Tax-advantaged retirement savings are a key part of your overall financial plan, but there can be some barriers to getting started. First, you have to have money to save and invest, and then you have to pick where you want to save and invest. Having to pick can make it hard to get started.
Military members have two main options for tax-advantaged retirement savings: the Thrift Savings Plan (TSP) and Individual Retirement Arrangements (IRA). If they are covered by the Blended Retirement System, they should strive to contribute at least 5% to their TSP so that they get the full government matching funds. Beyond that, there are pros and cons to either choice. You need to do a little research and pick one.
But then, just when you think you’re ready to go, you are faced with another choice: What type of tax treatment do you want your account to have?
Both TSP and IRAs have the option to choose a traditional tax treatment or Roth tax treatment. (IRAs are subject to income limits that change each year.) The basic difference between these two options is when you pay the taxes, but Roth IRAs also have non-tax differences that are important, too. These differences don’t apply to TSP.
When these products came out, there was only one tax treatment, what we now call “traditional.” Contributions are made pre-tax, meaning they are taken out of your pay before your taxes were calculated (for TSP) or you can take a deduction on your income tax return (for IRAs). This lowers your taxable income for the year, which means that you pay fewer income taxes in the year you make the contribution. You pay the income taxes on the contributions and income earned when you take distributions in retirement.
In 1997, the Taxpayer Relief Act created a Roth option for IRAs. If you select a Roth IRA, you don’t deduct your contribution in the year that you make them. Instead, Roth IRA contributions and earnings are income tax-free when they are taken out of the account in retirement. This appeals to people for three reasons: the cost of the taxes on the growth over the years, the possibility that income tax rates will increase over time and the possibility that you will be in a higher income tax bracket in retirement.
In 2006, the TSP got a Roth option. Contributions are made from your paycheck before your taxes are calculated. This doesn’t change your taxable income for the year, so you pay income taxes on the money used to contribute in the year that the contribution was made. However, distributions don’t have income taxes on the contributions or the growth that has happened inside the accounts, if you meet the two rules: being at least five years since you opened the Roth IRA, and also being at least 59 ½ years old or having a permanent disability.
So for both TSP and IRAs, you have a traditional and a Roth option. Often people call their IRA “a Roth,” and that’s confusing because it’s not clear whether they are talking about TSP or IRA. It’s sort of like having blue pants and a blue shirt. If you say you’re going to wear your “blue,” that doesn’t help anyone (unless you have some super-spectacular blue outfit that everyone will remember).
Roth IRAs also have two big differences from the other tax-advantaged retirement accounts: penalty-free access to contributions before 59 ½, and no minimum distribution requirements. As long as your Roth IRA has been open at least five years, you can withdraw the contributions at any time, without penalty or additional taxation. (There are rules, of course.) And there is no required minimum distribution on Roth IRAs, so you can leave that money in there even after age 72 if you don’t want or need the income.
Choosing between Roth and traditional accounts is one more step in the process of setting up your retirement savings, but understanding the basic differences between them will help you make that decision. Still not sure? Your installation has personal financial educators who can explain more.
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