TSP Showdown: Roth vs Traditional

12/31/22 UPDATE: SECURE ACT 2.0 GREATLY IMPACTS TSP AND RETIREMENT ACCOUNTS. INCLUDING SOME OF THE ITEMS IN THIS ARTICLE. PLEASE RESEARCH CURRENT LAWS BEFORE MAKING FINANCIAL DECISIONS.

I'm writing this article with the full understanding that the universe does not need yet another gaggle of words comparing the Roth to the Traditional.

It's the financial world's version of a never-resolved argument. Like Ford vs. Chevy, 9mm vs. .45, or for those of a certain age, Ginger vs. Mary Ann. It's not likely to be put to rest by me or anyone else anytime soon. But I get so many questions on it, and I see so many flawed justifications for one over the other in some horrendous financial article, I thought I'd take a stab at writing something that is actually understandable for the common person. And also based on honest math. I think that alone might make this version of the comparison unique.

BLUF (Bottom Line Up Front.) If you are insistent in your preference for the Roth TSP (or the Traditional TSP), I'll say this: I agree with you. You are correct. I'm on your side, whichever one you ultimately choose. What? Why is that? Because:

There are benefits (and drawbacks) to each, but the fact that you ARE saving significantly for retirement is far more important than WHERE you are saving for retirement.

REVIEW OF THE BASICS

Just so we're all on the same page, let's review the main difference between the two: Taxes. If you have money withheld from your paycheck going into the Traditional TSP, you are getting your tax benefit now. If you make $100k, and you contribute $10k to your TSP, you are really only earning (and thus only paying income taxes on) $90k this year. Your contributions come off the top. The Roth is the opposite. If you make $100k and you contribute $10k, you're still earning $100k this year and paying income taxes on that amount. Which is why you often hear financial nerds use terms like "pre-tax dollars" (Traditional) and "after-tax dollars" (Roth).

Now, at the other end of our timeline (when you withdraw the money), what hasn't gotten taxed yet will get taxed then. And what already has been taxed, won't get taxed again. In other words, all money gets taxed, but only once. So for you that got the tax benefits of the Traditional TSP when you contributed, you will now have to pay taxes when you withdraw money from your account. All of it will be taxable. And as ordinary income. Conversely, those of you that bit the bullet back then and paid taxes (Roth investors), you've already rendered unto Caesar so to speak, so your withdrawals won't be taxed.

As you can see from this short little explanation, you'll have to pay taxes one way or the other. The question is whether you want to pay them now or later. Most people make this determination based on what their tax rate is now compared to what they speculate it will be 10, 20, or 30 years from now when they take their withdrawals. And we'll get to this analysis in a few.

One caveat I should point out is that everything you just read applies to your contributions. ALL agency contributions (the automatic 1% and the matching funds) have to go into the Traditional side of the TSP. So even if you have a Roth and you put all of your contributions in it, you will still have a Traditional side that will grow...and ultimately be taxed. This should make sense, because that matching you got was never taxed on the front end.

So let's get into how the Roth is always the better choice.

Myth: The Roth will always be more in the long-run because of tax-free growth. 

This is the overwhelming argument for the pro-Roth zealots. Articles will show that if you put $10k (for example) into the Traditional and $10k in the Roth, the Roth will have more money after the taxes are paid on the Traditional at withdrawal time. Here's their math:

Traditional: $10k annually for 20 years at 8% return = $490,000

Roth: $10k annually for 20 years at 8% return = $490,000

Fast forward 20 years and it's now withdrawal time. Let's say we're in a 27% tax bracket (24% for federal and 3% for state), so each withdrawal gets dinged 27%. If we apply that rate to the Traditional that would be $132k in taxes over time, and we're left with only $358,000 in the Traditional. Clearly the Roth beats it since no taxes are due on the Roth.

Of course the Roth wins. It always will if you use this approach. But it's the wrong way to compare the two. Why? Because there is a flaw in the comparison itself. Remember back in my review when I said we have to pay taxes on our money before we put it into the Roth? Let's assume all we can afford to budget for savings from our paycheck is $10k. Because we have to pay taxes on that money before we can contribute it to the Roth, all of that $10k isn't going into the Roth. Some of it is going to the IRS as federal income tax, and some is going to state income tax (if you have that). If you can only afford to set aside $10k out of your income for the year, only about $7k of it is actually going into your Roth.

