TAX RECOVERY FOR THE TSP

One of the things I noticed about being a government employee is that the IRS knows everything you are doing with your money.  You can’t hide income.  You can’t put money in a Swiss bank account and act like the IRS won’t find it.  They will!

As a middle class person, you don’t have many options to find a tax shelter.  That is always the problem with being middle class.  You live pretty well, you can buy a house, you can take reasonable vacations, but you can’t escape the taxes.  The IRS knows pretty much everything you are doing with your income, TSP, banking, investments, etc.

I found one way to shelter your TSP money.  This would be for people that are getting very close to retirement or are actually retired.  This is called a Conversion.

Suppose you have $500,000 in your TSP and you are about to start your grand adventure in retirement mode.  It doesn’t matter if you have a job after retirement or not.  What matters is your ability to set things up right, from the start of your retirement.

You start taking out money from your TSP for expenses.  The money starts showing up in your checking account and you are on your way to Hawaii or Tahiti.  Life is great.

However, you start to notice that the taxes you paid when you made your distribution request to TSP are gone forever.  Well you have to pay bills, I get it.  Maybe you have to pay off your house or the kid’s student loans.  No problem.  But what about all that tax money you had to pay.  What can you do?

You open a Roth IRA.  As soon as possible.

Let’s say you need $2,000 per month from your TSP for expenses.  That goes straight to the checking account.  Then you also take out another $2,000 a month and that goes to your Roth IRA.  You still have to pay taxes but here is the plan.  You are putting money back into the Roth IRA and investing in the same funds or even maybe a fund with a little higher rate of return.  As you do this over time your Roth IRA will start to grow, a lot!

The actual taxes you pay on your $2,000 a month going to the Roth IRA is about $400 if we use a 20% withholding.  If we multiply the $400 a month by 12 months that turns out to be $4,800 per year in taxes.  Then multiply the $4,800 by 25 years, then we have about $120,000 in physical money taken for taxes over that time period.

But the actual opportunity loss from these taxes is not $120,000.  It actually grows to around $500,000!  That is the money you lost over the 25 years because you couldn’t keep that money to invest back into the TSP or any other accounts.

So the idea here is very simple, yet incredibly efficient.  Over time, you could be looking at over a 200% return on taxes you paid.

This procedure comes with a few caveats:

First, the Roth IRA is to accumulate wealth.  You can spend it later, much later, but in order for the account to grow you have to leave it alone.  There are no Required Minimum Distributions (RMD) with the Roth IRA.

Second, the rules say you have to have a Roth IRA for 5 years before you can spend any of the money in it.  This actually makes sense.  If you are not going to leave this money alone for 5, 10, 15, 20 years, then you probably shouldn’t be using the Roth IRA.  It will not grow well if you start pulling out money too soon.

Third, the rules say you have to be 59 1/2 to get access to the funds in the Roth IRA.  So if you retire at 50 and you put money into the Roth IRA, you can’t get to it until you reach 59 1/2.

Fourth, the idea is to take out a certain amount of money from your TSP but not to take out so much you are putting yourself in the 32% - 35% tax bracket.  I would say most people could probably put between $36,000. - $48,000 per year into the Roth IRA without hitting that threshold of $32% which is around $383,000.

What also matters here is whether both spouses work.  If between the two of you, your income is getting to $330,000, then the $36,000 - $48,000 limit would just make it.  If only one spouse works, then you can probably get away with putting $60,000 or even $72,000 a year into your Roth IRA.

The idea is not to take out $150,000 or $200,000 per year and blast into the next 2 highest tax brackets!

Over time, you will start to notice something very pleasing.  After 5 - 10 years, when you add the amount remaining in your TSP and the amount in your Roth IRA, you will start to notice your money doubling.  This is really a function of three things:

The rate of return you are getting from the funds you created in the Roth IRA.

a.  Maybe it’s the same as your TSP, maybe more aggressive, maybe more passive.  But really, you want to be a little aggressive and treat it like when you were working and putting money into the TSP.  That’s the whole point.  This is a growth strategy.

How much you put into the fund.

How much you take out of the fund.

Some people want to use the fund for some future expenditures.  Some want to leave it to their kids or loved ones.  That really doesn’t matter.  The main thing is you leave it alone until absolutely necessary.  Use your TSP for expenses.  Use your Roth IRA to move into another tier of affluence.

And if you don’t need any money from your TSP because of a new job, then you can still start putting money away, again with the limits on your income tax bracket.

One final thought.  It seems the Congress keeps coming up with ideas to balance the budget.  So they start making changes to existing laws about FERS or TSP or come up with brand new ones.  Maybe one day they say you can’t do Conversions to a Roth IRA any longer.

So okay, you can’t use the Roth IRA.  So what. You can create a Brokerage account, with the same people you would use to create a Roth IRA.  Very simple.  Then you  direst your payments into your Brokerage account.

There are some caveats to this fund too:

The Brokerage account is not a retirement platform.  There are no limits as to how much you can put into the account.  Much fewer rules and perhaps more flexibility. There is no 5 year rule before you have access to the money.

Your money grows the same way with the same funds. 

You will pay capital gains tax of 15% on the EARNINGS from the Brokerage account when you pull your money OUT.  So this is very significant.  Most middle class people or Government employees pay in the 22% -24% tax bracket.  Especially if both spouses work.  This is a very tax efficient procedure.

Think about this.  You are making a middle class lifestyle and you are taking money out of the Brokerage account and only paying 15% on additional money.  And remember, that 15% is on the earnings from the Roth IRA, not all the capital you put into it.  The money has to be in the Brokerage account for one year to qualify for the 15% capital gains tax.

So in the grand scheme of things, the Roth IRA is still the best alternative if you use this plan because it’s all After-Tax. But for whatever reason, if you can’t do it, then the Brokerage account comes in a close second as the next best option.

But the basic rules still apply, whether you use a Roth IRA or Brokerage account.

a.  Make consistent payments into the account and obviously watch the tax brackets.

b.  Invest the money like your TSP or higher rate of return.

c.  Don’t touch the money.  Start with 5 years (you really can do 5 years), then move to 10 years, then 20 years, maybe 30 years.  What’s your plan or timeline?

d.  Only take out enough from your TSP to convert so that you don’t start going into the 32%, 35% or even the 37% tax brackets!

This is just like when you were working and putting money into your TSP.  You set it and forget it.  The rest is up to time.

Good Luck!

Peter