Latest / Federal Retirement Advisors | FedLegacy / Before You Convert Your TSP to Roth, Can You Cover the Tax Bill?
Transcript
- William Smith: Hey, what's going on, everybody? Hope everybody's doing well. Tonight, we're going to talk about TSP and Roth conversions Right. The reason why this is an important topic, especially during this time, is because it's ending it's nearing the end of the year. People are starting to start to make tax count tax starting to make tax decisions before the year ends and how much money should you convert? Where should you convert it from, whether it's your TSP or any outside IRAs. And so so this is a perfect time to talk about it. and so especially, you know, we we're especially now we have a lot of clients who are who are retiring at the end the year and they're just not sure what to do. So we were like, okay, let's let's have this conversation so it's clear to everybody. So one of the things that that that always comes up when it comes to when it comes to the TSP of Roth conversions is is there a difference between the TSP, the Roth Tsp conversions versus And outside IRAs conversion. because as you all know, the TSP started doing Roth in service Roth conversions, in plan Roth conversions at the beginning of 2026. And so the the difference between how you do it in TSP and how you do it on the outside is when you're when you're in TSP, TSP is gonna require you to pay for the taxes yourself out of pocket. Right. And so we've had people that have done it and they're like, I wish I would have never done that because now I have to take my personal cash and pay the taxes. Now, if you have a lot of cash, a lot of emergency funds, a lot of money that you have just sitting to the side, it's easy. Why why not do it? But a lot of people that we speak to just do not have that type of cash laying around. And so if you do it, just understand that that is one of the things you're gonna have to do. They're not gonna withhold taxes. So if you if you convert a hundred thousand dollars and you you know your your tax rate is in that 20% range you're gonna have to take the twenty thousand dollars and pay the taxes yourself so that's how the TSP works there's just no way around that also you'll be it's not just the it's not just the federal taxes you're also gonna owe the state taxes and so along with that people people ask well is this smart while I'm working to do the Roth conversions while I'm working that You know, I'm not gonna say it's not smart or or it's not the thing to do, but I just cause I don't know everybody's situation. But what I will say is what you wanna look at when you're when you're when you're thinking about doing Roth conversions while you're working versus when you retire is you wanna you wanna look at you wanna look at what your taxable income is now versus when you retire. Now, if you're like most people, when you have when you retire, your taxable income is gonna be at the lowest it's been in a long time. Why? because your FERS pension is lower than your actual federal salary. And when you retire, there's also gonna be, we call it the these gap years. So if you're somebody that retires before fifty seven, I mean before sixty-two, you'll be getting your FERS pension and your and your FERS supplement, which is gonna be less income than what it will be when you collect start collecting your social security. And another thing, even with that, your social secur your your FERS supplement and your social and your FERS pension are both taxed fully as taxable income. Right? So that's one thing. That right there is one thing. That's those two are taxed at 100%. But once you turn 62, your FERS supplement is no longer, is no longer, is no longer gonna pay out. But you have a choice. You have a choice of do I take Social Security right now or do I take income from my TSP during this time? When I take that income, you could take some income, you can move some to the Roth IRA. But when you do that, your taxable income is lower. Than what it will be when you start taking Social Security. That's one point. And that's so that's what a lot of folks do during that time, from 62 to let's say 65 or so, whatever your t whatever your Roth conversion window is. And that's all based on what your balance is within your TSP. But another thing to consider, if you need all the income, is your social security is not taxed at a hundred percent. It's not taxed dollar for dollar. Okay. And then some states don't even tax social security. So depending on what states you live in, You won't pay state tax either on Social Security. So then that also, again, even though you're taking Social Security, is a prime time to start doing Roth conversions. Okay. And so, and so that's one thing to think about when it comes to the timing. But also when you think about it when it comes to the in-service versus out service, when you do it outside, one thing that happens is you know in it depending on the account, but it's most IRAs. What they're gonna do is they're gonna allow you to withhold the taxes instead of you having to pay out of pocket. So we're dealing with the client now. Both of them marry, both of them have over a million dollars in their TSP. you know, and and and and both, yeah, both federal employees both have over a million in their TSP. And the thing that they're the thing that they're they're they're they're they obviously have to do Roth conversions, but they both said, like, we don't have the cash to do to do these Roth conversions inside of TSP. So we're taking some, we're taking money out of the TSP and we want to do the Roth conversions that way. Right? Because again, they don't, they got a lot of money, but they don't have the cash sitting aside to do those Roth conversions. Again, like most people, these people have both of them combined, they have over like $2.5 million. But they don't have cash on the outside. All their money, clearly, have they been putting towards their TSPs, they funded it pretty well. Knowing now they need to do the Roth conversions, they're putting it into an outside IRA. Every time they do that conversion, they will with the we withhold the taxes, send that