This is a series intended to answer the question “I’m covering my bills, now what?” It’s for people who have a steady source of income and have a vague notion that they should be doing something more with their money, but don’t really know how to begin. This will go through what to do with that money post-bills, from setting up an emergency fund, to debt management, retirement, and investment. Although most of this information is applicable to civilians, we’ll also be providing resources and information specifically geared toward military servicemembers and their families.
I want to begin by giving any civilian readers a head’s up that unless you are a civilian federal employee, today’s post is going to apply only to members of the military and their kin. However, I hope any civilian readers continue to check back to Finances & Fatigues as the majority of our posts apply to civilians as well.
Through this Getting Started Series, we’ve covered setting up an emergency fund, debt management, and retirement accounts. In the last post on retirement accounts we covered a lot of ground with the different tax treatment options, IRAs, and the most common retirement plans, such as a 401k. However, the TSP doesn’t get its share of the limelight in most personal finance, probably because the military is currently such a small percentage of our country’s population. However, the TSP is truly an amazing deal and in my opinion one of the better financial advantages from the military. Davin frequently laments that he wished he knew about it sooner and could’ve invested in his TSP through his four years of medical school. So we are going to give the TSP its moment in the sun today- both to display why it’s so awesome and to raise awareness about it.
What is the TSP?
TSP, or Thrift Savings Plan, is the retirement investment plan available to all federal employees, including military servicemembers. It works very similarly to a 401k in that it automatically deducts from your paycheck, has contribution limits, and has age restrictions.
One of the beauties of the TSP is its high contribution limit. An IRA, for example, currently has a contribution limit of $5,500 up to age 50 and then $6,500 until age 70 ½, at which point you are no longer eligible to contribute. But the TSP has a contribution limit of $18,000 up to age 50, at which point you can contribute an additional $6,000 per year for a total of $24,000. That means you have the option of putting at least 3 times as much money into a retirement account as you could on your own!
So what are the tax treatment options?
Traditional (Pre-tax): This is the federal equivalent of a traditional IRA or a 401k. This money is “tax-sheltered”, meaning that it’s withdrawn from your paycheck before taxes. You pay taxes on this money once you withdraw it in retirement.
The benefits of a traditional TSP:
- A traditional TSP could keep you in a lower tax bracket. This link shows you the tax brackets for 2015. Let’s say for example that a married couple is earning $80,000 combined, thus placing them in the 25% tax bracket. The bottom floor of this bracket is $74,901. If we subtract $74,901 from $80,000, we find that $5,099 of their earnings is being taxed at the 25% tax bracket. According to the linked table, this couple would pay $10,312.50 + 25% x $5,099 for a total of $11,587.25 in taxes.
Instead, that couple could invest $5,100 into a traditional TSP. This would lower their taxable income to $74,900 and keep them firmly in the 15% tax bracket. By being in the lower tax bracket, the couple would pay $1,845 + 15% x ($74,900- $18,450) for a total of $10,312 in taxes. They saved over a $1,000 in taxes, plus they now have $5,100 accumulating interest in their TSP. Yes, they will have to pay taxes when they withdraw that money in whatever tax bracket they are in. However, that money is accumulating compound interest and growing rather quickly. Additionally, those who invest in a traditional TSP assume that they will likely be in the same or a lesser tax bracket when they retire.
- Because it’s not taxed, you are putting more money into the account as compared to a Roth, so with compound interest the traditional TSP grows more over time.
Let’s assume that you are a married couple earning $100,000 annually and in the 25% tax bracket. Let’s also assume that you are putting $10,000 a year into your TSP. If you put it into a traditional account, you are placing the entire $10,000 into that account since it hasn’t been taxed yet. Using a simple compound interest calculator (http://investor.gov/tools/calculators/compound-interest-calculator), and assuming 30 years and a 7% interest rate, we can see that the money grows to $944,611.70. On the other hand, if this couple chooses the Roth option, they are paying their taxes first, so they are only investing $7,500 annually. Over 30 years, this would only grow to $708,463.51. Yes, they would still have to pay taxes on that $944,611.70 once they take withdrawals. However, they may be in a lower tax bracket at that time as they will be retired and therefore come out ahead of the Roth option.
- Your paycheck reduction is less than the money you are investing. Imagine that your paycheck is $2000 and that 25% is withheld for taxes. This means that you take home after taxes $1500. If you choose to contribute $200 per paying period to a traditional TSP, your taxable income drops to $1800, so after taxes you take home $1350. Even though you are contributing $200 to your retirement account, your paycheck only dropped by $150.
Roth (Post-tax): This is the federal equivalent to a Roth 401k. This money is taxed now, so you don’t pay taxes on it in retirement. Unlike a Roth IRA, with the Roth TSP you will have to pay an RMD, a required minimum distribution. This is the amount that you have to start withdrawing at age 70 ½ .
