While working for the federal government, the TSP is an important part of preparing for your retirement from federal service. Between government matching contributions (up to 5% of salary) and low-cost investment options, the TSP is a no-brainer while still working for the federal government. Once you retire, you can either leave your money in the TSP or roll it over into an Individual Retirement Account (IRA), but which approach is the best for you?
Pros of the TSP in Retirement
Simplicity: The five core funds (G, F, C, S, and I) are tied to broad indexes, have a low expense percentage, and are simple to understand and use.
Familiarity: Even if you’re new to investing, it’s easy to get up to speed with the TSP. Plus, most federal employees accumulate decades of experience with it by the time they retire.
Cons of the TSP in Retirement
No Roth Conversions: You cannot convert your traditional TSP account to a Roth account within the TSP. Only IRAs allow this strategy. Roth conversions can be a powerful way to reduce future taxes and lower your Required Minimum Distributions (RMDs), since Roth accounts don’t have RMDs.
No Control Over Which Investments to Sell: When making a withdrawal from the TSP, you can’t choose which fund to withdraw from. Withdrawals are automatically taken on a pro-rata basis from all your investments. For example, if you have your TSP invested with 50% G fund and 50% C fund, and you decide to withdraw $1,000 from your TSP, $500 will come from the G fund and $500 will come from the C fund. Although there is a way to work around this, it can be inconvenient and time consuming. Check out this video to learn more.
Limited Control Over Tax Withholding: For most withdrawals, the TSP automatically withholds 20% for federal taxes. You can request a higher withholding, but in most cases, you can’t reduce it below 20%. This doesn’t mean you’ll owe 20% in taxes. Your tax liability will depend on your tax bracket. If you’re in the 12% bracket, for example, the government will hold the extra amount until you file your taxes. The exception is for installment payments expected to last more than 10 years, where a lower withholding is allowed.
No Qualified Charitable Distributions (QCDs): Qualified Charitable Distributions (QCDs) allow withdrawals to be sent directly to a charity, avoiding taxes on the withdrawal. This is one of the most tax-efficient ways to give for those who are charitably inclined, but as of now, QCDs can only be done from an IRA and not from the TSP.
Pros of an IRA In Retirement
More Control Over Taxes and Investments: As discussed in the previous section, IRAs offer the ability to do Roth conversions, control which investments to sell, control tax withholdings, and use QCDs. This additional control can save you a lot of taxes if properly used. Additionally, IRAs offer nearly unlimited investment options. This includes thousands of different individual stocks, mutual funds, bonds, ETFs, CDs, REITs, cash or money market funds, options & futures, precious metals, etc. This can make a difference in investment returns over time.
Professional Management: If you are not comfortable investing yourself or have limited knowledge of taxes and finances, an IRA opens that option to hire a professional to manage your investments and finances. There is a cost to use a financial or investment advisor, but a professional can help you manage your taxes, create budgets, invest your money, plan your estate, and manage your risk. A qualified professional should create more value for you than the cost of his/her services.
Cons of an IRA In Retirement
More Research and Knowledge is Required: Having more investment options isn’t always an advantage and can be overwhelming. Many investors end up losing money in their IRAs or earning lower returns on their investment than they would have earned in broad/diversified and low-cost index funds such as those available in the TSP. You also need to do some research to understand the fees being charged by the funds you invest in. For example, some mutual funds charge annual fees of up to 2% of your investment which is very high. The fees charged by TSP funds are generally low, but it is possible to find equivalent funds for your IRA that match or even beat the TSP fee structure. It is very important to do your research to make sure the risks associated with your investments and what fees you are paying. A financial advisor can help you with these choices and be an important part of a successful retirement.
Summary
The table below summarizes the pros and cons for the TSP versus an IRA during retirement. If you are willing to do some research and/or hire a financial advisor, the IRA will give you greater control over your taxes and more investment options than the TSP during your retirement.