You may be confused right now. That's ok. I'm sure you're not the only one. But stick with it. Because this is an important point. And I'll keep explaining it in different ways for you. Let's say two people make $100k and they each actually NEED $90k to live on. They can't go below $90k. That means they can each afford to "save" $10k. So Ginger puts $10k into her Traditional TSP. She doesn't have to pay taxes on $100k of income, only $90k, so she's good. Putting $10k into her Traditional only cost her $10k. Or, said another way, ALL $10k went into her TSP.

Mary Ann, on the other hand, has $10k she can invest as well, and decides to go with the Roth TSP. She's going to get taxed on the full $100k she earned. That means that even though she's trying to set aside $10k into her Roth, she can't put it all in there, because some of it has to go to taxes at the federal and state levels. After that money is taxed, she's really only got about $7,300 or so that goes into Roth.

Why can't she put the full $10k in? Well she could, but we said that she needs $90k to live on, meaning she can't go below that number. To put a full $10k in, she would have to reduce her salary to somewhere around $86,000 or so to have a full $10k left over after she pays her taxes. And since that puts her below our threshold of $90k, it won't work for her budget.

I'll say it one more way: To contribute $10k to a Roth, you have to actually MAKE about $14k, since taxes have to come out before you contribute.

So, let's get back to the original statement that you see in lots of the financial articles: Putting $10k into a Roth beats putting $10k into the Traditional. I said this was comparing apples and oranges. This is what I meant: To put $10k into the Roth, you have to actually make about $14k. If we really want this to be a fair comparison, we should compare $10k in Roth contributions to $14k in Traditional contributions. That's only fair, right?

I know your head hurts by now and you're ready to go veg out on mindless Tik-Tok videos, but let me say it in one last, different way to see if it makes better sense. When you have $750 deducted from your biweekly check to go into your Traditional TSP, that's all it cost you. And that's all you had to earn to contribute that amount.

When you have $750 deducted from your biweekly check to go into your Roth TSP, you actually had to earn over $1,000 to have $750 leftover to contribute (again, because of taxes). You could say that the $750 in savings cost you $1,000 in earnings.

So, an honest comparison would be to have $1,000 going into your Traditional vs $750 going into your Roth. I mean, if you can afford to have $1,000 deducted (both in taxes and Roth contributions) if you contribute to Roth, it's only fair to have the same amount deducted going into the Traditional side, right? It seems a bit dishonest (and flat wrong) to say "I can afford to have $1,000 deducted from my check for the Roth, but I can only afford to have $750 deducted from my check for the Traditional."

Anything short of this is unfair math, skewed in the favor of the Roth TSP.

Let's say we even out the playing field and unskew the numbers. What do we have then? Now we have a math problem comparing the following:

$14,000 a year for 20 years at 8% in the Traditional = $687,000

$10,000 a year for 20 years at 8% in the Roth = $490,000

Now it looks like the Traditional is the clear winner. But remember: That money is taxable. The Roth is not. Let's assume we are still in the 27% bracket like our first example, and apply this to the $687k as we withdraw it over time (Not all at once obviously!). After taxes we'd have about $500k. A little more than the Roth--but not by much. Of course, I'm rounding off these numbers to make them more readable. The point I want you to see is that the Roth and the Traditional come out to be about the same if you are honest about what is going into each one on the front end.

Again, to summarize, putting $10k in Roth vs $10k in a Traditional TSP means that the Roth will almost always win, but if you can afford to put in $10k into a Roth, the equivalent going into the Traditional is more like $14k so we need to compare those two numbers to be fair.

And what do they both come out to if you take this approach? Roughly the same, after-tax balance, come withdrawal time.

I've essentially tried to make only one point so far: When comparing the Roth TSP to the Traditional TSP, you have to be fully honest with the math, particularly with regards to the contributions. It's not as simple as saying, "Roth always wins" if you compare the two by putting the "same" dollar amount into each. It doesn't really work that way in real life. If you can afford to max out either the Roth or the Traditional ($19,500 for 2020), then yes, the Roth will almost always win. But understand that to max out $19,500 into the Roth, it takes a significantly larger amount coming out of your check to get that full $19.5k, and that has to be considered in your decision making. And if you can afford to max out your Roth TSP, you could also alternatively afford to max out the TSP Traditional AND put even more money aside in another investment vehicle...and, well, coming out roughly the same again.

The bottom line is that you can always afford to put more into the Traditional side than the Roth side. And any fair comparisons must include that point.

Some of you may be left wondering, "But what if my tax rate is higher in retirement? Or lower? Or the same???? Doesn't that matter in my decision-making?" Good question. It sure does. And, we'll get to that part now.