The benefits of a Roth TSP:
- You pay the taxes on this money in your current tax bracket, versus whatever tax bracket you end up in once you make withdrawals. For people who expect to earn much more income later, such as medical residents, Roth is a good choice. This is because a single resident earns somewhere between $40-50k annually, placing him or her in the 25% tax bracket. However, later in life the medical resident will become a staff physician and most likely land in the 33% tax bracket with an earnings of $189,301- $411,500 annually. Therefore, it’s beneficial for someone in this situation pay the taxes while they are in a low tax bracket rather than later in life when they are in a higher tax bracket.
- Since you already paid taxes on it, you don’t have to worry about your withdrawals affecting your taxes with your other sources of retirement income, such as pensions, a second job, or other traditional retirement accounts. Davin and I expect to earn pensions from our careers, most likely netting us about $90,000 annually, although this number fluctuates a lot as policies change and I’m unsure how many years I will get toward my pension due to PCSing. We also will be withdrawing RMDs (those required minimum distributions that the IRS mandates you withdraw from your accounts) from our traditional accounts, as well as paying taxes on our taxable brokerage accounts. While the Roth TSP also mandates RMDs, we don’t have to worry about overdrawing from our Roth accounts and putting ourselves in a position where we are paying more taxes than necessary.
One option is not better than the other; it just depends on your circumstances. While a traditional TSP is a better option for most individuals who will probably be in a lower tax bracket in retirement, we personally favor a Roth heavy portfolio and have a post planned at a later date explaining why we invest so heavily in Roth accounts. You can also use this calculator from the TSP website to aid you in choosing a tax treatment option.
Once you choose your tax option for your TSP, the next step is to choose how to allocate that money. The expense ratio, or the amount of fees charged for administration of the account, is essentially the same across the various TSP funds. And in fact, the TSP has the lowest expense ratio I’ve ever seen (just 0.029%) making it an even more awesome option! This means that all you need to worry about are your particular needs and goals since the cost is the same no matter which fund you choose. You can also split your TSP into multiple funds in order to bring more balance to your portfolio.
The L fund, or Life Cycle Fund, is essentially a target fund. It automatically adjusts from more risky to more conservative over time as you approach your estimated year of retirement by varying the levels of investment in the G, F, C, S, and I funds. This is ideal for people who take the “set it and forget it” approach to finance. (You can find the exact allocations here.)
The G fund, or Government Securities Investment, is comprised of bonds and is guaranteed by the U.S. government such that it will not lose your principal investment. This is a very low risk investment, and while you are guaranteed not to lose your money, you also should not expect to make much money.
The F fund, or Fixed Income Index Investment, is slightly riskier than the G fund, but still a relatively conservative investment. This fund is essentially a bond market index fund, meaning that is rises and falls with the bond market as a whole. Like the G fund, you shouldn’t expect to lose or make much money as compared to the other funds that invest in stocks. (See Part 5 for an explanation of bonds and Part 6 for an explanation on index funds.)
The C fund, or Common Stock Investment Fund, is considered a moderate investment fund. It essentially tracks the S&P 500. The S&P 500 is a sample of 502 companies that reflect the American market and the index fund purchases a weighted amount of each of these funds. The S&P 500 typically reflects the market. And since the market always grows in the long term, so does the C fund. (See Part 5 for an explanation of stocks and Part 6 for the S&P 500 and index funds.)
The S fund, or Small Capitalization Stock Index Fund, is a moderate-high risk investment fund. This fund tracks the Dow Jones U.S. Completion Total Stock Market. This does not include the S&P 500, so it includes less tried and true companies and may include more up starters, which may or may not pan out.
The I fund, or International Stock Index Fund, is another moderate-high investment fund. This fund tracks the international stock market, including Europe, Australia, and the Far East. It is an index fund so it will rise and fall with the market of those countries. However, currency and the relative value of the dollar compared to the British pound or the Australian dollar come into play here which in my opinion makes this fund riskier than the S or C fund because not only are in investing in the overall stock market of a foreign country, but you are also investing in their currency as compared to the value of the American dollar.
Generally speaking, the G fund and the F fund are more intended for maintaining wealth, whereas the C fund, S fund, and the I fund are geared toward building wealth. The L fund is the “set it and forget it” of the fund options and automatically adjusts as you approach retirement from wealth building to wealth maintenance. So depending on how close you are to your retirement, decide if you are in the wealth building or wealth maintenance stage and choose your fund appropriately.
My personal recommendations would be the F fund, C fund, or L fund. This is because I’m a huge proponent of index funds. The F fund is an index fund of the bond market while the C fund is an index fund of the S&P 500, covering a large piece of the stock market. With these two funds you basically own a little piece of the market, and since the market always goes up, your investment will as well. We will cover index funds at length in Part 6 of this series. Additionally, I recommend the L fund because it’s the simplest option for the everyday person. Usually life cycle funds like the L fund have more expensive expense ratios (to be discussed in Part 8 of this series).
For more information, click here for a handy little pdf produced by the government that goes into more depth about the TSP.
With high contribution limits and low expense ratios, the TSP is an excellent retirement account. I highly encourage all military families to do their best to contribute as much as they can. A pension is nice- but controlling your own financial destiny through investing is better.
Next week we will finally get to an introduction to investing, where we will look at different ways to invest and explain stocks and bonds.