It’s hard to believe that half the year has gone by already, and while summertime is perfect for going on family trips and sunbathing, it’s also a great time for some mid-year tax planning. Yes, I know, taxes, everyone’s favorite topic.
Although you may not enjoy reading through your 1040 or your 1099s, you will enjoy a smaller tax bill, and that’s what this 4-part series is all about. Specifically, the next 4 articles will cover tax planning tips for federal employees.
And while I can’t give you tailored financial or tax advice since I don’t know your unique situation, what I can do is share some general tax planning strategies that most federal employees will be able to use to hopefully lower their tax bills.
So, without further ado, let’s jump into this week’s topic, which happens to be the easiest to implement, maximizing your TSP contributions.
Why Maximize Your TSP Contributions?
Contributing to your TSP is a no-brainer. Not only is the TSP a critical part of your retirement plan, but if you’re not contributing, you’re missing out on up to a 5% match!
But when it comes to tax planning, contributing to your traditional TSP reduces your taxable income for the year, which means a smaller tax bill. This is how it works; since you make TSP contributions via payroll deductions, your contributions are made before taxes are taken out of your pay. These pre-tax contributions provide an upfront tax benefit by deferring taxation until your funds are distributed in retirement.
This means that in 2022 you could contribute up to $20,500 to your traditional TSP ($27k if you’re 50+) and reduce your taxable income by that amount.
Also, by reducing your taxable income, you may become eligible for additional tax deductions and tax credits that have adjusted gross income “phase-outs.”
What Might That Look Like?
Let’s look at a simplified example; Bob is a married federal employee who files a joint tax return and has taxable income for the year of $100,000, which puts him in the 22% marginal tax bracket.
He is on track to have a federal tax bill of $13,234. However, if he were to contribute $20,500 to his TSP, his tax bill would be reduced to $9,129. That’s a tax reduction of over $4k!
Now granted, it doesn’t make sense for everyone to save $20,500. For some, saving the maximum allowed is not necessary to meet their retirement needs; for others, it’s just not possible given their cash flow.
However, assuming you have already established your emergency fund, you should contribute at least enough to get the full match, which is 5%.
End Of Year Deadline
While most federal employees know that they must fund their IRAs before they file their tax return or April 15th, you only have until December 31st to make your TSP contributions.
So, if you plan on increasing your TSP contributions, you’re better off starting as soon as possible to spread them throughout the year.
Additionally, the sooner you get your money into the account, the sooner it has the potential to grow tax-deferred.
Maximizing your traditional TSP contributions can significantly reduce your current tax bill and set you on the path to a fruitful retirement. However, it’s important to note that your distributions in retirement will be fully taxable at ordinary tax rates.
Therefore, you must compare the traditional TSP’s current tax benefits against the Roth TSP’s benefits to determine which account or combination of the two will reduce your taxes the most over your lifetime.
You can read about the differences between the traditional TSP and the Roth TSP here.
Lastly, because tax and retirement planning isn’t something you can wing and require careful ongoing analysis, if you need help or aren’t confident running your own analysis, consult a fee-only Certified Financial Planner™.
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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.