Another Roth vs. Traditional debate, but for high-income Feds

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deskjockey
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Another Roth vs. Traditional debate, but for high-income Feds

Post by deskjockey »

I went to a financial planning seminar that my Agency offers to employees and the presenters (all Feds themselves or recently retired annuitants, so not trying to sell anything) said that it generally makes more sense for federal employees to opt to go 100% Roth TSP even if you are a senior fed (GS-14, 15, SES, or equivalent) and in a high tax bracket. They stressed that if they had to do it again (they all had 30+ years of service) today, they would max out TSP in Roth and not bother with traditional contributions. Their reasoning was as follows:

1. Feds will get a hefty pension, especially those who are FERS Special, so there will be less space to do Roth conversions after retirement (especially if you become a contractor).
2. Thanks to the hefty pension and SS, high-income feds, even those currently in the 28% or 33% bracket, will be in an even higher income bracket after age 70 1/2 if they have sizeable TSP balances, so RMDs will be taxed at a very unfavorable marginal tax rate.
3. Thanks to a hefty pension and SS, most high-income feds will be able to life off of their pension and SS and will only need to tap into a small portion of their TSP balances, if any. One guy laid out his specific situation, showing how his net monthly pension check came within $750 of his net take-home pay.

I came up with the below quick and dirty scenario to help illustrate this.

Joe Fed earns 150k as a fed and maxes out TSP. He is single (to make this easier) and will never get another raise, so his high-3 will be 150k. He will retire at age 50 with 30 years of service and a 1M traditional TSP account. His FERS Special pension is 66,000 (44% of high-3). Would he have been better off by switching all of his TSP contributions to the Roth option when he started working? We'll ignore the fact that the Roth option only came into existence in 2012 and assume he would have contributed 18K a year to TSP whether in Roth or traditional. He also has $0 in any other savings vehicles.

I think in this specific instance it might make sense for Joe Fed to only contribute to the Roth option, but I'm not sure that would be the case for many folks who live in the real world and have other savings (taxable, 529s, IRAs, etc). Anyone care to opine?

In fairness to the presenters at the seminar, they stressed that this was something that would have worked better for them in their specific situations, and that it would be highly dependent on individual circumstances.

As an aside, this was one of the better financial planning seminars I've seen in the federal government. They discussed backdoor IRAs, 529s, and Roth conversions in retirement. They also emphasized that investments should be low cost and diversified, and also mentioned Vanguard specifically as a family of funds that met both criteria.
KlangFool
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by KlangFool »

deskjockey wrote:
I came up with the below quick and dirty scenario to help illustrate this.

Joe Fed earns 150k as a fed and maxes out TSP. He is single (to make this easier) and will never get another raise, so his high-3 will be 150k. He will retire at age 50 with 30 years of service and a 1M traditional TSP account. His FERS Special pension is 66,000 (44% of high-3). Would he have been better off by switching all of his TSP contributions to the Roth option when he started working? We'll ignore the fact that the Roth option only came into existence in 2012 and assume he would have contributed 18K a year to TSP whether in Roth or traditional. He also has $0 in any other savings vehicles.
deskjockey,

<< Would he have been better off by switching all of his TSP contributions to the Roth option when he started working? >>

Why? Do the calculation and show us why this is true?

<< assume he would have contributed 18K a year to TSP whether in Roth or traditional.>>

Joe Fed would have to pay tax on 18K to Roth TSP. So, this assumption essentially makes the whole comparison invalid. Then, what is there to discuss?

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retiredjg
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by retiredjg »

I am convinced it is good for people with a pension to use some Roth TSP. I'm not convinced it should all be Roth TSP.

