Author – Joe Turkal, LtCol (Ret) USMC
Every active-duty military member or military reservist (while in active status) has access to the Thrift Savings Plan (TSP) program. Although some of the more tenured military members are still on the high-three retirement system, the great majority are now on the blended retirement system. All active military (henceforth in this article used both for active duty and reservists in an active status) can contribute to their TSP for the purpose of increasing their retirement savings and getting the benefits of tax-favored accounts. Those still on the high-three system do not get a government match to contributions, but those on the blended retirement system receive a government match into their account with each contribution up to specified limits. As such active military should be fully educated on the TSP, its benefits, its limits, and its shortfalls. Unfortunately, most do not have a thorough understanding of the benefit and worse, most do not even have a basic understanding. My intent with this article is to provide a thorough but simple description of the benefits of TSP with the information organized as account types, contributions, investments, loans, withdrawals and best practices from an active military perspective.
Account Types and Tax Treatment:
The TSP offers two different investment account type options. This is true of most retirement programs, including the most popular civilian sector program known as 401(k). The two types are pre-tax also referred to as traditional TSP and after-tax referred to as a Roth TSP. The main difference is in tax treatment, which is the main advantage of retirement accounts. In either the Traditional TSP or the Roth TSP the contribution is made automatically by the Defense Finance and Accounting Service (DFAS) based on the service member’s election, which is done in DFAS My Pay.
If a member chooses traditional TSP for contributions, the money is contributed on a pre-tax basis, meaning that earned income is not taxable income and goes directly into the service member’s TSP account. While in the account, the taxes are deferred until the money is withdrawn at a future date. Taxable income in that tax year is lowered by the amount contributed. There are two distinct advantages to this type of account, one being the lower tax burden in the year of contribution, the other having the ability to choose when to withdraw. Ideally one would choose to withdraw after age 59.5 to avoid penalties and when in a lower tax bracket, thus paying a lower amount of taxes on contribution and the growth. Another potential benefit is the ability to contribute more in comparison to a Roth contribution. Since a traditional TSP is a pre-tax account and the service member would have a tax burden in the year of contribution, this could leave room in the budget to increase the total contribution.
If a service member chooses to contribute to the Roth TSP, the money is contributed after tax. The contribution is still automatically deposited by DFAS; however, it is considered taxable income for that year. The member has chosen to pay his or her taxes on the contribution upfront, rather than deferring those taxes until a later date. The benefit to this account is that all the gains grow tax-free. So, in contrast to traditional, where upon withdrawal, one must pay taxes on the original contribution (principal) and the gains, in Roth, the taxes were paid on the contribution (principal), and all the gains are withdrawn tax-free when qualified after age 59.5.
Contributions:
Now that we have discussed account types, the logical question is what is advantageous for me, Roth or traditional? This is going to highly depend on an individual member’s situation. It requires a more in-depth financial analysis and outside the scope of this article, however I discuss it in depth in my article “When is it Advantageous for Me to do A Roth Conversion in my TSP?” When Is It Advantageous for Me to Do a Roth Conversion in My TSP?. Since the conditions for Roth contribution and conversions are virtually the same this article can provide a good insight.
