Many Americans are saving for retirement in the wrong type of investment vehicle such as low-yielding personal savings accounts that don’t offer any special tax benefits. A 2016 retirement benefits savings survey by NerdWallet found that 55% of those saving for retirement do so in a regular (taxable) savings account. For millennials between the ages of 18 and 34, the rate jumps to 63%.
With the goal of retirement in mind, there is an overwhelming variety of retirement programs to choose from. You may be asking yourself which is the most appropriate for your circumstances? What are the ramifications of not saving in a tax-friendly retirement account?
Time to Prioritize
Federal employees have access to the Thrift Savings Program (TSP) as part of the federal benefits package. The TSP offers federal employees the same type of savings and tax benefits that many private corporations offer their employees under “401(k)” plans. As a federal employee, your first priority when saving for retirement is to ensure that you are enrolled and maximizing contributions to your TSP. Unless you are taking full advantage of your Agency’s TSP matching contribution then you are passing up free money, a decision that is never advisable.
By contributing just 5% of your salary to your TSP you are eligible for the government’s full match of an additional 5% of your salary. Automatically this brings your saving rate from 5% to 10%, which is a quicker path to retirement. Contributing less than 5% not only means that you are giving up matching funds but you are also compromising the possibility of a comfortable retirement
Tax Benefits Matter
In the event that your current financial situation does not afford you the ability to immediately increase your TSP contribution to the target rate of 5%, even contributing a lesser amount still provides you with an attractive tax break. As your finances improve and you climb the pay scale ladder, dedicate to steadily increasing your contribution amount until you achieve and hopefully exceed the 5% target.
Contributions to a Traditional TSP are taken out of your wages before they are taxed, which reduces your taxable income and in return reduces your income tax liability. For instance, if your annual salary is $60,000 and you contribute $6,000 to your TSP, your taxable income would be reduced to $54,000.
In addition to the matching contributions from your Agency, an important benefit of a Traditional TSP is the deferral of taxes on any investment gains that are generated within the account until you actually retire and begin withdrawals. In contrast, in an ordinary personal savings or brokerage account, the gains and dividends will be taxed in the year they are realized, and that can hinder the growth of your portfolio.
The Roth TSP
If you are already maximizing your TSP contributions, anticipating a higher tax bracket during retirement or planning to pass on a large share of your retirement assets to your heirs, then you may want to consider allocating all or a portion of your TSP contributions to a Roth TSP. Both the Traditional and Roth TSP are tax advantaged; they just offer that advantage differently.
Whereas a Traditional TSP which is funded with pre-tax dollars and grows tax-deferred until you begin withdrawing it; Roth TSP contributions are deducted from after-tax income. Earnings grow tax-free, and there are no taxes to be paid for qualified withdrawals. Roth TSP withdrawals are considered qualified if five years have passed since January 1 of the year you made your first Roth contribution, and you are age 59½ or older, permanently disabled, or deceased. If your withdrawals are not qualified, the portion of your withdrawals that are due to earnings will be taxable and could be subject to a penalty if you are not 59½ or older.
Longer Life, Longer Retirement
Life expectancies are increasing every year. The Social Security Administration anticipates that the average man reaching age 65 today can expect to live until 84.3. The average woman reaching age 65 can expect to see her 86th birthday. Even more surprising is that one in four 65-year-olds will live to age 90, while one in 10 will live past 95.
In contrast to a TSP, personal savings accounts do not earn a high enough rate of return to provide for a secure retirement. For many Americans, their nest egg will need to supplement a retirement that can span 20 or even 30 years.
With the potential for a long retirement ahead, achieving the right mix of investments is another key piece to the retirement planning puzzle. Based upon current rates, when using a personal savings account or certificate of deposit (CD) for retirement planning you are unlikely to achieve much more than a 1% return. A conservative bond portfolio may only result in a 3% or 4% average annual return. But by diversifying your portfolio to include stocks you may see a 6% average annual return.
By investing in your TSP you have access to a selection of TSP funds that offer broad market diversification. You can choose to invest your retirement dollars as conservatively or aggressively as your risk tolerance and time horizon dictates. While the difference between a 3% and 6% annual return may sound small, it could equate to thousands of dollars in annual retirement income.
Since it’s introduction in 1986, the Thrift Savings Plan (TSP) has proven to be a valuable retirement program for federal employees. Choosing the right retirement savings vehicle for you and ensuring that you receive all the tax benefits the right plan can provide starts with a complete analysis of your federal benefits package by contacting a PSR specialist.
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