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RETIREMENT IS TOO BIG AND TOO IMPORTANT TO SCREW UP

Dispelling Some Financial Myths

Let’s face it, there’s a lot of bad information going around about finances.  And it may be even worse regarding FERS. It seems no matter how wrong the information is, repeat it often enough, and the general public accepts it as fact. Like when people use “irregardless” as a word.  Or when people believe that the moon landing was real. 

So, in the spirit of clearing things up, and educating all of us so we can make better decisions about our retirements, I want to address a few of the myths that seem to continue to circulate.



I’m worried my TSP won’t grow in retirement since I’m not contributing anything.



If you are at, or near, retirement age, chances are contributions LONG AGO quit being the driving force behind your TSP balance growing.  In other words, your account is growing more because of the market than because of your contributions, even if you are doing the catch-up payments.

Here’s what I mean.  (Spoiler alert: math time.)

Let’s say you are near retirement and you have a $600,000 TSP balance.  Let’s say you are conservative with that balance and you have it 60% in the C Fund and 40% in the G Fund.  And you had that allocation for all of last year. Let’s also assume you are over 50, so you’re participating in the full catch-up, and your agency matches 5% of your $130,000 salary.  Here’s how that breaks down:



2019 Contributions:  $19,000 (max) + $6,000 (catch up) + $6,500 (agency matching) = $31,500 Total

2019 Investment Gains: C Fund = $113,220,   G Fund = $5,376 = $118,596 Total



What this means is that this theoretical investment account increased far more from the gains than the contributions.  Almost four times more, in fact.  

Looking at it another way, say you earn 8% on your $600,000 account.  That’s $48,000 a year. Which, again, is more than the allowed contributions (including catch up and matching).  

While it is true that contributions help grow your account, they become a smaller and smaller fraction of the increase the older you get and the larger your account grows.  In retirement, your TSP will continue to grow from gains, even if you are not contributing anything. Now, if you go 100% into the G Fund that earns 2% a year, then yes, perhaps your contributions would be more than the market gains.  But unless you have a very specific situation, I am hoping that you are not 100% in the G Fund. Even the I Fund (which I despise personally) has averaged over 5% for the last 10 years, meaning it generates $30,000 on a $600,000 balance.

(Incidentally if you were wondering the 10-year average return for the C and S funds are, they were 13.59% and 13.08% respectively.  That means the account almost doubled TWICE in 10 years: a $250k TSP grew to almost $1m. Think twice before going 100% in the G. Yes, 2020 stinks so far. But there’s still 9 months left.)

Bottom line is that when you were starting out as a GS-7, even $10,000 in annual contributions might have doubled your TSP balance.  But when you have balances in the mid-six figures, those contributions factor in less and less. Do they help? Absolutely.  No question. But can your account also grow substantially WITHOUT contributions? Absolutely again.



I’m worried if I split my TSP in retirement into multiple IRAs my nest egg won’t grow as much since it’s not all together.  Shouldn’t I keep everything together in one big balance so it grows more?



I think this is simply a matter of being confused on how investment gains work.  

Assume one big TSP account of $500,000. And it earns 10%. That’s a $50,000 gain in one year.

Now, let’s say that a retiree keeps half of that in the TSP, and splits the rest of the balance into an IRA that invests in 3 different mutual funds.  Mutual Fund A gets $100,000. Mutual Fund B gets $100,000 and Mutual Fund C gets the remaining $50,000.

Once we do all that transfering, we’ll have this:

  • TSP: $250,000

  • Mutual Fund A: $100,000

  • Mutual Fund B: $100,000

  • Mutual Fund C: $50,000

    Total: $500,000


Now, let’s say each account earns the same 10%.  TSP now earns $25,000, Fund A earns $10,000, Fund B earns $10,000 and Fund C earns $5,000.  Add those together and we still get the same $50,000 gain.

In other words, a $500,000 account earning 10% is the same as if you split that balance into multiple accounts, each at a 10% return.  Your account does not grow slower if it is split up. Conversely, your account does not grow larger simply because it is all together.  

(This is of course, assuming the investments return the same gain.  If you are talking about different investments, then of course it will grow at different rates, but I don’t think that is what the question is.  The way people explain it to me is that they think their account will grow faster if all the money is in one account.)

I get Cost of Living Adjustments (COLA) on my Supplement (RAS).

Wrong.  You do not.  This is a common myth that just won’t die.  Not even retired LEO’s get COLA on the Supplement.  I have heard financial advisors say this. I’ve also heard government benefit specialists say this.  It….Is….Wrong. There is no COLA on the Supplement.  

There is a COLA on the annuity, depending on what category employee you are and what age you are.  But there is NOT one on the Supplement. If someone is insistent on telling you this, be careful with whatever else they’ve told you.

The Supplement is taxed like Social Security, i.e., it’s not all taxable income.

Wrong again.  The FERS Retiree Annuity Supplement (RAS) is taxed as ordinary income.  In other words, like regular wages when you were working. There is no reduced rate, and there is no step or ladder where a portion is taxed at a different rate, like SSA benefits.  It is taxed as normal, regular income, at normal, regular income tax rates.

