If you are currently contributing to the Thrift Savings Plan but don’t know the significant difference between the Traditional and Roth option (or that the Roth option actually exists), then this post is for you.

The fact that you invest in the TSP at all is a great first step! It means you likely have a basic understanding of the Thrift Savings Plan, have already started contributing at least 5-10% of your base pay, and know which Funds you want to invest in. If this is not the case, then I recommend reading WTF is a TSP: The Beginner’s Guide to Crushing Military Retirement and the BRS vs HIGH 3 articles before continuing.

This article is the next step in the progression for understanding how the Thrift Savings Plan works and will help you understand the key differences between the two systems.

This decision is very important! Take the time to weigh the pros and cons, it will be worth it. You could potentially pay THOUSANDS of dollars in extra taxes if you pick the wrong option for your situation.

For tonight’s match-up, I give you “Ole Faithful” (Traditional TSP) vs the “New Hotness” (Roth TSP)! Two men will enter, one man will leave!

Bottom Line Up Front

The main difference between the Traditional and Roth TSP is WHEN you pay taxes on your contributions. Uncle Sam will always get his money; you either pay him now or later. With the Traditional TSP you will pay taxes based off your future tax bracket when you retire (typically age 59 1/2). With the Roth TSP, you will pay taxes based off your current tax bracket when you deposit your money.

While it may seem complicated, deciding whether to invest in the Traditional or Roth TSP is actually pretty easy; you just have to answer one very important question…

Do you think your salary will be higher at age 59 1/2 than it is now?

For MOST service members (key word being “most”) the answer is YES. The answer to this question is important because a higher salary means a higher tax bracket which then helps you determine whether to go with Traditional or Roth. The answer to this question should influence your decision in three ways:

• Invest in the Traditional TSP if you expect your withdrawal tax bracket to be lower than your current tax bracket (ie. you believe you will have a LOWER salary at age 60 than your current one).
• Invest in the Roth TSP if you expect your withdrawal tax bracket to be higher than your current tax bracket. (ie. you believe you will have a HIGHER salary at age 60 than your current one).
• There is absolutely no difference between Traditional and Roth if your withdrawal tax bracket equals your current tax bracket (ie. your salary remains the SAME later as it is currently).

Amplifying Information

*This article only covers the differences between the Traditional and Roth as it concerns the Thrift Savings Plan; not IRA’s and 401(k)’s.

Index

• Key Terms & Definitions
  • Retirement Age, AGI, Tax Deferred, etc.
• Traditional vs Roth: The Basics
  • Comparing the Pro’s and Con’s between the two
• Current vs Future Tax Bracket
  • How to actually figure out your current and future tax brackets
    
• Staying in for 20 vs getting out early
  • Diving into the effects of a pension on your decision
• How to switch from Traditional to Roth
  • A step-by-step guide to switching from one to the other
• Frequently Asked Questions
  • Short and sweet answers to the most common questions

Key Terms

Retirement Age aka Withdrawal Age

Many service members get confused by this. “Retirement Age” is NOT when you retire from the military after 20 years and are only 40 years old. “Retirement Age” is when you retire from working completely and begin withdrawing your money from your TSP (typically around age 60).

Adjusted Gross Income (AGI)

Your total income minus tax-free deductions (BAH, BAS, combat pay, etc). Your AGI determines what tax bracket you fall under. This term will be very important later.

Retirement Income

The income you rely on to sustain yourself once you quit working. Pension, TSP/IRA/401k withdrawals, social security, capital gains on other investments, etc. Your retirement income will be the base number for calculating your AGI.

Tax Deferred Contributions

You pay taxes on your money later.

Tax-Free Contributions

You pay taxes on your money now.

Traditional vs Roth TSP: The Basics

Traditional TSP

The money in your TSP will grow tax-deferred, and you will pay taxes on your contribution and their earnings upon withdrawal in retirement. For example, if you make Traditional contributions of $5,000 into your TSP account in 2018 and that money grows to say $25,000 upon retirement, you will pay taxes on the $5,000 contribution plus the $20,000 in earnings when you withdraw them. If you are in the 22% tax bracket in retirement and you withdraw that $25,000, you will pay 22% in taxes ($5,500).

Pros:

• You deposit MORE MONEY initially which then leads to greater compound interest over time.
• You will earn more money through this increased compound interest if your income tax bracket LOWERS when you retire and withdraw your money.

Cons:

• You will pay MORE TAXES if you are in a HIGHER tax bracket when you retire and withdraw the money thus negating the increased compound interest.
• If you withdraw money from your TSP before age 60, you will pay a 10% early withdrawal penalty tax IN ADDITION TO income tax on the amount withdrawn. For example, if you are age 40 and in the 22% tax bracket and decide you want to withdraw $25,000 for a down payment on a house, you will pay Uncle Sam a whopping 32% of your withdrawal (or $8,000)!

