Latest / Federal Retirement Advisors | FedLegacy / Roth vs Traditional TSP: The Conversion Decision Most Federal Employees Delay
Transcript
- William Smith: Hey, what's going on, everybody? Hope everybody's doing well tonight. Today, we're going to talk about Roth versus traditional. Now, the question we always ask people when we're meeting with them is how much do you have in your TSP? And so when we ask that question, most people are like, Well, I got 500,000, I got 700,000, I got 100,000, whatever it is. And then I say, Well, what percentage of that is Roth TSP versus traditional? Most times people say, Well, I think all of it's in my traditional TSP. Then I say, Well, then that means of your 500,000, really, only 350 of that is yours. The rest is the IRSs. Why does that happen? Because with the traditional TSP or any traditional IRA, the taxes are not paid when you put the money in. You get a tax deduction when you put the money in. But what happens is That money, you pay the taxes, but you just pay it on the end. And so you get that tax deduction. It's great when you put it in. But then when you go to take the money out, the IRS gets the taxes on the back end. So that's how traditional TSP works. So you know you make a hundred thousand in in and and as a federal employee, you put twenty thousand into your TSP every year, or ten thousand ten, let's use ten thousand into your TSP every year, then your taxable income is ninety thousand dollars because you put ten thousand into your TSP. Now That tax is deferred, though. With the Rov TSP, that money, you pay the taxes going into that. And so then whatever you see is there is there. But if you make 100,000, you put 10,000 in TSP, you're going to get taxed on 100,000. That's the difference. But when it comes to that though, the TS the traditional TSP has been in existence since the 80s. The Rov TSP. just came into existence in two thousand twelve. That's why it's so new to so many people. But when it comes to and and one and one thing I also want to clear up, a lot of times people come in they like, well how what's the max I can put into my Roth, right? Because most people are can are are accustomed to having a outside Roth IRA. Now, when it comes to a Roth IRA outside of the government, there is a limit that's much lower. There's a lit the limit when you're outside of the government is eighty six hundred dollars as of today. It's $8,600 is the most you could put into a Roth IRA outside of the government. However, when it comes to your Roth Tsp, the only the same limit that you that your TSP has is the same limit that your Roth Tsp has. So if you're 50 and above, you could put 32,500 into your Roth TSP. Now, if you're 60 to 63, there's the there's a new rule that got into put into play recently where you could actually put 35,750. into your into your Roth Tsp or your traditional TSP. So in that 60 to 63, you're able to do the 35,750. Right. And there's no income limit cap. So that's a big difference. When you when you're outside Roth, there's a cap. Inside the TSP, there's no cap. It's the same limits that you could put with your traditional TSP. That's a big, big deal because now you're seeing people who since since it just started in 2012, You know, you you're starting to see people who have had their put and contributing money into their TSP for 10 years, 12 years, five years in some cases. And so they're retiring with these big Roth TSP balances, which is significant because it allows you to do a lot of things in retirement with tax free money. Very, very, very important. So the difference again between a traditional TSP and traditional and Roth TSP. is when you pay the when you take put the money in traditional TSP, you pay the taxes right away. I mean you do you you get a tax deduction right away, but that money you pay, you pay the taxes on the back end. When you put the money in the Roth TSP, you pay the taxes right away. There is no tax deduction. But if you put it in there and let's say your TSP grows to a hundred thousand, that hundred thousand, not the matching piece though, I want to get into that, but I'm just saying the hundred thousand that you contribute, all of that Taxes are paid. That hundred thousand can grow to a million. All that money you never have to pay taxes on again, no matter what it grows to. Super, super important. Super important to understand. And this is why a lot of folks do Roth TSPs, put money into the Roth TSP, because they just don't want the IRS in their in their business. Okay. So when it comes to Roth TSPs, I gotta explain the clock. I made a mistake. I was l I was listening to the call last week. I made a mistake. On somebody asked a question last week. If you start the Roth TSP, does that count with their outside Roth IRA as far as the clock goes? No, it does not. If you start your Roth TSP and you have an outside Roth IRA, those are two different clocks. So your Roth TSP clock is one clock, and and you have a and and let me explain what I mean by a clock. Anytime you put money into a Roth I Roth, anytime you start a Roth account, whether it's Roth Tsp, or Roth IRA. You have a five-year window. You have to have the money in there for five years before you can take it out and benef and and and and and reap the benefit of the tax, the tax-free growth. Okay. You have a five-year window. In that five-year window, you could take money out, but you won't, you'll get still get taxed on the growth, okay? But if you have a Roth TSP and you started your Roth TSP five years ago and then you retire and you start up a Roth IRA outside of the government, you have a fresh Five year window. Okay. Now that five year window is it will will will count for any raw other Roth IRAs you do you do outside of the government, but the you won't get credit for the Roth Tsp window. The Roth TSP is its own separate window. So I want to clear that up because I was looking at the recording this week and I was like, I misspoke misstep misspoke on that. The Roth IRA has its own window. Now, one caveat, and this is coming up a lot because of last year with Doge and people retiring early. If you are 55 and you retire and you want to start doing Roth conversions, that I mean you're before fifty nine and a half. Every conversion you do starts a new window until you turn fifty nine and a half. So let me give you an example. Let's say, let's say you convert a hundred thousand. Let's say you let's say you have five hundred thousand. You retired at fifty five and you wanna and you wanna convert a hundred thousand over to your Roth to your from your traditional IRA to a Roth IRA. That once you do that, that starts the five year conversion on that Roth IRA. But let's say a a year later you want to do another hundred thousand. Now that hundred thousand is a fresh five years. That continues until you turn 59 and a half. Okay. And the reason why that is, is because the government, the