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Roth TSP vs Traditional TSP: A Guide for Federal Employees

The Thrift Savings Plan (TSP) is a type of retirement investment plan for federal employees and members of the uniformed services. Over 6 million people have a TSP, making it the largest defined contribution plan in the world. Moreover, it is said that about 9 out of 10 contributors are either satisfied or extremely satisfied with TSP.

Originally, only one type of TSP was available. In 2012, however, a new tax treatment option was introduced, the Roth TSP. This gives federal employees the option to choose how they will be taxed for their TSP contributions.

Before you start investing in a TSP, you need to decide between Roth TSP vs traditional TSP. Both options have their own strengths and risks, and which one is better depends on certain factors, including where you are planning to retire, your current and future tax brackets, and whether you want to pay taxes now or later.

The Difference Between Traditional TSP and Roth TSP

What is a Traditional TSP?

Introduced in 1986, a traditional TSP allows you to make contributions that won’t be subjected to taxes. You will only be required to pay taxes once you decide to withdraw the funds during retirement. Traditional TSP will also have an impact on your tax bracket as all the amount you put into your TSP will be deducted from your taxable income.

To help you understand this better, let’s say your annual income is $150,000 and you want to set aside $15,000 of it for your traditional TSP. What will happen is that the amount you made as a contribution to the traditional MSP will be deducted from your taxable income, making it only $130 thousand. 

What is a Roth TSP?

In 2012, a new tax treatment option for TSP contributions was introduced called a Roth TSP. By choosing this option, you will be required to pay taxes before you make any contribution.

Since you will have already paid taxes, you will not be required to pay any additional taxes once you take the money out during retirement. This means you will get the full amount you contributed and the earnings you made throughout the years. It makes this option appealing to a lot of federal employees as they view it as an opportunity to have a tax-free stream of income once they finally retire.

Using the same example, if your annual income is $150 thousand and you decide to put $15 thousand of it to your Roth TSP, your annual income will remain at $150 thousand. The good thing is once you retire, all of the money you will take out is going to be tax-free. However, you will have to pay taxes ahead of time. 

The Benefits and Risks of Traditional TSP and Roth TSP

What are the Benefits and Risks of Traditional TSP?

The main advantage of investing in a TSP is that you don’t have to pay taxes for your contributions right away. More importantly, it gives you the opportunity to lower your taxable income. With that said, the higher your annual earnings are, the more traditional TSP would benefit you.

Traditional TSPs also do not require contributors to pay capital gains tax on any TSP transactions. This allows your money to grow tax-free, increasing your retirement savings.

The main risk of choosing a traditional TSP is that you cannot predict the amount of tax you need to pay once you retire. It is likely that tax rates are going to increase in the future. There is also no possible way to predict whether your tax bracket would be lower or higher in retirement. It will be up to you if you are willing to take the risk.

What are the Benefits and Risks of Roth TSP?

The main advantage of choosing a Roth TSP is that once you retire, you don’t have to worry about paying taxes for the amount you withdraw. This allows you to enjoy your full retirement savings, which is the total amount of the contributions you make and the earnings from TSP.

A Roth TSP can also be beneficial to those who are just starting their careers as federal employees. It is likely for them to have bigger salaries in the future, which will increase their taxable income. However, a Roth TSP protects you against future tax increases, so you don’t have to worry about it since taxes were already paid before you made any contributions.

The biggest disadvantage of a Roth TSP is that you will lose the opportunity to lower your tax bracket while you are still earning. As mentioned above, no matter how much you contribute to your Roth TSP, you will not be able to lower your taxable income, preventing you from getting into a lower tax bracket.

Another important thing to know is that in order for you to ensure that you will not be charged with taxes when you take out an amount, you need to be at least 59 years old and six months and have had money in the account for a minimum of five years.

If you are not able to meet either of these two requirements, you need to pay taxes. However, only the earnings on the contributions will be subjected to tax deductions. All amounts that are considered part of your contributions will remain tax-free.

Roth TSP vs Traditional TSP: Which One to Choose

The main difference between a traditional and a Roth TSP is with regards to when you need to pay taxes, but there are a lot of other things to consider before deciding which one fits you better. Both a traditional TSP and Roth TSP have their own advantages and disadvantages, and the answer to which one you should choose will depend on what looks more beneficial to you based on your unique circumstances. Whichever you choose, as long as it suits your preference and meets your expectations, you will be extremely satisfied with investing in a TSP.

If you want to pay taxes now, so you don’t have to worry about it in the future, we suggest that you go with a Roth TSP. If you want to lower your tax bracket to have a larger take-home pay now, then a traditional TSP is most likely the best choice for you.

You can also consider other things, such as where you want to retire. If you are planning to move to a state with a high-income tax, it would be better to choose a Roth TSP, but if you are going to stay in a state with little income tax, then a traditional TSP is most definitely more ideal for you.

Regardless of which one you choose, both a traditional and a Roth TSP are exciting additions to your retirement toolkit. This guarantees you that you will have a continuous cash flow once you retire, allowing you to enjoy your senior years much better.

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