I'm also convinced that there is no way to know with any precision. To me, that is another reason to use both.
Super Hans
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by Super Hans »

I'm paying AMT now, so I'm looking for every opportunity to reduce my AGI. Also, the prospect of avoiding state tax forever by retiring in a more tax-friendly jurisdiction helps keep me 100% tTSP. The scales might tip for those who carry guns and get the "super" pension.
rkhusky
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by rkhusky »

The 28% tax bracket for single goes up to $191K. Not sure how one reaches that, even with $66K pension (doubt that many feds get that high) and $1M TSP account with 4% withdrawal rate and max SS. Maybe with $3M TSP account.
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FiveK
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by FiveK »

deskjockey wrote:Joe Fed earns 150k as a fed and maxes out TSP. He is single (to make this easier) and will never get another raise, so his high-3 will be 150k. He will retire at age 50 with 30 years of service and a 1M traditional TSP account. His FERS Special pension is 66,000 (44% of high-3). Would he have been better off by switching all of his TSP contributions to the Roth option when he started working? We'll ignore the fact that the Roth option only came into existence in 2012 and assume he would have contributed 18K a year to TSP whether in Roth or traditional. He also has $0 in any other savings vehicles.
This scenario is very close to a coin flip, even with the benefit of hindsight.

His current marginal saving rate for traditional contributions is 28%. It's a reasonable guess that historically the rate was that amount or lower.

The marginal rate on the first dollar of tIRA withdrawals, given a $66K/yr pension, is 25%. Thus at least some amount of traditional contributions can be supported.

For someone maximizing Roth contributions, the breakeven withdrawal tax rate can be less than the contribution saving rate. The exact amount depends on many things. For example, (see rows 139-153 in the 'Misc. calcs' tab in Tools and calculators - Personal_finance_toolbox) using the assumptions below contributions invested for more than ~16.5 years would have been better in Roth, while shorter term contributions (again assuming a 25% withdrawal tax) would have been better in traditional:
Image

Traditional withdrawals also affect Medicare premiums. The chart below (from the Calculations tab of the tool noted above) approximates the combination of federal income tax and Medicare premiums, with the spikes indicating premium step changes. It doesn't take much from traditional withdrawals to make Roth look better.
Image

Again, this has the benefit of hindsight. For someone just starting, without guaranteed employment and the consequent high pension, using traditional in the 28% bracket would not be unreasonable at all.

Any SS income would tip the scales further toward Roth.
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grabiner
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by grabiner »

If you plan to retire before 70-1/2, and are in a 28% bracket, then it probably makes more sense to contribute to the traditional TSP while you are working, then roll part of it over to an IRA and convert it to a Roth then, likely at 25%. In addition to the lower tax bracket in retirement, you may retire in a lower-tax state, or in a lower tax bracket in the same state. For example, high-salaried Feds here in Maryland may have an 8.45% combined federal and county tax rate, which will drop to 7.95% when they retire even if they stay in the DC suburbs.

Here's a discussion, not specific to Federal employees, although quite relevant for them. Roth 401(k) in a 28% bracket thoughts
Super Hans wrote:I'm paying AMT now, so I'm looking for every opportunity to reduce my AGI. Also, the prospect of avoiding state tax forever by retiring in a more tax-friendly jurisdiction helps keep me 100% tTSP. The scales might tip for those who carry guns and get the "super" pension.
This makes the traditional TSP especially attractive. If you pay AMT, your marginal federal tax rate is probably 35%, and you can't deduct your 8.5% DC tax, for an overall tax rate of 43.5%.
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motorcyclesarecool
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by motorcyclesarecool »

A strategery I've been playing with on I-ORP:
-100% traditional TSP contributions to save on high income taxes in my current locality
- Retire under the MRA+10 (Minimum Retirement Age and at least 10 years of service) "immediate" retirement provision, then postpone (not defer) receiving my annuity for a few years. My MRA is 57. If I postpone taking my annuity until 60 (using the age 60 and 20 years of service provision in the OPM FERS manual), I will receive an unreduced annuity, be able to resume my FEHB and FEGLI at 60, and have three years of "low income".
- Geographic arbitrage myself and Mrs. motorcyclesarecool to a warm, income tax free state.
- Aggressively convert to Roth for the three years between separation and my first FERS annuity payment.

I-ORP models show that I can have nearly the same net income under the above scenario as if I worked until 60 and retired on an immediate, unreduced annuity with an additional three years of service and accumulated sick leave upping my annuity amount. The difference is, I significantly reduce my exposure to RMDs, pay less tax along the way provided I and /or my surviving spouse live long enough, and retire three years earlier.

YMMV, but I suspect an SES or high GS earner who lives in a HCOL locality could benefit from such a strategery.