IRS wants to avoid people circumventing that 10% penalty. So you have to be you have to be 59 and a half. But once you turn 59 and half, that window stays the same. Now for any Roth IRA you you you do after that. So I so so just so we clear, right? And so and so that that's that's how that works when it comes to Roth IRAs in retirement. Now When it comes to one one of the driving points that that is pushing a lot of people to Roth IRAs is the fact that RMDs require minimum distribution. So required minimum distributions are important because at that point, well, it is an important thing to know about because once you turn once you turn 73, if you were born before 1959, then 73 is your window. If you're born 1960 and afterwards, Your window is now 75, is when you have to start paying taxes on your traditional IRA. And so one of the things we always talk about on these calls is you have a window when you first retire, especially if you had to retire after 62 or 59 and a half. Well, 59 and a half really. but most people retire between 59 and a half or 62, right? And that's why I use those two numbers. But when you retire, those ages. Your taxable income is less than what it was when you were working the year before. And so from that point until your RMD age, whether it's 73 or 74, 75, that's ideal time to start converting money into Roth IRAs because at that point, your taxable income is the least it's going to be. Why does that matter? Because the higher, the higher your it, the higher your TSP grows, and it will grow in most cases if you if you're investing it right, it will grow. As long as your income is going to grow too, because you're getting cost of living increases. And so once it comes time to do your RMDs, requirement of distributions, now you're forced to take income from the TSP. And when you do that, or large, but not even say income, but you're forced to take take withdrawals. And when you do that, that can push you into higher tax brackets. What does that mean now? Now you might have been in a 24% tax bracket. You now might go into the 32% tax bracket. That's significant because you also pushes you up a state tax, your local state tax plus your federal tax. Now you're paying 38% on on taxes on money you could have paid 22% in taxes if you would have done it earlier. And so you want to make sure that and and and the money that you paid the t the taxes on earlier, as that money continues to grow later on into life, it gets bigger and bigger and bigger and the taxes are done. We talk all the time about the 10-year rule with the kids. You know, you you're especially as your balances grow, it prevents your kids going into those forty percent tax brackets when you when you consider the federal plus the states. So it's a whole lot of benefits of taking advantage of what we call the TS the the the tax window from when you first retire to before you do RMDs. And you want to do it with some level of structure. and that's one area that we definitely will support you on. And so another thing when it comes to this topic. That's really important when it comes to Roth conversions, is you want to understand Irma and Medicare. Super important. And so when you're doing conversions, and why why I will advise you to seek some level of support when you're doing these conversions is if you're taking Medicare. If you're taking Medicare, especially Part B, there's an income limit, right? Now there's a two-year look back. And I get this question all the time when they talk about the two-year look back. What happens if I'm working and then I retire? Do they take the two years that I was working and and apply the premium to that? So they will if you don't do anything about it. And that's something that I've been I've been seeing a lot. And I've only had only had one person come to me with this already done. There's a form you can fill out. It's form SS44. SSA 44. And what it does, what it is, is this, especially if you if you're retiring this year, you want to make sure you look up this form, plan for it, so that you can get is it's considered a life changing event when you retire. Now they're not gonna reach out to you and tell you this, but they will they will they will take care of it if you submit the form. Oftentimes people just don't know to submit submit the form. I've like I said, I've only had one person come to me. And say, hey, I've already submitted this form. Most people wait till we have to tell them to submit the form to do it. And so if you retire, you qualify for a redo, right? And so what they do is they'll relook at what your fresh number is, not the two-year look back. Okay. If you retire, which which which you all are are doing, you just gotta make sure you do it. You have a cut back an hour. So let's say, let's say you're working in the government and maybe you You get a contracting job now. You didn't retire all way, but you reduce your income by significantly. That also qualifies. You don't have to be fully retired. You just took less pay, but you want to match it to the current pay, not the one twenty or one fifty that you were making in the government. You wanna match it to the lower pay that you're currently getting. That qualifies. If you get married, that matters. If you get a divorce, that matters. You just have to submit the form and it will match your They will they will match it to your your current reality. Now, what doesn't count though is if you do a hundred thousand dollar Roth conversion or eighty thousand dollar Roth conversion, that gets taxes income, and they see, okay, let's say you make a hundred thousand and you do a conversion of eighty thousand. Now your tax taxable income is one eighty, and you say, Well, but it's not really income. I just come I just transferred money from my Roth IRA. They don't care about that. That gets That gets calculated and that pushes you into that that higher ermor premium. So you wanna you wanna be careful when you're doing those or just it it just or or or plan accordingly income wise so that you know exactly what you're doing. I've seen people do it, try to undo it, like, shoot, I went a little bit over. And you just wanna make sure you understand what you're doing when you do it. 'Cause there's a whole bunch of little rules tied to it, like how much of the the tax bracket, Do you take up? What was your income before? There's a whole lot that goes into it. I won't go into it on this. But what I'm what I'm saying is you wanna make sure you have a plan when you're doing the Roth convergence, especially if you're taking Medicare. So and I'm not gonna be here to tell you that's next week's session where we talk more in detail around Medicare, FEHB. We go deeper into that stuff next week. But if you wanna book a call with us, that's some of the stuff that we go over when we're when we're talking about When we're talking about Roth conversions and things like that.