He’s always there for you. The same time every year he greets you like an old friend, happy to see you. Is it jolly Saint Nick or the Easter Bunny? Guess again. He was excited for your birth, your first car, your first job, and like a faithful buddy he will be there at your death. The old pal at your door arrives at tax time every April. Sales tax, property tax, and income tax are just a few of the forms he appears in, but he never forgets to stop in to say hi. For the federal employee, this friend has a keen interest in your Thrift Savings Plan (TSP). Let’s examine when he will arrive and what you can do to deal with him.
TRADITIONAL VS ROTH
Federal employees have two options for the tax status of their TSP: traditional or Roth. In both instances you will pay TSP tax; however, the primary difference between a Roth and a traditional account is when you pay taxes. For the Roth, it’s at the time of contribution into the account, and for the traditional, it’s at the time of distribution from the account.
Traditional wisdom believed in deferring taxes until retirement to take advantage of lower tax brackets. The underlying assumption behind this principle is that tax brackets will be lower in retirement. So, is this the case for federal retirees?
TRADITIONAL TSP WITHDRAWALS
At the federal taxation level, taxes in retirement usually decrease when taxable income drops. For federal retirees, taxable income is generally comprised of a portion of a FERS pension, potentially a portion of Social Security benefits, and withdrawals from traditional TSP accounts. IRAs, 401(k)s or other investments can also impact taxable income.
Will your standard of living decrease in retirement? If you’re currently living on $3,000 a month, are you realistically going to be able to live on a number less than that in retirement? Say $1,600 for example. If not, this money will need to come from somewhere. If you withdraw from your traditional TSP in retirement to meet income needs, that money becomes part of your taxable income. Therefore, if your standard of living remains the same in retirement, then it seems likely that your taxable income will remain near the same level it was while working — unless you have tax-free funds to draw upon.
TAXES IN THE FUTURE
No matter how much we would like to, we cannot predict future tax rates. Even though there is a certain amount of uncertainty about future rates, a holistic retirement plan takes a deep look at how to mitigate the power of taxes. Understanding TSP taxes is a significant piece of the retirement puzzle for FERS retirees. Withdrawals from traditional TSP can impact your taxable income and potentially have a tax impact on your Social Security benefit.
Each retirement puzzle is unique. Different people have diverse goals, income streams, and hurdles to overcome. When considering TSP taxes, it may be wise to speak with a financial professional about your specific case. Whatever the future holds, it seems likely that your old friend tax will stop in to say hello, but this is not a relationship where you are powerless. Through careful planning you can have a say in when he stops by and how much he takes when he leaves.