Planning for the ROTH TSP

We don't have any new information about the ROTH TSP option that was approved last year and is supposed to go into effect in 2011, but we're beginning to plan ahead in case it gets implimented as scheduled. The question for so many will be, should we contribute to the ROTH TSP or stick with the pretax variety.

What are the differences? Well, if you contribute to a ROTH IRA today, you are investing money that you've already paid taxes on. The earnings you eventually withdraw from that IRA can be withdrawn tax free. Some theorize that if the government gets into a bind, they might retroactively begin taxing ROTH accounts, but that is a remote possibility. (See this Marketwatch Story.)

Today's TSP, however, sets aside a portion of your military pay and puts it into a tax-deferred account. It grows without taxes being taken out until the money is distributed, and distributions must begin when you reach age 70-1/2. This benefits you in two significant ways. First, you defer paying taxes now, increasing the amount you have to invest. Second, you defer gains on your investments, such as capital gains and dividends. Over time your balance should grow nicely.

So, if given the option of the ROTH TSP or traditional TSP which should you choose? The ideal choice for most military members is the ROTH TSP. While you pay taxes on your income today, you'll avoid future taxes and required minimum distributions later. In addition, withdrawals from a ROTH IRA account are not currently factored into your income for purposes of deciding if your Social Security benefits are taxable. If that wasn't enough, contributions to a ROTH IRA, and likely the ROTH TSP as well, can be withdrawn from your account prior to age 59-1/2 as long as the account has been open for 5 years.

So, for all these reasons, I recommend that today you fully fund a ROTH IRA before contributing to the TSP. Once you've allocated $5,000 to a ROTH (plus an additional $5,000 for a spouse if married), then contribute up to the maximum in the TSP, 0r $16,500 for 2010. If you can save more than that, consider purchasing a tax favorable mutual fund, such as an indexed fund. Because these funds rarely turn over their portfolios, there are rarely capital gains taxes to be paid because of "churning."

Next year, because of the investment choices and flexibility available in ROTH IRAs, I recommend that you contribute the max to your ROTH IRA before contributing to the TSP. When you do contribute to the TSP, choose the ROTH TSP, and focus your investments on the C, S, and I funds. You'll be glad you did in about 30-40 years!