Roth TSP

You pay taxes on your contributions at the time of investment. The money in your TSP will grow tax-free and you will not pay taxes on contributions or earnings upon retirement. For example, if you make a Roth contribution of $5,000 that grows to $25,000 upon retirement, you will not have to pay taxes on either the $5,000 contribution or the $20,000 in earnings when you withdraw them during retirement, since taxes were paid on the initial contribution of $5,000 ($1,100 if in the 22% tax bracket).

Pros

• You will pay LESS TAXES in the long run if you are in a HIGHER tax bracket when you retire; thus potentially negating the decreased compound interest on your investment.

Cons

• You deposit LESS MONEY initially which means smaller compound interest over time.
• You will pay MORE TAXES up front if you are in a LOWER tax bracket when you retire

Comparing the Two

Despite all the arguments on either side, there is no real advantage with either system IF YOUR TAX BRACKET STAYS THE SAME. The effects of compounding the higher contributions made to a traditional TSP exactly match the benefit you obtain by not paying taxes on the gains under a Roth TSP.

The only question you need to answer to make this decision is whether you expect to be paying a higher tax rate now or when you retire. If you believe you will be in a lower tax bracket after you retire, you should stick with the traditional TSP. If you believe average tax rates will go up in the future or you will be in a higher tax bracket at the point you start withdrawing, you should seriously consider a Roth TSP. If you are likely to be in the same tax bracket, it probably doesn’t matter which you chose.

From the TSP.gov website:

 

How to Figure Out Your Current And Future Tax Bracket

“Okay, I got it. It all depends on my tax bracket now versus my tax bracket in retirement. But how will I know that?” Well, most military members are extremely “tax-lucky,” meaning they have the advantage of great tax breaks.

Military members have a very high likelihood of seeing a higher bracket later in life. This is because an equal income in retirement has to cover BAS (food), BAH (housing), and medical plan expenses (Tricare). We don’t pay taxes on any of those while Active Duty.

Let’s use your Adjusted Gross Income (AGI) to determine your current and future tax bracket.

 

Let’s use a married E-7 with over 10 years TIS stationed in DC as an example (items in red are tax-free):

• Base Pay: $3968
• BAH: $2763
• BAS: $369
• Health Care: Free
• Total Monthly Income: $7,100
• Total Annual Income: $85,500
  • Adjusted Gross Income: ($7,100-$2763-$369) x 12 = $47,616
  • Current Tax Bracket: 12%
  • Future Tax Bracket upon exiting military to keep the same standard of living = $22%

These calculations do not even include getting promoted and do not include the cost of paying for your own health care (which can vary from hundreds to thousands of dollars). Remember, once you leave the military these tax-free benefits on your income are gone, your free health care is gone, and you can actually get fired if you suck at your job (as opposed to being rewarded with less responsibility but still getting paid the same).

I did the math with a handy-dandy Traditional vs. Roth Calculator using my current tax bracket of 12% and a theoretical future tax rate of 22% over 28 years of growth. The Roth option beat the Traditional option by over $55,000.

 

What if I stay in for 20 years?

The biggest difference between private sector 401k’s and the TSP boils down to one word: pension.

First, only about 17% of military members stay in the service long enough to get a pension, so keep that in mind and don’t necessarily count on getting that monthly check. But let’s see what it looks like if that same E-7 in DC makes SGM, stays for 20 years, and receives a retirement pension.

An E-9 with 20 years of service would receive a monthly pension of around $3,000 a month. That money is all taxable and is added to whatever other income he receive (Social Security, VA Disability, investments, bonds, or maybe a second pension from a plush government civilian job).

While your Social Security benefit will vary, an estimate for that E-9 when he is 62 and eligible to receive it is around $1,000/month. Add in the withdrawals he will make from his TSP and you can quickly see it is very likely his monthly earnings in retirement will be greater than his current earnings, making Roth contributions favorable.

Military members who don’t stay 20 years won’t get a pension. However, it still likely makes sense to do the Roth TSP because the TAXABLE income in the military isn’t that high. After leaving the military, you will likely get a job in the private sector that pays the same or more but is all taxable. It makes sense to do the Roth TSP now when your tax rate is low.

When should I NOT use a Roth TSP as a Military Member?

While Roth contributions are better for MOST military members, here are a few examples where Traditional contributions may be better:

1. You have a high-earning spouse (lucky) and you file taxes jointly. Your spouse’s salary may bump you both into a high tax bracket now and perhaps you would benefit more from the tax-break of Traditional contributions later.
2. You are senior in the military and have few deductions. Traditional contributions lower your current year tax liability.
3. You plan to retire from the military at 20 years to a state with no state income tax and live solely off your pension, minimal TSP withdrawals, and social security. In this scenario, your tax rate could be lower in retirement.
4. You believe tax rates are going to decrease in the future or the tax law will change (wouldn’t THAT be nice).
5. You get a big ass promotion and you don’t think you’ll ever be in a higher tax bracket so you decide to switch over to a traditional TSP.

