As a federal employee, there are some major advantages to contributing to the TSP, such as having the choice of making pre-tax (Traditional TSP) or/and post-tax contributions (Roth TSP). Being able to select how you want your contributions treated for income tax purposes is a powerful tax planning tool, but what if you decide to change your retirement savings strategy? What if, after years of contributing to the Traditional TSP, you now decide to contribute to the Roth. Can you transfer your funds from the Traditional to the Roth account? And why would someone want to employ this strategy? These are the common questions surrounding the Roth TSP that I come across. So, in this article, we’ll review the answers to these questions.
What Is The Roth Conversion?
First, what is a Roth conversion? A popular strategy, especially amongst those with Individual Retirement Accounts (IRAs,) that involves taking all or part of the balance of an existing Traditional retirement account and moving it (or convert it) to a Roth account.
Why Do A Roth Conversion?
There are a few reasons, chief among them is managing taxes: Withdrawals from Roth accounts in retirement are tax-free if you satisfy the Internal Revenue Services (IRS) requirements. Other advantages include minimizing required minimum distributions (RMDs); although both the Traditional and Roth TSP are subject to RMDs, if you roll your Roth TSP to a Roth IRA, you can avoid the RMDs. Another benefit of a Roth conversion is avoiding or reducing the amount of taxes you’ll pay on your Social Security. Because the extent to which your Social Security income will be taxed is based on your taxable income, taking non-taxable Roth distributions in retirement can reduce or eliminate the amount of tax you’ll pay.
A crucial point to be aware of is that Roth conversions are no free lunch. Meaning you’ll generally owe ordinary income taxes on the amount you convert in the year you make the conversion. So, you should proceed very cautiously when considering a large conversion in a single year because you risk moving into a higher tax bracket, and the additional income that year can have other repercussions.
Can You Convert Your TSP?
Now that we’re familiar with the Roth conversion strategy and why you might want to employ it, let’s review whether you can convert your TSP to the Roth? The bad news is the answer is no; there is no option for an in-plan conversion. However, the following two options might work for you:
- Contribute to the Roth TSP: Although the TSP does not allow conversions, it does allow you to change the tax status of your contributions from Traditional to Roth, which will affect your contributions moving forward.
- Transfer to an IRA and convert: Another option that might be appropriate for you is to transfer funds to an IRA. If you are separated from service or over age 59 ½, you can make a direct transfer and move a portion of your TSP to an IRA and then convert those funds to a Roth IRA. If you’re thinking about transferring your TSP to an IRA, make sure to read this article covering the things you need to consider before transferring.
Planning Tip: When considering a Roth conversion remember the words of caution mentioned earlier. The funds converted are taxable in the year of the conversion. Hence, it is usually better to spread the conversions over several years and be strategic when selecting which years to perform the conversion. If you know there will be a year when your taxable income will be lower than usual; perhaps your spouse retires before you, and your income drops, then it might be the right year to do the conversion. Or maybe there’s a decline in the market, and you anticipate the market will recover in time, then it might be the right period to perform the conversion.
Although the TSP does not allow conversions, you have other options if you decide that contributing to the Roth is a better strategy. Remember that the decision of whether to contribute to the Traditional or the Roth account hinges primarily on your tax rate now versus later and the tax bill you’ll have to pay if you convert. And although we didn’t cover it, there are some estate planning issues to consider when making the comparisons between the two accounts. Lastly, everyone’s situation is unique, and I encourage everyone to consult with a tax or financial advisor who can help you weigh the tax consequences before employing the Roth conversion strategy.
Want To Make Smarter Financial Decisions?
Start on your path to financial freedom by getting our monthly articles full of tips on maximizing your benefits and making smart financial decisions, plus the occasional freebie.
2023 Legislative Change Notice
The SECURE ACT 2.0 passed and impacted many of the articles on this website. While the articles were correct when written, it’s impossible to re-write every article. Please consult a qualified professional (i.e., CFP®, CPA, or attorney) before implementing any strategy.