Thrift Savings PlansPosted by Badger Coach on May 29th, 2014
In an attempt to save money on its future pension liabilities, the federal government, in 1986, decided to discontinue offering its Civil Service Retirement System (CSRS) pension plan to new hires. Since that time, new federal employees are offered the Federal Employee Retirement System (FERS) and have not been given a guaranteed pension for retirement. As a result, they are now required to learn how to save, invest, and contribute enough of their own money if they want to retire like many of their older colleagues receiving a pension.
TSP and 401(k) Comparisons
Employees of the federal government are able to save and invest for retirement through the Thrift Savings Plan (TSP). TSP is similar to the 401(k), in that employee contributions are made on a pre-tax basis and grow tax deferred until withdrawal at age 59½ or retirement. Additionally, TSP participants receive a dollar-for-dollar match on the first 3 percent of their contribution, and a 50 percent match on the next 2 percent of an employer’s matching contribution.
The TSP has further similarities to a 401(k) plan in that TSP accounts are subject to a 10 percent early withdrawal penalty for withdrawals made before age 59½, although early in-service withdrawals that are subject to I.R.C. 72t can avoid this penalty. And like the 401(k), TSP participants may take hardship loans and/or claim other triggering events to withdraw money from their TSP account without penalty, so long as certain rules are followed. In order to avoid any tax issues, it is a good idea to talk with a TSP advisor or a qualified tax professional before withdrawing any money from this TSP account.
One of the advantages of the TSP over a 401(k) plan is that it offers the G-Fund. This fund guarantees its account holders that their money will never lose value and that it will increase in value every single year, because this fund invests in government issued bonds. It is for this reason that G-Fund account holders did not lose any money during the 2008 stock market collapse or any other stock market decline since 1986. Perhaps this is why G-Fund account holders are able to rightfully say that they are saving for retirement and not investing for retirement.
TSP Contribution Tax
Uncle Sam charges you an upfront tax on any contribution classified as “elective deferrals” that were made by you or on your behalf by your employer. For each contribution made you will pay Social Security (6.20%) and Medicare (1.45%) tax. This is what I call a TSP contribution tax.
To help you gain a better understanding of how your TSP money is taxed, the IRS states the following:
- Elective deferrals (other than designated Roth contributions) aren’t subject to federal income tax withholding at the time of deferral and …
- Although the law doesn’t treat amounts deferred as current income for federal income tax purposes, they are included as wages subject to Social Security (FICA), Medicare and federal unemployment taxes (FUTA).
What this means to you is that contributions that you and your employer make to your TSP account do not count as income and may be deducted for federal income tax purposes. However, employee and employer contributions are counted as wages for Social Security and Medicare tax purposes. Uncle Sam wants his money first. For example, if you contribute $250 per pay period towards your TSP account and your employer matches your contribution for a total of $500 per pay period, depending on your federal income tax rate, you may deduct a percentage of the $500 for federal income tax purposes. However, Uncle Sam will hit you with a TSP contribution tax of 15.3 percent before your money is deposited into your TSP account. As you can see, Social Security and Medicare tax completely destroy any benefits of an employer match. The good news is that half of this tax is covered by your employer.
Another advantage of the TSP over a 401(k) plan, is that although it discloses its net expense ratio to its plan participants, it does not have to disclose how much it pays its fund manager to invest.
An Investment Company Institute paper (The Federal Thrift Savings Plan: A Model for the Private Sector) states, “It is not clear exactly how much revenue the fund manager earns directly or indirectly from its relationship with the TSP, as the investment management agreement and associated fee structure are subject to a confidentiality agreement and not available to the public.”
TSP Account Balances
Not knowing how much TSP participants are paying an investment firm to handle their money has caused some to cry foul, as 401(k) plan sponsors are however, required to follow a recently enacted July 2012 DOL Rule 408(b)(2), a.k.a. the 401k Fee Disclosure Rule. This rule applies to all Employee Retirement Income Security Act (ERISA) covered retirement plans. It requires these plans to disclose all fees to its plan participants, even the hidden fees. However, this rule does not apply to the TSP.
