An overwhelming number of federal employees that come to me for help have most of their retirement assets in a tax-deferred account, meaning the traditional Thrift Savings Plan (TSP) and/or a traditional IRA.
And while saving diligently in your TSP throughout your career is a great thing, using other account types to build diverse tax buckets can help lower your lifetime tax bill.
So, this week we are discussing the three types of accounts that most federal employees should consider using when saving for retirement.
The Three Tax Buckets
Similar to how diversification reduces your investment risk, spreading your money across diverse tax buckets can reduce your long-term tax bill.
This is why most federal employees should consider saving in tax-deferred, tax-exempt, and taxable accounts.
What is a tax-deferred account?
This is the account type that most federal employees use when saving for retirement. Tax-deferred accounts, such as the traditional TSP or IRA, allow you to reduce your taxable income by either contributing to your account with pre-tax dollars (TSP) or by granting you a tax deduction for your contributions (IRA).
This reduction in taxable income provides an upfront tax benefit by deferring taxation until your funds are distributed. Hence, these accounts are often referred to as “Tax Me Later” accounts.
The key thing to remember is while your contributions and earnings will grow tax-deferred, your distributions from these accounts are fully taxable at ordinary tax rates.
What is a tax-exempt (aka Roth) account?
Roths, such as the Roth TSP and Roth IRA, allow after-tax contributions and tax-free withdrawals. You pay taxes upfront contributing to your Roth with money that has already been taxed.
Once in your Roth, your contributions grow tax-sheltered, and if you meet certain IRS requirements, your withdrawals are tax-free in retirement.
Roths have various other benefits that you can read about here.
What is a taxable account?
A non-retirement brokerage account is an example of a taxable account. These accounts don’t have any tax benefits, but they offer fewer restrictions and more flexibility than tax-advantaged accounts such as your TSP or IRA.
Unlike retirement accounts, these accounts allow you to withdraw your money at any time, for any reason, with no penalty.
If you hold an investment for less than a year, the gains will be taxed at your ordinary income tax rate. However, if you hold the investment for at least a year, you’ll pay the more favorable long-term capital gains rate, which ranges between 0%, 15%, or 20%, depending on your income tax bracket.
These accounts are called taxable because any increase in value or income from your investments is taxed during the year you experience them. For instance, when selling a stock at a gain or receiving dividend payments.
Why Use All Three?
If you’re a regular reader, then you’ve heard me say this plenty of times; as a FERS federal employee, you have great retirement benefits. These retirement benefits, including your FERS pension, Social Security benefits, and any traditional TSP withdrawals, will, however, be taxed at your ordinary income tax rate. Meaning no preferential treatment.
This is why diversification will be critical to leveraging the other account types and lowering your tax bill.
Read this article to learn more about how your FERS federal retirement benefits will be taxed.
For instance, in years when you need to take a larger withdrawal, say for an additional vacation or home repair, withdrawing the extra monies from your traditional TSP might bump you into the next tax bracket creating a larger tax liability.
If, however, you took the withdrawal from your Roth TSP or Roth IRA, you would get the additional cash without moving into the higher tax bracket and incurring a larger tax bill. This is because withdrawals from Roth accounts are tax-free (assuming qualified distributions).
Additionally, suppose you had withdrawn the money from your taxable account. In that case, you could also have avoided the bump into the higher tax bracket since the withdrawal would have been taxed at the long-term capital gains rate (assuming a holding period of at least a year).
These two examples, although simplified, demonstrate the optionality available to federal retirees when they build diverse tax buckets.
Although diverting some of your retirement savings to accounts other than your traditional TSP or IRA means you will sacrifice some tax benefits now, the financial flexibility you create could be invaluable in retirement.
While tax diversification is generally the right strategy for most, there is no right mix of tax-deferral, tax-exempt, and taxable account balances that works for everyone. Hence, the ideal combination will depend on your financial situation, goals, and current tax landscape.
Because tax and retirement planning aren’t a set it and forget it strategy, it requires careful ongoing analysis to determine whether new circumstances warrant a change in the approach. This is why it’s critical that you consult a fee-only Certified Financial Planner™ if you need help or aren’t confident in creating your financial plan.
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