limit for after-tax contributions in 2024 is an additional $46,000 which includes an employer match. As a result the total contributions an employee and their employer at a typical large corporation can make to their 401(k) retirement plan is $69,000.
This might look like an employee contributing $23,000 to a traditional 401(k), the employer matching $6,000 to the traditional account and then the employee making an additional $40,000 of contributions to their after-tax 401(k) account. On an apples-to-apples basis, this means the corporate employee enjoys an extra $40,000 of tax advantaged retirement savings per year than the federal employee or military service member does. What is more is that the $40,000 of contributions are typically allowed to be moved from the after-tax account into the Roth account on a daily basis by means of an in-plan Roth conversion. This is allowed because the employee has already paid taxes on the earned income that was contributed to the after-tax retirement account. Why leave the money in the after-tax account where it will be taxed AGAIN in retirement when you can transfer the principal to a Roth account and pull it out tax-free in retirement?
It is speculation on my part that this is what the TSP is thinking of as they roll out the in-plan Roth conversion functionality but it is something that will be on my radar going forward.
I'll keep you posted as I learn more.
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Disclaimer: This blog post is intended for educational purposes only, it should not be construed as tax advice or financial planning advice. Consult a professional for tax and financial planning advice before making any changes. All photos are from open source domains.