EDIT: typo fixed
Understand that choosing an HDHP is very much a "red pill" approach. Most would rather pay higher premiums for a $20 copay per visit. They will think you weird for choosing an HSA.
Leemiller
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by Leemiller »

I contribute to the traditional TSP because my husband and I are in a high tax bracket for federal, state, and local taxes. I'm also not worried about paying more in taxes because I have such a high income stream in my 70s. I'd rather have a larger paycheck now. Like the other poster, I will also choose my resident state taking into account taxes.
MichDad
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by MichDad »

I’ve been contributing to the TSP since 1987. My total TSP balance is now over $1.7 million. From 1987 to 2012, I had no choice but to invest into the regular TSP. Beginning in May 2012, I started investing only into the Roth TSP. [Of course, the government match has continued to go into the regular TSP.] My thinking was that my regular TSP balance was going to be very high, leading to high Required Minimum Distributions over time after age 70.5. This is especially the case since I'll have a sizeable FERS pension.

At present, I’ve got about $1.6 in the regular TSP and over $150,000 in the Roth TSP. My wife and I have other substantial Roth assets so, in combination, our Roth assets represent about 30 percent of our total retirement portfolio.

I plan on doing serious Roth conversions after I retire next year at age 62 and until I begin to collect Social Security benefits at age 70. Unfortunately, the TSP does not permit within-plan Roth conversions, so I’ll transfer all but about $200 from my TSP account to a rollover IRA with Vanguard, Fidelity, or another similar firm.

MichDad
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deskjockey
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by deskjockey »

Thanks for all the replies folks--as I intimated in my OP, I'm not convinced the advice they gave on Roth vs. traditional is optimal for most feds. Klangfool hit on the main reason--it ignores the fact that the money to pay for taxes has to come from somewhere--either it was destined for consumption or it was slated for savings.

I do think in certain cases, it makes sense to go for 100% Roth TSP throughout your career, but in many cases it does not--especially for high-income feds hit by the AMT or in high-tax states. For lower-level feds, which is many folks (given that the average fed retires as a GS-12 step 6 or thereabouts--I forget where I heard that, but it was true a few years ago), the pension wouldn't bump them to a higher tax bracket in retirement.

If I were to do it over again, I would go 100% Roth TSP for the first half of my career, then switch over to traditional once I hit the 28% tax bracket. As it is, I only got the chance to put money in Roth TSP for a few years before it made more sense to go with traditional contributions. I now put the money that would have otherwise gone to pay for taxes into a backdoor IRA and 529s for my kids.

FiveK--that's a good spreadsheet I hadn't seen before.
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deskjockey
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by deskjockey »

I used the spreadsheet FiveK referenced and another one from the Finance Buff to play around with some assumptions and here's an insight I had (at least I think it's an insight--I could be wrong):

It seems that, if you are maxing out your 401k/TSP, it does make more sense to put it all (or most of it) in Roth. I've seen a couple of articles advocating this (see this one, for example: https://thefinancebuff.com/roth-401k-fo ... e-max.html ). That said, these scenarios assume that any money that is not placed in a traditional 401k/TSP will go into taxable. What if, instead, that additional money goes into a backdoor Roth or mega backdoor Roth? After adjusting the spreadsheets to mimic that scenario, it's clear that maxing out traditional TSP and putting the tax savings in a backdoor or mega-backdoor Roth edges out simply maxing out Roth TSP even if you are in the same tax bracket in retirement. It would therefore make sense to recommend that high-income feds who max out TSP use traditional TSP and put the tax savings in a backdoor Roth.

Am I on track with this line of thought, or have I missed something?
dharrythomas
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by dharrythomas »

We use Roth accounts exclusively now (except for the matching) in both TSP and IRAs. Over the last few years of my career before the Reserve pension kicks in, we'll probably sell some taxable investments to fund our Roth IRAs.

I'm not nearly at the 150K salary level, but it's not that hard to get to a $66K pension in federal service if you had military service. There are a number of people who started work in the early to mid 1980s, did 10+ years in the military, got out during the drawdown, bought their military time for their civilian pension, and retired from the Reserve component (many double-dipped again for time when mobilized for Afganistan and Iraq). If you retired as a 12 step 6 at 62 with 40 years of service plus as a Lieutenant Colonel with 27 years of service (12-14 of active duty) you would exceed the $66K. I spent the first 13 years after I got out of the military in the private sector and though my my career will not match the example, my pensions will exceed the $66K.