money to the IRS based on their effective tax rate. And then they, they, they, you know, their Roth just grows. And so what that looks like is let's say, let's say they're converting 100,000 again, just just for just for example purposes here. You're converting 100,000. Say the taxes are 20%, just to keep it even. It's never that clean, even though TSP takes 20%. People's effective tax rate are are never that clean. It's it's always something 18 and a half, 17, whatever. It's never clean, it's just flat 20. And so in their situation, let's just say it's 20%. You know, so $20,000 and owed in taxes. So when we do the Roth conversion, $80,000 will go into that Roth account. $20,000 will be withhold to the state and to the federal, into the federal taxes for example purposes. And then every year if they do 100, it's gonna be 100, 100 taken out, 80 to the new account. Now, what does that look like? Now that the 80,000 is sitting in that Roth account, that 80,000 now is tax free for the rest of their life. So as that 80,000 goes 80,000 deposits pot deposits keep adding up, IRS is now completely out of that account forever. So now, 10 years from now, that that Let's say they were converting a million dollars, that a million dollars might be 80, 800,000 to start because it's just 20% of the whole thing, right? But as that 800,000 compounds and grows to 3 million, now that whole 3 million is completely taxed. And that whole 3 million is completely theirs, right? Or 2 million, whatever, right? Is it's completely theirs. Or if you're at 500,000 and you're converting and it goes down to 350 because of the 20%, then That 350, now when it gets to 800,000, is now completely taxed. Now, if that 500 grows to 800,000, now, especially if you let it get to RMDs, you could owe more in taxes because it will it will put you into higher tax brackets when they force you to start taking the money. Or if your kids are in a place where you have a million dollars in your TSP, and I'll always talk about that 10-year rule where now you have a million dollars in your TSP. And they're forced to take 100,000 out of that TSP every year. Now their taxable income on what they're making, say they're making 100,000 in the government. Now they're at 200,000 taxable income. Now the IRS is getting a bigger chunk of it. Whereas if you would have paid the taxes on it in your early 60s or mid sixties, wherever you are, if you would have paid the taxes on it during that time, when they inherit the money, they're not, they're not paying 30, 40% in tax taxes now. They're they all that money's been taxed to the 100% of that money is theirs. That ends up being a big difference in retirement. I mean, in retirement and when you're leaving wealth to your family, that number becomes a really big number. And so this that is why Roth conversions matter a lot. another another reason why Roth conversions matter a lot is because you have like, and now let me let me actually share my screen. I'm gonna share my screen on this one. Give me a second. I'm gonna show you a chart. Because another reason why Another reason why they matter. Is this so y'all can see my screen? So there's certain limits that when you're doing Roth conversions that you have to be strategic about, right? So IRMAA is one of them. And so there's there's there's there's a there's an income limit that you have to make sure you stay within because even if your Roth convert if your Roth conversions go over your well, not your Roth conversion, but your total your total income goes over a certain amount, then it can push you into higher higher Medicare payments. Right. So 218 as of this year is is is a threshold that you want to try to stay below if possible. Right. That's one of the thresholds. Another one is the senior deduction that, and these are just little things that we try to pay attention to if you're close, right? Is $150,000 in income, you get a six thousand dollar deduction if you under that. So it's one of those things you also want to make sure that you that you want to stay below when you're doing your Roth conversion planning. And then also just reiterating back to what I was saying earlier, your social security is only taxed up to 85%. Right. And so those are some things that you just want to think about when you're thinking about Roth conversions. because you know, you know, you just you just want to make sure you stay but stay if you can. Sometimes sometimes it doesn't make sense to. If you if you if you have, you know, like that couple's case, if you have millions of dollars. They have to do this because even if they go over there, it doesn't even matter to them because they can afford to pay it. Right. So for them, it num and they have to convert a bunch of money. And so for them, it's not that big a deal. For others, it is a big deal. And I don't know where everybody is on this call, but for others, it is a big deal. They want to stay below a certain amount because they want to they want to pay more. they don't want to take money out of their TSP for income for that for that, for for to pay that. So it doesn't make sense. Again, again, that's case by case. But these are some of the things that you risk just not understanding when you're just doing it all by yourself. You want to make sure you understand where you are. and you know, I want to show this slide just again, reiterate what I was saying earlier about how to time it. And so the last year, last year is a working, probably not a good idea because you're at your highest earning years. And then if you're making, you know, 120,000 or so, Y'all got it good as federal employees. Because here's the thing we talk a lot of times to people that are not federal employees. And a lot of times their salary is less, way less. You know, we don't, we don't, and I say we talk because we deal mostly with federal employees. We're dealing with spouses and things like that. But without fail, like the federal market, federal government market has been good, especially to our people. And so I just want to commend y'all for that because we're talking these salaries. I know I'm throwing these salaries out, but this is normally where people are, right? And that hundred. 