For federal government employees, I would like to change the perception that the Thrift Savings Plan (TSP) is the only investment vehicle you need when saving for your retirement. If you have read my article “Five Things to Consider about the Thrift Savings Plan” you already know that the TSP, while an excellent savings tool, does not have all asset classes for optimal diversification. Emerging markets, small and mid-size foreign companies and Real Estate Investment Trusts (REITS) are just a few types of investments that most individuals should own for the long term but are not available in the TSP. This is where your Roth IRA comes in handy as it opens up opportunities for investing in the above asset classes and rounds out your retirement portfolio. Of course, traditional IRAs offer the same mix of available asset classes as the Roth—and could be tempting for some with a potential tax deduction; however, if you already have a TSP, I urge you to forgo the traditional IRA and go for the Roth IRA for three main reasons.
Select a Roth IRA before you reach the phase-out limits
It might be hard to fathom if you are a new federal employee, but at some point in your career you may not be able to contribute to a Roth IRA. It is best to do it now while the option is still available. For individuals filing Single, the Roth IRA contribution amount is reduced at $118,000 of Modified Adjusted Gross Income (MAGI) and is no longer available once you hit $133,000 of MAGI. This means that single FS-02s—and potentially FS-03s and FS-04s with language pay, differential and danger pay—risk being unable to contribute. Tandems and dual-income married couples often find that the window for investing in a Roth IRA closes earlier in their careers than they anticipate. The 2017 phase-out for Married Filing Jointly (MFJ) is between $186,000 and $196,000, after which time it becomes completely unavailable. While there is a method to get money into a Roth IRA after your income has reached the limit (a “Backdoor Roth”) – these can be complicated and paperwork intensive. It is better to fund your Roth IRA while you can and worry about a “Backdoor Roth” later. Hint for future taxes—it also easier to accomplish a “Backdoor Roth” if you do not have a traditional IRA.
Roth IRAs can do double-duty or triple-duty
Roth IRAs have another advantage over traditional IRAs. While your money grows tax-deferred with either a traditional or Roth IRA, only the Roth IRA allows you to remove your contributions (your original investment before earnings) without a penalty, at any age. This is not true for traditional IRAs in which a withdrawal results in a tax bill and a 10% penalty on the earnings if you are younger than 59½ years old (with some exceptions.) Because of this feature, some individuals use a Roth IRA as an emergency fund since the contributions can be removed. Most financial planners would rather you have a separate emergency fund but a Roth IRA is a nice backup to the backup plan. In a pinch, Roth IRA contributions can also be used to fund college before you hit 59½ and the 10% penalty on earnings (the money earned from your original contribution) is waived for qualified educational expenses. Again, most financial planners would rather see a separate 529 college savings plan for each child so you do not impact your retirement, but a Roth IRA provides additional flexibility, if needed. In other words, Roth IRAs can pull triple-duty for you.
Everyone has heard of a diversified portfolio. Individuals try to own many different asset classes across the globe with the hope that when one part of the portfolio is going down, another part is going up. Diversification aims for a smoother ride during market volatility. Tax diversification is a different concept. The idea is that as you approach retirement, you have your money in three different imaginary “pots”. The first pot is your TSP/Traditional IRA/401K. This is money that you deferred pre-tax and saved all your working years. The good news is that this “pot” should be quite substantial by the time you reach retirement—the bad news is that it will be time to pay Uncle Sam. When the time comes to withdraw your money, you will be taxed at your regular income tax rates. You can defer only so long; once you turn 70 ½ you must start removing your money (called Required Minimum Distributions - RMDs.) The second pot of money is your Roth IRA (and to a slightly less extent your Roth TSP/Roth 401k because of RMDs). Your Roth IRA is the best because you have already paid taxes on your contributions and the earnings will be tax-free once you are older than 59 ½ years (assuming you have had the account for at least five years.) There are also no RMDs like the money in pot one making this a great source of funds for your legacy. The final pot is money that you have already paid taxes on and is invested in a normal (low cost) brokerage account. If you have money in these three types of accounts then you are tax diversified, which will open up a whole host of tax planning strategies between the time you retire and when you start collecting Social Security and RMDs. Some of these strategies include tax loss harvesting, delayed retirement credits for Social Security, tax bracket arbitrage, maximizing college financial aid, Roth conversions, etc. Fund your Roth IRA now so you can take advantage of these strategies later.
All in all, a Roth IRA is a tremendous opportunity to reach financial independence earlier in your life. The contribution limit is $5,500 per year if you are under 50 with a $1,000 a year catchup for those over 50. If you contribute $5,500 per year at 6% over 25 years, your Roth IRA will be worth $301,754. You can also fund a non-working spouse Roth IRA which would double the money in your “tax-free” pot. It will take $458.33 a month over 12 months to make the maximum contribution. I hope you will get started now.