TAX BRACKETS

What about tax brackets? (I know-your eyes are starting to glaze over). After all, this is the heart of the Roth vs. TSP, right? Pay the lower tax now, so you can pull out as much as you want later on without having to pay a higher amount—isn’t that the key?

It is, but that’s not always as simple as it seems. This only works if the taxes you are paying now are less than what they would be in the future. Are they less now than they will be? Who could possibly say for those in the latter part of their career?

I think we could all agree that the 22 year old, new GS-7 who is making $40,000 is probably better off sending his contributions to the Roth. After all, he’s in the 12% tax bracket for 2020. That’s a pretty safe bet. 12% is an historically low tax rate and one you’d be glad to take advantage of. Would I volunteer to write one check for 12% on all of my investments right now? You better believe I would! I would take out a second mortgage to pay it if I had to!

The question becomes more of a quandary when you are later in your career and are in the 22% or 24% tax bracket, which is where I would estimate the vast majority of my readers are located. These brackets cover (for married individuals) $80,000 to $326,000 of income. That’s a broad range. Do you want to pay 24% now in the hopes that the brackets will be larger in the future? Granted, these brackets are only valid for the next 7 years or so, when the Tax Cut and Jobs Act expires. Will taxes go up? Almost certainly some brackets will go up. But what is more relevant is this: Will YOUR tax bracket go up?

Incidentally, this is at the heart of the Roth conversion question. As a federal employee, unlike a lot of people, you will not have a year in which you earn zero income, which is when the Roth conversion is at its most powerful. You will either be earning your salary, or you’ll be earning your pension. So any conversion you will attempt to do, will ALWAYS be on top of income, sometimes substantial income. Does it make sense to do it? You’ll have to talk to a financial advisor to run those numbers but understand, it is not simple for federal employees. You may have less money in some years (if you don’t pull from your TSP), but you will never be at $0 income.

I’ll leave you with one complete example that sums all of this up. If you haven’t read everything above, it’s ok. Here’s an example that encapsulates all of my ramblings:

Imagine a married couple who are both 40 years old. They make a combined income of $150,000, so they are in the 22% bracket. They plan to start withdrawing at 60 years of age, so they have 20 years of this account earning money. And let’s say the account earns 8% each year. They can afford to have $19,000 deducted from their check for this year. So, let’s look a comparison:

ROTH:

They can afford to lose $19k but that is taxed now, so the amount actually going into the ROTH TSP ends up being $14,820 after tax.  Let’s just take this one year of contributions to show what happens to that money. Compound that money for 20 years at 8% and you have $73,015 at age 60, tax free. $14,820 turned into $73,015.

TRADITIONAL:

They can afford to lose $19k out of their check and since it's not taxed, the full amount goes into the Traditional TSP.  20 years at 8% is $93,609.  However, that's now taxable money.  Let's assume even in retirement they are in the 22% tax bracket and they withdraw the full amount at one time, getting hit with the maximum tax possible.  22% of $93,609 is $20,594.  They would owe $20,594 in taxes. Subtract this amount from the $93k and you know what you're left with?.......$73,015!!!  The same exact amount as the ROTH equation. 

Now, this is an oversimplified example—who contributes for only one year? But I wanted to isolate that amount of money so that you can see what would happen if you took it in a withdrawal 20 years after you contributed it. Would this fictional couple be in a higher tax bracket in the future? Possibly. Could they be in a lower tax bracket in the future? Also possible. The only known tax due is today.

SUMMARY

Again, I’m not advocating against the Roth or the Traditional. I’ll be honest, I don’t really care. I am more concerned that you have a plan and are contributing substantially to your plan. Only in hindsight will we ever know which plan would have been the best one for your life, and at that point, it will be too late.

The other thing I want you to takeaway from this is that you will almost certainly benefit from a financial advisor helping you come up with the best solution for you and your own situation. He or she can take all of the inputs and estimates you’ll have over your lifetime and run various scenarios that will probably help you to save thousands. Why someone would balk at paying $2k or $3k on a solid financial plan when your net worth is $500k or more, is beyond me. I mean we pay a lot more than that for our car insurance, and the car may only be worth $30k!

If you’ve read all this, I commend you. Thanks for your time—I know it’s valuable!

Until next time, keep feeding that TSP!

DISCLAIMER

I will say yet again, I’m not advocating for one or the other. Don’t base financial decisions solely on some article you read online, even if I wrote it. Seek some professional help. Personal finance is very personal. It is personal to your situation, and your situation only. Copying what your coworker does because it “feels” right, is not a financial plan. It’s pretty much the opposite of a plan.