I’ll start a business in retirement so the business makes all the money and I won’t lose my Supplement by earning too much.

This one is a little more uncommon, but I feel it must be gaining popularity out there because I’m hearing it more and more.  As a brief refresher, once you hit your MRA (56-57 for most of you), your RAS becomes earnings tested. Earn over a certain amount ($18,240 for 2020) and you start to lose the RAS.  OPM only counts EARNED money towards the limit. Investments, pensions, etc., don’t count towards the earnings limit.

So some creative individuals out there have come up with the idea of starting an LLC so that the business “earns” the money, and then they pay themselves a very small salary, very carefully calculated to be juuuuussst under the limit.  

While I proudly take my hat off to you for trying to find a way around the rules, there are a couple of issues with this strategy that don’t make it feasible.  One is that all earnings for the business also count as earnings for the owner in a set-up like an LLC.  I don’t want to get too far into the tax weeds here, but income flows through the business to the owner.  Whatever the business makes, the owner makes. That puts the owner over the limit if the business earns over the limit.

The other issue is that the IRS requires the owner of a business to pay themselves a “reasonable salary”.  You can’t have a business where you are the sole owner/employee and pay yourself $18,000 if that company is making $130k a year.  That would not be what the IRS calls reasonable. In essence, the auditor’s question becomes, “If you are only doing $18,000 of work for the company and you are the only employee, who is generating the other $112,000?”  

There is no hard and fast rule on what the definition of reasonable is.  I have seen some CPA’s claim 50% of the earnings are reasonable, under certain situations.  Under other situations, perhaps 80% would be the minimum of reasonableness.

The bottom line for our purposes is that it would be difficult to keep a reasonable salary under $18,000 if your company is making any amount of money that would be substantial enough for you to be working full-time in it in the first place.  

You might ask about other business entities like partnerships, C or S Corps. Is there a way you can make that work? Possibly. It would almost certainly require another person or company to be an owner, and you to be simply an investor-employee. I would say that if you are going to try this, make sure you find a good CPA and a good FERS benefit advisor. And preferably those two would be the same person. You misstep here and you might have a problem with the IRS, and/or have to pay back years of the Supplement. Both would be, shall we say, less than optimal.

Disability is a better retirement because it’s tax-free!

I think the fact that this myth makes the rounds so often these days is because people are interested in retiring more than ever. And willing to consider just about any option out there.

A disability retirement is a complicated thing under FERS.  There are a lot of moving parts. It MAY be a better retirement if you only worked a few years under FERS because you get a pretty generous percentage of your salary toward the retirement:  60% the first year, 40% for every year after that until you hit 62. On the other hand, it also means you’ve got some rather serious medical issues. So, while it’s better than no retirement, it’s probably not something you’re going to want to actively seek out, unless there is no other option. But listen folks, if this really is honest and truly where you are—like you have a serious problem and are unable to work up to par, please look into a disability retirement. Don’t further destroy your health by just sucking it up and coming to work to squeeze in a few more months or years. It may be very detrimental to your overall well-being.

But back to our original statement—it’s tax free, right?  Wrong. A FERS disability annuity is fully taxable as wages until you reach your MRA.  Once you reach your MRA, a small portion (maybe a very small portion) of the monthly check is not taxable.  This is just the part that you had paid already into FERS—you get to recover a little bit of that each month. But the vast majority is totally taxable.  It is NOT tax-free.

I don’t want to make more money (work OT, get a raise, sell appreciated stock, etc.) because the government will just take it all in taxes since I’ll be in a higher tax bracket.

This myth persists due to the fact many people don’t understand how taxes work in this country.  Currently the top federal income tax rate is 37%. That means no matter how much you earn, you always get more than the federal government gets.  If you are in this tax bracket and you earn a dollar, you get $.63 and the federal government gets $.37 (we’re ignoring any state tax and FICA for a moment). And to even get into the 37% tax bracket, you need to earn over $622,000 if you’re a married couple.  That’s a lot of money, I don’t care who you are.

But here’s the thing—is that entire $622k taxed at 37%?  No. That’s not how it works. That would be the case if we had a flat tax rate in this country.  But we don’t. We have a progressive tax rate. Meaning, you “progress” through the different income levels, and you only get taxed at that particular level’s percentage.  

I’ll use a married person as an example.  They make $130,000. The first $14k gets taxed at 10%.  The next $29k gets taxed at 12%. The next $32k gets taxed at 22% and the rest of their salary gets taxed at 24%. 

If that person works overtime (like a LOT of overtime) and somehow gets up into the next tax bracket (32% of anything over $321,450), ONLY THE EARNINGS IN THAT TAX BRACKET GETS TAXED AT 32%.  Not ALL of their salary.  

In other words, if you make a dollar of OT, you may take home $.68 instead of $.76, but you’re not LOSING money.  The government (as it is set up right now) always gets less than you get. It’s always beneficial for you to earn more money, from an income tax perspective.

