One of the most critical yet often overlooked decisions in retirement planning is the order in which you withdraw funds from your Thrift Savings Plan (TSP). The topic we will be covering will go over withdrawal strategies if you have both traditional and Roth TSP money. The strategy you choose can have a massive impact on how long your savings last and how much you ultimately pay in taxes.
The Basic Strategy: Let Roth Ride!
A fundamental principle of retirement withdrawals is that, in most cases, you should start by withdrawing from your traditional (pre-tax) TSP before touching your Roth TSP. This approach is advantageous for several reasons:
Tax-Free Growth on Roth Funds
Imagine you have $300,000 in your traditional TSP and $300,000 in your Roth TSP. Let’s say you leave the Roth funds untouched and they grow to $500,000, that entire $200,000 in growth is tax-free. Conversely, if that growth happened in your traditional TSP, every dollar of those earnings would be subject to income tax upon withdrawal.
Anticipated Higher Tax Rates
Although the future is uncertain, there is a possibility that tax rates rise due to policy changes or increased government spending. If you delay Roth withdrawals, you ensure that more of your future income is tax-free when rates are potentially higher.
Avoid Required Minimum Distributions (RMDs)
Traditional TSP accounts are subject to RMDs, which force you to start withdrawing funds (and paying taxes on them) starting between ages 70.5 and 75. Roth TSPs are not subject to RMDs.
Tax-Efficient Inheritance
If you pass a traditional TSP to your heirs, they will have to pay taxes on withdrawals. Roth funds, on the other hand, pass to beneficiaries tax-free, providing a much more efficient way to transfer wealth.
The Advanced Strategy: Coordinating Investments with Withdrawals
For those looking to optimize their retirement finances further, there’s an advanced approach that involves aligning your investment strategy with your withdrawal plan.
Since you will be drawing from your traditional TSP first, those funds should generally be invested more conservatively. Meanwhile, your Roth TSP funds, which will remain untouched for a longer period, should be invested more aggressively to maximize growth potential.
The Challenge of TSP Investment Restrictions
The TSP does not allow you to invest your traditional and Roth balances differently within the plan. To fully implement this advanced strategy, you may need to roll your TSP funds into an IRA (Individual Retirement Account), where you have greater flexibility in managing different asset allocations.
The Remaining Pitfall of TSP Withdrawals
Despite improvements, one major drawback of the TSP remains: withdrawals come out proportionally from all invested funds. If you have a mix of conservative (G or F Fund) and aggressive (C, S, or I Fund) investments, withdrawals will be taken proportionally from each, rather than allowing you to strategically withdraw from safer assets when the market is down. Now, you might be able to work around this by buying back into the funds you like to replace soon after making the withdrawal. For more information on that strategy, check out this video.
In contrast, an IRA allows you to withdraw from specific investments, giving you better control over how your assets are managed in retirement. There are many things to think about when deciding whether to move your money from the TSP to an IRA. We have a great article that goes over the pros and cons of each. Click here to check it out or see our summarized illustration of it:
Conclusion
Deciding whether to withdraw from your traditional or Roth TSP first is a crucial part of retirement planning. In most cases, it makes sense to withdraw from the traditional TSP first, allowing your Roth funds to grow tax-free for as long as possible. Additionally, structuring your investments strategically and taking advantage of the TSP’s new withdrawal options can significantly enhance your financial security in retirement.
While the TSP has made it easier for federal employees to control their withdrawals, rolling funds into an IRA may provide even greater flexibility. By making informed decisions now, you can ensure a more tax-efficient and prosperous retirement.
