Author: Brian O'Neill, CFP®

Categories
Taxes

The C-Word(s)

If you really want to upset someone, use the C-Word. Or the other C-Word. If you want to really get them spinning, use the other, other C-Word.  Of course, we’re talking about Contribution, Conversion, and (Re-)Characterization and how they apply to your IRA. This is a personal finance article, not edgy British banter but these C-Words cause untold confusion, consternation, and conundrums for IRA investors. Wouldn’t be great to finally comprehend the C-words?

IRAs and the C-Words

The C-Words crop up for IRA investors because each C-Word has considerable IRS-driven rules and limits that affect what you can and can’t do with your IRA. Let’s break down each C-Word.

C-Word #1–Contribution

Contribution: A Contribution to an IRA is new cash conveyed into the IRA. You transfer money from say, your checking account, to your IRA each year if you meet certain criteria:

  1. Calendar Year: Contributions are limited to the calendar year, plus the time to the personal income tax filing deadline, usually April 15th. I.e., you get 15 ½ months from January 1, 2023 to April 15, 2024 to Contribute cash to the coffer. 
  2. Ceiling: No matter how much you earn, you can’t Contribute more than the annual Contribution limit. In 2023, that’s $6,500 or $7,500 if you’re over age 50 (including the year you turn 50). 
  3. Compensation: Depending on how much you earn, your Contributions can be limited. Common compensation limits (for 2023) include:
    1. $218K—above this, you need to bring Backdoor Roth IRA into your crosscheck ($138K for single tax filers). 
    2. $116K—above this, you can’t deduct the whole Contribution… if you have an employer plan too such as the TSP or 401(k). ($73K for single tax filers). 
    3. $6,500—below this level of earnings, you can’t Contribute the full amount to your IRA. Except for a non-working spouse, you must have earned income to Contribute to your IRA. For two spouses, $13K is the number and over age 50, add $1K-$2K for single and married.
    4. There are many other limits, but these are the most common.
  4. Company: If you work for an employer that offers a plan such as a pension, 401(k), TSP, etc., then the existence of their plan affects whether you can Contribute to, and DEDUCT from income, any amount to an IRA. Most larger employers offer some sort of plan, but not all. 
  5. Combo: While you can Contribute to both a Traditional IRA and Roth IRA in the same year, it’s uncommon do so. You have the same overall cap: $6,500 or $7,500 in 2023, so you would be splitting it between both types of accounts.  In some novel cases, this could make sense. 

Contributing is the main C-Word most of us do each year. We earn cash, cogitate about Contributing, then convey the dollars from our checking to our IRA account. It’s quite possible you’ll never have a merge with the other C-Words, but let’s check them out anyway!

C-Word #2–Conversion

 

Conversion: A Conversion in IRA parlance is the act of transferring money from a pre-tax (Traditional) account such as an IRA, TSP, or 401(k) into a Roth account, usually an IRA. The logic of a Conversion is that you decide it’s better to pay taxes on the Converted amount today rather than some future date, e.g., retirement. Considerations for Conversions cover the spectrum:

  1. Cost: Converting costs money in the form of additional tax dollars paid that year. If you Convert $100K from a pre-tax account to a Roth account and you’re in the low portion of the 24% federal bracket, you know the Conversion will cost at least $24K.
  2. Customs: Most of the rules for Contributions come from Aunt IRS. Many of the Conversion rules do as well. But employer plans can have their own Conversion rules. E.g., many airline 401(k) plans allow “Mega Backdoor Roth IRA” Conversions inside the plan. The main rules that apply to Conversions include:
    1. One 60-day rollover per year. It’s possible to have your Traditional IRA/401(k) custodian cut you a check for the Conversion amount. You then have 60 days from receipt to deposit the entire amount into the Roth IRA. In the intervening 60 days, you can buy whatever vapor investment your troops are telling you about and hope it goes to the moon… but you still must come up with the whole rollover amount by day 60 or you’ll not only pay tax on the Conversion but an additional 10% if you’re under age 59 ½. 
    2. No limit on amount Converted. One of the main sources of C-word confusion is that IRAs have Contribution limits, e.g., $6,500 per person in 2023 but you can theoretically Convert infinity dollars per year.  
    3. No interplay between Contributions and Conversions. Just as there is no interplay between the amount you Contribute to your IRA and the amount you Contribute your TSP/401(k)/403(b), there is no governing limit between the amount you Contribute to your IRA and the amount you Convert to your Roth IRA in a year.  You might self-impose a limit based on the amount of tax you want to pay, but Tax Uncle won’t cap your Conversions. 
    4. Unlimited trustee-to-trustee Conversions. While you can only take personal possession of your Traditional dollars as part of a rollover once per year, you can have your brokerage (e.g., Vanguard, Fidelity, Schwab, etc.) perform Conversions as often as you like (to pay taxes…). 
  3. Cinco Year Rule: There are many five-year rules in the IRA world, and for younger investors, they’re generally irrelevant. Nonetheless, Converted dollars must stay in the IRA five years before being pulled out or they incur a 10% penalty tax.  The reason why this rarely matters is that IRS rules for ordering the dollars coming out of an IRA stipulate that Contributions precede Conversions which precede earnings on exit from a Roth IRA. As long as you’ve been Contributing for a few decades by the time you start pulling money from your Roth IRA, you’ll have a low pK of transgressing the 5-year rule.
  4. Counting: Tax professionals often caution against Roth Conversions because they increase your tax bill in a single year. The core reason for the Conversion is to lower the lifetime tax bill by boosting the current year tax bill. If you don’t count the expected cost of your taxes over your lifetime, you can’t really assess whether the Conversion makes mathematical sense. 
  5. Common: Once you join Backdoor Roth Club, you’ll be doing both a Contribution and Conversion each year. This will be your normal practice.