In this article, I will discuss contributions to the TSP. Again, a member can choose to contribute to a Roth TSP, Traditional TSP, or a combination of both. For more senior members on the high-three retirement system, the government does not match any contributions. But for those on the blended retirement system, the government will contribute 1% of his/her earned salary per year (this salary only not BAH or other tax-free entitlements). So even if a member chose not to contribute at all the government will contribute 1%. The government will then match 100% up to 3%, and 50% up to 5%. In simple terms, if a member contributes 5% of his/her earned salary in a given year, the government will match with a 5% contribution. Here is an example, if the member’s earned salary is $100,000 per year and contributes 5% in that year ($5,000), then the government will match 5% (another $5,000). A member should not give up this benefit since it is a garenteed100% return on investment. There are some important caveats to be aware of. First off, though the members can choose to contribute to Roth or traditional, the government match will always be to the traditional TSP. Secondly, this is very important, the government matches up to 5% per month (with 1% automatic). So, in order to get the full government match, a member must contribute at least 5% each month (the practical approach is 5% per paycheck). If all $5,000 were instead contributed in January, for example, the government would match approximately $333 for the month of January and provide the 1% ($83) automatically. If the member does not contribute the remaining 11 months, the government does not match and only contributes 1% each consecutive month. This would result in an annual government contribution of approximately $1,330 instead of the $5,000 contribution if the member had contributed each month. Lastly, one more important caveat to be aware of, although all contributions by a service member and government matches are immediately vested (meaning non-forfeitable), the government 1% automatic contribution has a two-year vesting period. A service member must achieve two years of service before the 1% contribution is permanent. If that member leaves the service before the two-year mark, the 1% contribution is forfeited.
Investments:
The TSP offers service members 5 different investment classes as well as Lifecycle funds appropriate to one’s anticipated retirement time horizon. The 5 separate classes are as follows:
G Fund – Cash / Cash Equivalent
F Fund – Fixed Income (i.e. Bonds)
I Fund – International Stocks
S Fund – Small U.S. Company Stocks
C Fund – Large U.S. Company Stocks
TSP also offers Lifecycle funds. These are mixed portfolios of the funds defined above that automatically adjust risk and expected return over time, based on a target retirement year. Currently TSP offers L-2030 through L-2070. This is ideal for contributors who are not trained in investment portfolio construction, which is the vast majority of service members. To select the appropriate fund, a service member would project their future retirement date and select the L-fund that reflects the anticipated year of retirement. For example, if a service member intended on retiring in 2060, he or she would select the L-2060. The great feature about the Lifecycle funds is that they are automatically adjusted over time as one approach retirement (aggressive / volatile when the time horizon is long – – to conservative / less volatile with a short time horizon to retirement). This is a fundamental part of financial prudent planning, reducing risk/volatility the closer one gets to retirement (i.e. withdrawing funds). In practice it mitigates a poorly timed market drop just prior to and while withdrawing funds. Drawing funds when a portfolio drops in value depletes the portfolio much quicker than when the portfolio is growing, as such reducing volatility (i.e. a more conservative portfolio) reduces the drop and helps to preserve wealth. One nuanced, but very important point about choosing the appropriate lifecycle fund is when projecting your retirement date, military retirement date is only appropriate if your plans are to completely retire at that time and potentially access your retirement funds. This is not the case for most military retirees. So, the proper way to select the appropriate lifecycle fund date is to project the date you will retire from the work force or the date you will begin to draw your retirement savings for income. For example, if a military member projects military retirement in 2040, but intends to continue to earn income after military retirement until 2055, then the L-2055 would be the most appropriate lifecycle fund.
Loans:
TSP loans are a great opportunity for a relatively low interest rate. The rate is fixed for the life of the loan set to exactly match the yield of the G Fund on the date the loan is processed. The G Fund yield is essentially the same as the G Fund return. So, to find the current G Fund yield listed on TSP.gov, simply find the most recent monthly yield and annualize it. For example, at the time of writing this article the latest monthly yield was .37% so .37 x 12 (months) = 4.44%. The low interest rate is a great feature, but an even better feature of this loan is that the borrower is paying the interest back into their own TSP. Usually with loans the borrower pays interest to the lender, in this case the borrower, for all intents and purposes, is also the lender. The limitation on the TSP loan to up to one-half of the balance in the TSP account and limited to a maximum loan of $50,000. The $50,000 loan limit is inclusive of all loans, meaning a contributor can have more than one loan, but the limit of all combined loans cannot exceed $50,000. A borrower can choose the repayment period of 1-5 years for a general loan or 1 to 15 years for a residential loan.
Withdrawals, Separation, and Rollovers:
What are the circumstances of withdrawals and when are they permitted?