So, how much money have TSP participants accumulated during the past 26 six years? Not much. Since the inception of the TSP program, of the current 4.6 million TSP participants, only 1,656 (0.04%) have accumulated more than $1 million, this, according to Kim Weaver, Director of External Affairs at Federal Retirement Thrift Investment Board. What is interesting is that many in this group are senior government officials who rolled over money from their previous private sector 401(k) plan.
According to the National Institute of Transition Planning, the account balances for the remaining 4,598,400 TSP participants are as follows:
- Under $50,000: 2,798,820 (60.9%)
- $50,000 – $249,999: 1,424,999 (31.0%)
- $250,000 – $499,999: 335,638 (7.4%)
- $500,000 – $749,999: 71,272 (1.6%)
- $750,000 – $999,999: 11,063 (0.2%)
From this data, two numbers stand out. The first, is that approximately 61 percent of TSP participants have accumulated less than $50,000 for retirement. The second, is that approximately 7 percent of TSP participants have less than $250,000 saved in their retirement account. What is not discernible from these numbers is the total dollar value of the amounts contributed by these account holders. In other words, how much of the $50,000, $250,000 or $750,000 is a result of an employees’ cost basis or personal contributions? This is important to know because it will let TSP participants know how much of their account value came from the stock market and employer match, and how much came from themselves.
Another problem with the TSP is that, unlike 401(k) plans, TSP participants are unable to determine which companies they are investing in, the individual(s) named as the fund manager, or how long the fund manager has handled the account. Simply put, TSP participants are investing in a black box. Because FERS employees do not have a pension to rely on, transparency is critical to the success of TSP participants.
If the goal is to have $1 million in your TSP account upon retirement, ask yourself– how much of that money will be lost to taxes once you start taking withdrawals? For example, if you are in a combined 33 percent federal and state tax bracket, you will only get to keep $670,000. And if you then calculate how much you contributed and add the all-in fees extracted from your account over the years, a cost benefit analysis may reveal that you will have netted a lot less than $1 million. So, my recommendation for you is to not focus on how much you make, but focus on how much you net.
It appears that the odds of a TSP participant accumulating $500,000, much less $1 million, are quite remote. Now, one could say that the best way to increase the odds is for TSP participants to increase their contributions to at least 20 percent of their pre-tax income. While it is true that employee’s need to direct at least 20 percent of their income towards a retirement account to enjoy a better retirement lifestyle, directing these dollars toward a pre-tax retirement account instead of an after-tax retirement account (401(k)/TSP alternative), may only make sense if the future retiree expects to remain in a lower tax bracket throughout retirement. Also, with tax payers funding recent wars, baby-boomers draining social security benefits, corporate bail-outs, and the on-going quantitative easing by the Federal Reserve Bank, Congress may have to increase taxes to pay for it all, which will not bode well, from a tax planning perspective, for retiree’s invested in a TSP account. And finally, your TSP is not a tax savings plan. It is a tax-delayed plan. If taxes are higher during retirement, contributing to a TSP may not be a wise thing to do.
The opinions expressed are those of the author and is for educational purposes only, and not an offer to buy or sell securities. Investing involves significant risk, even the loss of capital. Invest only what you can afford to lose. Guarantees provided by an insurance company are based on its claims paying ability. Policy loans will reduce the death benefit, until repaid in full. Upon termination (not death of policy holder) of a policy, unpaid loans and the accrued/capitalized interest will be taxed as ordinary income. (See: I.R.C. sec. 6662(a) accuracy penalty). If there is an outstanding policy loan when the contract is surrendered, terminated or lapsed before the death of the insured policy holder, ordinary income tax rates may apply. Policy loans may be taxed at ordinary income tax rates in the year of the lapsed, surrendered, or terminated policy. As always, please consult with a qualified legal, tax, investment or insurance professional before making any investment or insurance decision.