Pay Right Away or Wait for Later
In previous years there was a series of advertisements that involved an auto mechanic trying to market a particular brand of oil filters to viewers. At the end of the commercial, there was a warning reminding viewers that they could pay immediately or wait and pay later.
The warning meant that failure to immediately buy an oil filter would lead to extra costs as dirty oil would cause a lot of damage to the engine.
The same concept is applied when it comes to retirement savings programs where one has an option of paying lower taxes now, or risk paying higher taxes later. The federal Thrift Savings Plan is a perfect example of retirement savings programs that apply to this type of investment concept.
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The fact that pre-tax dollars are normally put into investments for traditional balances means that individuals with higher income benefit from the substantial up-front tax break. However, there is full taxation for the earnings and the other amount upon withdrawal.
On the hand, after-tax money is used to make investments when it comes to “Roth” balances. Such investments do not attract any taxes on withdrawal but the participant should be deceased, disabled, or at least bet 59 ½ years old. In addition, one has to wait for at least five years in order to make a withdrawal.
As an indication that this choice is critical, there has been a debate in recent years over tax policy on Capitol Hill. Putting limits on the traditional balances investments is one way of offsetting lost revenue in instances where tax cuts are made introduced. Setting a lower threshold has been the latest suggestions where any extra amount above the threshold for those above 50 years should only be invested after tax.
For now, the new ideas have not been implemented as most sponsors feel that Roth investments may only have short-term revenue benefits. The discussion is healthy as it is important to remember that a person’s retirement finances are at stake as considering the long-term effects.
The Centre for Retirement Research Report
According to this report, the participant’s taxes were immediately cut by the traditional 401(k)s contributions but this remains an issue of perception. A typical participant may not be attracted by Roth 401(k)s due to lack of tax relief.
However, it is good to know that you can only spend the money in your account. In this case, participants are guaranteed full support in retirement as the Roth account does not attract other taxes. Upon withdrawal, there will be taxation on the traditional account funds as the account balance is typically higher than the support funds.
Consequently, TSP investors have to make a decision on where to invest every pay period and what proportion to invest. Investors can choose to invest in the two plans but can opt out if the annual limits are less than the combination. However, the investor may also decide to stick with the combination.
Traditional investment attracts lower taxes on withdrawal as the retirees are classified in lower tax brackets. This is the major advantage associated with this type of investment. On the other hand, a tax-free withdrawal is the main benefit associated with Roth investments.
According to the report, there are some instances where an investor has no control over certain variables as the decision is very complex. There is a general perception by participants that they are more likely to have a lower tax rate in retirement considering the fact they will be living on less.
However, the ever-increasing federal budget deficits might make future Congress raise taxes due to the dynamic nature of the tax system. Therefore, the Roth choice is rarely applied in the TSP as a result of such complexities. For a TSP account with $500 billion, Roth balances should only be $8 billion.
Military personnel have a high rate of Roth balances, and this can skew the amount. Until 2012, the only type of investment allowed in TSP was the traditional system and this is the reason why there is a movement towards this type of investment.
For questions on your own TSP, please reach out to your local financial representative.