1. We've got a significant balance in traditional accounts, IRA and TSP from before Roth options were available and matching.
2. I like the idea of not having to pay anything else on the accounts.
3. Roths are the best accounts to leave to heirs, followed by taxable accounts, last is traditional accounts.
4. My father was a CPA and his experience was that people with adequate funds absolutely hated MRDs.
5. We all make the assumption that a person is going to do something smart with the money. Am I the only one here who thinks that my wife is willing to let me save 15% of my salary in either traditional or Roth TSP, but if I put it in the traditional would want to spend a good portion of the tax savings? Am I the only one who after a fight has let the spouse spend some money I had earmarked for investment? I try to make my plans based on the real world I live in.

Of course, I'm one of those guys that believes in paying off your mortgage early, so take it with a grain of salt.

The future is unknowable and behavioral economics demonstrates that people are irrational. We each do the best we can and as Taylor says "There are many roads to Dublin". Good luck with your choice.

Harry
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FiveK
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by FiveK »

deskjockey wrote:I used the spreadsheet FiveK referenced and another one from the Finance Buff to play around with some assumptions and here's an insight I had (at least I think it's an insight--I could be wrong):

It seems that, if you are maxing out your 401k/TSP, it does make more sense to put it all (or most of it) in Roth.
...
Am I on track with this line of thought, or have I missed something?
It still depends on the marginal tax savings a traditional account would provide now, compared with the marginal tax cost from traditional withdrawals later.

What large annual contributions do is move the indifference point for comparison. Once an annual contribution becomes larger than (IRS maximum)/(1 - contribution tax rate), the commutative property of multiplication is not the correct model. Instead, one needs to analyze things using one of those spreadsheets (or the equivalent).

But, as often happens with a traditional vs. Roth question, the answer still needs to include "it depends..." because, well, it depends....
Last edited by FiveK on Sun Jun 25, 2017 11:15 pm, edited 1 time in total.
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Watty
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by Watty »

deskjockey wrote:They stressed that if they had to do it again (they all had 30+ years of service) today, they would max out TSP in Roth and not bother with traditional contributions. Their reasoning was as follows:

1. Feds will get a hefty pension, especially those who are FERS Special, so there will be less space to do Roth conversions after retirement (especially if you become a contractor).
2. Thanks to the hefty pension and SS, high-income feds, even those currently in the 28% or 33% bracket, will be in an even higher income bracket after age 70 1/2 if they have sizeable TSP balances, so RMDs will be taxed at a very unfavorable marginal tax rate.
3. Thanks to a hefty pension and SS, most high-income feds will be able to life off of their pension and SS and will only need to tap into a small portion of their TSP balances, if any. One guy laid out his specific situation, showing how his net monthly pension check came within $750 of his net take-home pay.
One thing to keep in mind is that the all had great outcomes to their careers and retirement so with 20/20 hindsight a Roth might have worked out well for them because they were lucky and did well. They are also saying this while the stock market is near a record high.

I have seen lots of people run into trouble with things like never getting a big promotion, job loss, health problems, disability, death of a spouse, or divorce so they had their retirement plans turn out a lot worse than they had hoped for and they end up in a lower than expected tax bracket in retirement.

Instead of saying the Roth was better than the traditional they could just as well have encouraged you to party more and not save too much, just because they ended up with excess retirement funds.
SpecialK22
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Re: Another Roth vs. Traditional debate, but for high-income Feds

Post by SpecialK22 »

I prioritize Roth accounts for the forecasted reasons that your presenters currently live. I'm in the 28% tax bracket and the combination of FERS Special, a Reserve component pension, and SS Supplement will by themselves put me firmly in the 28% bracket immediately on retirement in my mid-50s. Down the line I may switch to traditional. For example, if I transfer to a high COLA part of the country which pushes my Federal rate to 33% with higher state and locality taxes to boot.

I still believe the biggest part is just consistently saving. It's often only in hindsight that it becomes clear whether traditional or Roth was the better option. You can interject about any reason that one will work better than the other in planning though.
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