Invest after-tax income now and pay ZERO taxes when you retire! Sounds pretty enticing doesn’t it? This is the promise of the Roth Account whether TSP, 401(k) or 403(b). For some of you it makes sense. For some of you it doesn’t. Fortunately, there are some Rules of Thumb…
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If your tax bracket is lower now than it will be in retirement, then chose the Roth
- If you are above the threshold to contribute to a Roth IRA, contribute to the Roth
- If you don’t have a Roth Account you’ll pay a huge hit on taxes in retirement…so take the Roth
I’m guessing that you’re not Average, so why would you base a decision on a recommendation for the Average American?
Here’s my rule
It isn’t how much you pay in taxes…
it is how much you keep
Let’s look at a specific case. Suppose your employer offers matching on the first 5% of income contributed. Let’s say you have $7,500 of discretionary income and $7,500 equals 5% of your income. You can do one of two things with the $7,500.
- Invest $7,500 in TSP/401(k)
- Pay $1,875 in taxes (25% of $7,500) and contribute $5,625 to a Roth account
Which should you do? The rules of thumb above may lead you to the Roth TSP/40(k). But apply my rule and let’s see what happens.
In scenario #1 you’ll get $7,500 in matching funds. If we assume around 7% return for 20 year your contributions plus matching will equal $52,432. After you pay taxes (25%) on the $52,432 distribution you will have $39,324 in your pocket
In scenario #2 you’ll get $5,625 in matching funds contributed to TSP/401/(k) (matching funds are non-Roth). If we keep all the assumptions the same, you will pay taxes of $4,951 (25% x value of employer’s contributions) and have $34,408 in your pocket
Last time I checked, $39,324 (#1) is greater than $34,408 (#2).
O.K. So it works if tax rates stay the same. What if tax rates go up? The rule of thumb says to go for the Roth. If we keep the scenario the same and increase the tax rate at retirement to 39.6% here are the results.
Scenario #1: $31,668
Scenario #2: $31,537
Scenario #1 still puts more money in your pocket
As a reminder, 39.6% is currently the highest tax bracket.
So, don’t invest in the Roth TSP/401(k), right? No, this is a very specific example. My point is that Rules of Thumb generally don’t apply to YOU. It is worth it to get opinions/rules that account for your individual situation.
Curt Sheldon is an Independent Fee-only Financial Planner located in Alexandria VA with clients throughout the US.
He specializes in assisting transitioning Senior Military Officers reach their financial goals.
Amat Victoria Curam 