Bernie Sanders once mentioned a tax top rate of 100% if he got elected.  I don’t know how that would work. In that situation, no one would work since they are working for free.  But under our current system here in reality land, working more and earning more is always beneficial to the bottom line of your paycheck.

As a bit of a history lesson, top tax rates in this country have sometimes been very high. VERY high.  You may complain about taxes now (and that’s certainly a right you have if you pay them), but we have it relatively good, historically speaking.  In WWI, the top rate was 77%. In 1952-1953, the top tax rate was 92%. The highest I’ve been able to locate was 94% in 1944-45, which of course was to help pay for the war.  And it was only on the ultra-wealthy.

All of the above talk was about tax rates on wages, or earnings.  There are other tax rates at the federal level besides ordinary income. For example, maybe you buy and sell mutual funds, or a stock.  If you make money on the sale, you pay something called capital gains tax. The highest long-term capital gains rate right now is 20%. So, better to make money selling stock than working at a job, right?  (Make enough capital gains though, and you may be dinged with an extra 3.8% Additional Net Investment Tax, but still you’re only at 23.8%). Dividends from stocks are taxed much the same way. Short-term capital gains (investments held less than an year) don’t get the reduced tax benefit-they are taxed at your income rate.

Sorry if the CPA came out in me a little bit there.  I know taxes are boring. I just want you to understand that you aren’t hurting yourself by earning more money.   At least not from an income tax perspective. Could you earn just enough to lose the RAS, or SSA benefits and hurt yourself that way?  Possibly. But that’s a separate conversation.

Let’s continue with a taxes a little bit more….


I can’t pay off my house.  Then I won’t have a tax deduction.


Ugh—this one is fingernails on a chalkboard to me! It’s wrong on two levels.  First of all, under the new Tax Cuts and Jobs Act (TCJA), the standard deduction was raised so high ($24,800 for married this year), most people aren’t itemizing (i.e. getting the deduction) anyway.

Even if you are itemizing and are claiming mortgage interest, let me explain how that works.  Remember how we talked about tax brackets above? Let’s say you are in the 22% tax bracket (and most of my readers are in the 22% or 24%), for every $1.00 in mortgage interest you pay, you get to deduct that $1.00 in federal taxable income, which means you save $.22 on your taxes.   (Remember that for every dollar you make in that tax bracket, you pay $.22 in tax?) The reverse works as well. If you reduce your income by $1, you save yourself $.22 in tax.

So what this means is that for every $1 you pay to the bank in interest, you get back $.22 in the form of tax savings.  $1 to the bank, $.22 back to you. But look at that math for a second. You are paying $1 to get $.22 back. You are still out $.78 net.

(Incidentally, if you still think this is a good deal after reading this paper, I have a special, unlimited-time offer. I’ll DOUBLE whatever the IRS gives you back. For every dollar you send me throughout the year, the following April I will give you back $.44. Hey, let’s make it an even $.50. Send me $1,000 and I’ll send you back $500. There is no limit to the number of times you can do this, and I will offer this deal to anyone—100% pre-approval. No credit check required. Contact me to make the arrangements. I accept PayPal, Zelle, Venmo, CashApp, gold, silver, Euros, and any virtual currency you prefer.)

Conversely, if you pay your house off in full (and we are assuming you have the ability to do just that, or this whole argument is pointless anyway), you no longer get the $.22 back from the IRS, but you also no longer have to pay the $1 to the bank.  So, now you’re AHEAD $.78. 

Just so we are clear, being ahead $.78 is better than losing $.78. 

Now, the next argument you may throw back at me might be “My mortgage is 3% and I can make 8% on my money, so why would I pay my mortgage off?”    I’m not arguing with you on that point. Deciding not to pay the house off because you can make more money elsewhere with that cash is an entirely separate argument.  I’m simply saying if you are keeping your mortgage for the sole reason of a tax deduction, you’re hurting yourself when you net the numbers out.

Summary


I think the moral of this story is to just be careful. Where are you most likely to hear these myths? Unfortunately, probably from the self-proclaimed expert at work who is always offering his opinion on what you should do with your TSP. Remember that details on every single piece of our retirement is publicly available on OPM or other government sites. It may be an inconvenience to wade through it all to look it up, but it is probably easier than you think. If you’re at a retirement seminar and the presenter says something that just doesn’t jive with what you have heard in the past, ask for an official reference. If they can’t give one, try to find one yourself. If you can’t, be concerned. Contact me, Dan Jamison, or some of the others out there that CAN provide you chapter and verse.

That’s enough for now I think. If you have a myth you want cleared up, post it in the comments below or shoot me an email and I’ll do my best to let you know the truth.



Disclaimer: Personal finance is VERY personal. What works for one may be terrible for the next person. Do yourself a favor and invest in yourself by seeking professional help with your questions. Don’t make important financial decisions based on what some person on the internet wrote, even if that person is me. I’m not trying to dish out financial or tax advice, so don’t interpret this paper as either of those. I’m simply trying to educate you so you know how to arrive at the best decision for your situation.

Chris Barfield3 Comments