In-Service Withdrawals:
Age-Based – When a member is 59.5 year of age or older and still active. In this case there is no early withdrawal fee, and a member can withdraw part or all of the vested balance. If withdrawn and taxes are owed, then it will be considered taxable income. A member can execute a rollover to an IRA or another qualified employer plan. In this case again, no early withdrawal fees and it acts similar to a transfer, so no taxes will be owed until it is eventually withdrawn for income.
Financial Hardship – In this case the member is still active and can demonstrate a qualifying immediate need such as medical expenses, legal expenses, funeral expenses, disaster, negative monthly cash flow. There are requirements associated with hardship withdrawal such as it must be certified, it cannot be repaid, it is subject to income tax (if taxable), if under age 59.5, a penalty of 10% may apply unless an exception can be applied.
After Separation – After a member is inactive, a partial or full withdrawal can be made at any time. It is important to understand the rules for withdrawal before age 59.5 (or rule of 55, not covered in this article) do apply for penalty and tax purposes. However, a rollover to either an IRA or another qualified work sponsored plan can take place without penalty or tax implications (remember think of this as a transfer to a like account rather than a withdrawal).
Best practices / common mistakes:
- Best Practice: If the government provides matching, prioritize contributions to get the full maximum match. Common mistake: not contributing enough to take advantage of the government match; or front loading or lump sum contribution missing out on months of government matching (must contribute enough each month to get the full maximum match for a given year).
- Best Practice: Make sure that you are contributing to an appropriate Lifecycle fund to achieve diversification, automatic rebalancing, and appropriate risk based on your time horizon. Make sure to choose the lifecycle fund date that aligns with your workforce retirement date, not necessarily your military retirement date. Common Mistake: Setting individual investments in the different investment classes, then not rebalancing or reassessing time horizon; or when changing investment allocation, not setting the new investment allocation for both current and future contributions; or choosing a lifecycle fund based on projected military retirement rather than workforce retirement date.
- Best Practice: Choose Traditional TSP contributions if your current income and tax brackets are high and you expect your future income and tax brackets to be lower in retirement (typically describes a more senior member closer to retirement or a military retiree with a high income post military retirement, but prior to full retirement): or choose Roth contributions if in a relatively lower income and tax bracket than later in life (typically junior to mid-career member). Common mistake: Allowing the government’s preset contribution to continue without due consideration for Roth vs Traditional.
- Best Practice: (THIS IS THE MOST IMPORTANT TIP FOR THOSE WHO DEPLOY TO A COMBAT ZONE) Prior to deploying to a combat zone that will receive combat zone tax exclusion (CZTE), setting all contributions to Roth TSP. If the tax-free income received in a combat zone is contributed to the Roth TSP, all future growth will be tax-free, achieving the very rare occasion of receiving tax-free income, growing tax-free and withdrawing contributions and all growth tax-free in retirement. Common mistake: Deploying to a combat zone and not contributing to the TSP or contributing to traditional TSP. Even if you do not receive a match for contributions, take advantage of this very special situation of tax-free income; tax-free growth: tax-free withdrawal. If you contribute to the Traditional TSP in a combat zone, all the growth from your contribution will be taxable.
- Best Practice: Utilize a TSP loan up to one-half of your current balance to a maximum of $50,000 when needed if it provides a lower interest rate loan. Common mistake: Taking a higher interest rate loan instead of a TSP loan; or separating with a TSP loan but not setting up a direct deposit repay to TSP (prior to separation the repay is automatically drawn from salary).
- Best Practice: After separation or age 59.5, when withdrawals are needed transfer TSP accounts to an IRA and Roth IRA. Withdrawals from TSP are always pro rata (partially from traditional and partially from Roth), withdrawals from an IRA / Roth IRA can be done strategically to access tax-free or taxable funds when needed. Common mistake: Withdrawing from the TSP prior to age 59.5 for reasons that are not a qualifying event leading to taxation and penalties; or withdrawing from the TSP after separation or after age 59.5 directly rather than from an IRA limiting the withdrawals to a pro rata formula.
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