140, 150, and we'll be above, like that's where we are, right? And so when you're in that, when you're in that, when you're in that income bracket, you know, you're you're already in a in a in a decently higher tax bracket. You're not in the 12 and 10% bracket. You're in a higher tax bracket. And so if you take another 100,000 or so and you're converting that while you're working, that money that you convert is goes goes on your taxable income. And so that could push you into those higher brackets. So you want to just be mindful of that. It's not as simple as I'm just going to transfer this money over there. It has rec repercussions. Okay. And so there's no point in paying the IRS more when you can pay them less for the same thing. And so one thing you can do if you're still working though, is you can you can you can you can start contributing more to your Roth Tsp. By just simply going into your payroll system and changing that contribution. That's something you should do. But converting that money is is is not always the best thing. But you have those, that window. That window is when you retire for some until you start taking social security, or when you retire until RMDs. Some people just they need to take social security. That's fine. That's most people actually. Take it as soon as you retire. You take your social security too. And then you start converting at that point, but at that point, you're still you're still below where where you would be if you were working, right? And so you just want to make sure you get it during that time frame. here's a chart though that we also created for doing Roth conversions inside of Tsp versus outside. Again, just talking about that withholding piece makes a big difference. If you got a lot of cash, sure you can make it work with the Roth conversions. Outside cash, but most people don't. And so that's why most people want that money withheld, just so that money can grow and it's out of sight, out of mind. But now you have a ton of money that's tax-free, ends up saving you and your family hundreds of thousands of dollars. So, and so for us, you know, okay, here's another example that that's that's clear of like what a $200,000 conversion looks like while you're working versus not, right? $200,000, somebody in the higher 24% tax bracket will end up paying fifty-six thousand. Somebody converting two hundred thousand in the lower bracket, which a bunch of money in the lower brackets is around two four with with a base income of fifty thousand, the tax is owed to twenty-four thousand. It makes a huge difference what bracket, how much you are in of each bracket makes a big difference when you're doing those Roth conversions. And this this this was pulled from a real example from our retirement analyzer system. It's just all about All all about timing. And so you know, for us, we we we take everything back to our financial house model, which is all about you wanna have these and what is what we notice over time is when we're dealing with retirement plans, it's we want to make sure people have a foundation where they have their protected money. That's money you will need in an emergency, that's the right amount of income you need. All that stuff needs to be in a protected bucket. Then we have we call our walls. This is where what we're more so talking about. That's not really, it's not really money per se. It's strategies around money. So you want to make sure you're insulated from high taxes, you know, the older you get when it comes to RMDs, when you're leaving your leaving your spouse. And that's one thing we we don't talk enough about. And we see it though, is when when somebody passes, you or your spouse passes, you go from married filing jointly to filing single. And when you file single, the tax brackets are different, right? The the lower tax brackets are smaller, you know, and so I mean a bigger and the lar the the the the the the the I mean sorry the small tax brackets are smaller and the bigger tax brackets are bigger. And so you could be, you know, when you're married in a 22% tax bracket, but then when you're now when you're filing single and you have all this cash that you have to do RMDs on, you're in the 32% tax bracket. And we've seen that. And so just because the money gets transferred to you doesn't mean you s your taxes stay the same. It changes. Your Medicare premium pay payment changes. Like all that stuff changes. And so and then and so that happens with the spouse, with the single spouse, but also happens even more significantly with your kids because of that 10 year rule. And they're still most kids are when their parents pass or are still in their higher earning years. And so now you have all that there. And that we've seen that one even higher. So You know, we want to make sure you have a strategy on that tax side. And then the last part we talk about is is the roof. And the roof is what you've been doing if you've been working your whole life, right? If you've been working your whole life, you should be actively putting money in your TSP. if you're more than two years out from retirement, you should be doing it in C S and I or somewhere that some mixture of that, you know, aggressive, aggressive, aggressive. Two years before retirement, you start scaling it back because, you know. Over time the market does do well, but the the thing that you don't want to be is retired and all of a sudden the market has a dip because you might not have time to recover. If you're working, you still have time to recover. So playing it riding the brakes while you're working, it can really put you behind. But if you're working, you can go full throttle. And then the closer you get to retirement, you can kind of start putting the brakes on a little bit. But you still at all, you still at even in retirement, still want to have some money in growth, especially you are as I talk about all the time. You as federal employees, because you don't need your TSP for income, like the private sector. And so you all can afford to take more risk than than most. And you don't want to put everything at risk, but you still want to have some there.