Your family has worked hard for that money in your TSP and your military pension. You probably have substantial pretax dollars in your TSP as you may not have known about the Roth option and even if you did and made that change, the matching service contributions are made in pretax dollars. You've heard of Roth conversions but aren't sure if it will benefit you. Is it wise to convert pretax retirement money into a Roth? Most people are in a lower tax bracket after retiring and think it is just fine that their income be taxed at the lower rate during retirement. Why convert to a Roth and pay taxes now when you can just withdraw that money in retirement and pay the taxes then at the lower rate? The Roth conversion question is a complicated one. In this post, we'll review the concept of Roth conversions and the factors that determine if you are likely to benefit from converting.
A quick review of the concept of Roth conversions is essential to give you a base of understanding. When people save pretax money in an account, it's called a tax-deferred account because they got a deduction on their taxes and they'll pay ordinary income tax on it when they withdraw it. Pre-tax money is the default that TSP accounts are invested in as a part of the Blended Retirement System. The income tax amount varies based on the total income the more you
Money in a Roth account is treated entirely differently when withdrawn. Qualified withdrawals from Roth accounts are tax-free--both the principal and the gains. The drawback is that you must pay income taxes on the money when you earn it or convert it into a Roth. So, literally, the million-dollar question is, "should I pay the tax to get my money into a Roth so I can withdraw it tax-free later?" As you can probably guess, the answer is still; it depends. So, what is the answer for your family? There are multiple factors to consider when considering converting pretax retirement accounts to a Roth account. There are several factors to consider when thinking about transferring traditional TSP account dollars into Roth dollars.
Effective tax rate. Compare the effective tax rate in the years you're considering converting to the effective tax rate when you'd otherwise withdraw the funds and be taxed. For many people in high-earning years, converting to Roth may mean paying a higher tax rate than withdrawing the money slowly in retirement years when their tax rate might be lower. However, for big savers, and sometimes for military members, their tax rate in retirement may be equal or higher than their current tax rate. Besides Federal taxes, any planned changes in the state of residence and effective state tax rates should also be considered.
Impact of required minimum distributions (RMDs.) When we turn 72, Roth IRAs don't require required minimum distributions (RMDs) like Regular or Roth TSP/401Ks require. For big savers, RMDs from tax deferred TSPs/401Ks/IRAs can drive individuals into higher tax brackets during their retirement years and create significant tax bills. There may also be second-order effects such as potential increases in taxes on social security and Medicare.
IRMAA. Income-related monthly adjustment amount or IRMAA is Medicare’s way of ensuring that higher income folks pay a fair share of their medical cost. Essentially Medicare charges a set monthly amount for participating in Medicare. As your income rises at certain break points the premium paid by the individual rises. Distributions from a Roth account are not included in the computation for IRMAA.
Passage to heirs. If leaving some of your assets to your heirs is a priority. The Roth account provides a much more efficient mean of transferring to your heirs. After the passage of the SECURE act the recipient of the Roth account has 10 years to take the funds out of the account. None of these withdrawals are taxable to the heir. A traditional account requires the funds be withdrawn in a quicker timeline and that they are taxed to the heir.
The decision to transfer a traditional account to a Roth can be very lucrative if done at the right time. The factors in this decision involve financial factors such as effective tax rate and IRMAA and factors more of a preference factor such as ease of transferring the account to heirs.