How to switch from Traditional to Roth and vice versa

1. Login to Mypay
2. Select “Traditional TSP & Roth TSP” from the main menu
3. Select the % of your Base, Special, Incentive, and Bonus that will go to either Traditional or Roth
4. Make sure your address is correct in Mypay
5. Create an account at TSP.gov
6. Select which TSP funds to invest in

Frequently Asked Questions

I’ve contributed to the Traditional TSP my whole career! Can I convert that money into a Roth TSP?

No. Under current TSP rules, you cannot convert your existing Traditional TSP balance to your Roth TSP. If the rules change in the future, you will have to pay taxes on the Traditional balance based off your tax rate at the time of the transfer.

What should I do if I’m deployed?

The only time Uncle Sam doesn’t get paid is when military members are serving in a combat zone. In this scenario, your income is tax-free and it can go right into a Roth, thereby avoiding all taxes on both contributions and earnings. TSP contribution limits are also raised for those serving in a combat zone.

I’ve switched to the Blended Retirement System, what happens with the government matching funds?

All of the matching contributions are deposited into your Traditional TSP account, you cannot change this

Do I base my future income and tax bracket off the salary of my last job or my income through retirement?

Your tax bracket at retirement is based off your pension, payments from your TSP, and any other income you have available (social security, rental income, dividends, interest, etc.)

Can I contribute to both Traditional and Roth TSP?

Yes, you can split the percentage however you want.

What if I want to make early withdrawals?

An early withdrawal is any payment from your TSP before you reach age 59 ½.

With a Traditional TSP, you will pay a 10% early withdrawal penalty tax IN ADDITION TO income tax on the amount withdrawn, unless the amount is for an annuity, death benefit, divorce settlement, qualified medical expenses, or if you become totally and permanently disabled. For example, if you are age 40 and in the 22% tax bracket and decide you want to withdraw $25,000 for a down payment on a house, you will pay Uncle Sam a whopping 32% of your withdrawal (or $8,000)!

With a Roth TSP, it gets confusing, because it is NOT the same as a Roth IRA. With a Roth IRA, you can withdraw money early completely tax-free and without a 10% penalty. You cannot avoid this 10% penalty with the Roth TSP except under very specific circumstances. HOWEVER, if you want to withdraw early, you can get around this by transferring your Roth TSP to a Roth IRA.

• Since you’ve already paid tax on your Roth TSP contributions you can switch it to a Roth IRA and withdraw your contributions at any time and at any age without paying income tax. Additionally, you will NOT have to pay the 10% early withdrawal fee if you’ve had your Roth TSP for over five years. Read more here and here.

I’m getting out of the military, what should I do with my TSP?

You can no longer make TSP contributions after you retire from Federal service; leaving you with three main options:

• Leave your money in your Traditional or Roth TSP and continue earning money through compound interest.
• Roll your TSP into your new employer’s 401(k) retirement plan.
• Convert your TSP into an Individual Retirement account (IRA).
  • Do not blindly roll your TSP into an IRA without weighing the pros and cons. Many financial advisers will try to convince you to do so because they stand to gain financially if you do. Sadly, many military members do this every year, only to be exposed to fees that are often 10-20 times higher than the TSP. The TSP has the lowest fees in the industry, averaging .033%, or 33 cents for every $1,000 invested. For comparison, the average expense ratio for a civilian equivalent fund is .44% or $4.40 for every $1,000 invested!

What if I drink too many monsters and die before age 60?

The Roth TSP is great for members who wish to pass on as much as possible to their heirs. After they retire from federal service, Roth TSP owners are allowed to roll over their Roth TSP accounts to a Roth IRA. Roth IRAs have no required minimum distribution requirements starting at age 70.5 like traditional IRAs, 401(k) retirement plans, the traditional TSP, and the Roth TSP. As such, a Roth IRA owner can hold onto the account indefinitely and pass it on tax-free to their beneficiaries upon his death.

That’s it

While this may seem a little overwhelming, it is critically important to understand the pro’s and con’s of each option so that you truly leverage the best tax benefit that fits your situation. As I demonstrated above, your choice can drastically affect the ultimate sum of your money by thousands of dollars. Hopefully, this article will help you make an informed decision.

If you wish to learn more about how about how all this works then I encourage you to read If You Can: How Millennial’s Can Get Rich Slowly by Dr. William Bernstein and The Little Book on Common Sense Investing by John Bogle. They are highly successful financial advisers that can break this stuff down way better than I can.

If you found this information helpful, please share it on your social media outlet of choice, and subscribe to my email list to receive more articles like this delivered straight to your inbox. If there is something that I missed or something that didn’t make sense, please comment below and I’ll get right back to you.

In closing, I hope I demonstrated that in MOST cases it makes sense for young military members to use the Roth TSP because they will likely have a higher taxable income in the future and have the ability to pass it off to their heirs tax-free.

Orrrrr you can be like a certain E-7(P) in my company, and say “screw my kids, those little bastards ain’t gettin shit! And ain’t no way I’m going to pay the government money now when I’m going to die on a mountain of brass surrounded by my enemies bodies by the time I’m 45!” 🙂

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