Conversion is the second most common C-Word. Younger savers that have had access to Roth IRA and TSP/401(k) their whole working lives may never have to Convert. The rest of us old codgers need to understand Conversions to max-perform them.

C-Word #3—(Re)Characterization

 

Characterize is the third C-Word. It’s most often found in its “re-“ format in IRA world, so we’re going to count “Recharacterize” as a C-Word. Recharacterize is the C-Word that trips many a tax return self-preparer up because it’s both similar to Conversion with its “C-ness” and with its definition. 

Recharacterizing an IRA Contribution is the act of Contributing to a Roth IRA or Traditional IRA, then deciding to switch to the other type in the same tax year before filing your tax return. When contemplating Recharacterization, consider the following:

  1. Contributions only:  Congress cancelled the ability to Recharacterize Conversions some years ago. You can only Recharacterize amounts that you Contributed in the current year.  This prevents a strategy of continuously flopping money from one tax status to another based on market conditions and other tax events.
  2. Common Cause: The most common reason for Recharacterization is that you Contributed to a Roth IRA but were over the income limit for that year and needed to charge your dollars into Backdoor Roth Club. When you originally Contribute to a Roth IRA but change those dollars back to a Traditional IRA in the same year, that’s not a Conversion, it’s a Recharacterization.  The same is true if you Contribute to a Traditional IRA thinking you’ll receive a deduction, but after realizing that you’re over the income limit to deduct a Traditional IRA, you decide to Recharacterize the Contribution to a Roth IRA before the tax deadline (April 15th most years). 
  3. Complications: When Recharacterizing, you must account for not just the Contribution, but losses and gains as well.  
    1. Losses are easier to handle (mathematically, not emotionally). If your $6,500 Contribution to a Roth IRA becomes $6,000 because of market conditions, you can not only Recharacterize the $6,000 to your Traditional IRA (probably as part of a Backdoor Roth IRA maneuver) but you can top off the $6,000 back to $6,500 so that your ultimate Contribution amount for the year is at the annual limit (2023). 
    2. Gains have complexity. If you Contribute $6,500 to your Roth IRA and the market goes up before you realize the need to Recharacterize, then you’ll have to remove the $6,500 Contribution (to Recharacterize it) and the earnings associated with the Contribution. There’s a specific formula for determining which gains are caused by your recent Contribution versus gains associated with the prior balance of the account, so it’s often best to consult a professional for help. 
      1. You’ll likely pay income tax on the gains plus 10% penalty tax on the gains when you remove them from the Roth IRA if you’re under 59 ½. You won’t pay any additional tax on the principal amount (e.g., $6,500) if you remove it prior to the tax filing deadline (plus extensions, so usually October 15th) since you should have already included that amount in your income. 
  4. Chance: You get one chance to Recharacterize without a truly unholy mess. Let’s say you Contributed to a Roth IRA in 2022 but upon consideration, you earned over the income limit. You can Recharacterize before October 15th (really the 16th due to holidays) without starting to pay a 6% tax on the Contribution… per year until you remove it. At least you can still Recharacterize last year’s Contribution and still get it inside an IRA wrapper for preferential tax treatment.  Often, high income families realize, “Fiddlesticks… we weren’t just over the Roth IRA limit last year… we’ve been Contributing while earning over the income limit for several years!” 

Unfortunately, you can’t Recharacterize Contributions from a year prior to the prior tax year. I.e., you can’t Recharacterize 2021 and prior year excess Roth IRA Contributions (Excess Contributions is the IRS term for a Contribution you weren’t allowed to make.) You must withdraw those Contributions and pay the 6% excise tax plus interest.  While you do get to leave the earnings in the Roth IRA, you’ve forever lost the opportunity to maintain Roth treatment for the Contributions. 

Imagine a dual-military couple that first earned over the Roth IRA limit in 2013. Ten years of excess Roth IRA Contributions could be at least $57K each that is now nakedly hanging around exposed to the (tax) elements each year. 

Recharacterization trips up many a taxpayer. It’s easily confused with Conversion but is considerably and consequentially contrasted. Recharacterization commonly chases Contributions caused by confusion over compensation ceilings.  If your cranium is currently circling concentrically about this… call for help!

Cleared to Rejoin

Congratulations on conquering the C-Words. Clearly, Contribution, Conversion, and Recharacterization confusion has been corrected now, right? Okay, so consternation could continue, but let’s recap the crucial considerations:

  • Contributions have several limits. Measure twice before Contributing.
  • Conversions have tax consequences, but they can be good ones.  Consult help before Converting.
  • Recharacterization often happens after a (series of) mistake(s). This can be bad news that ages poorly.  If you were told there would be no math, you may be disappointed as you navigate Recharacterization…

It’s a catastrophe that the collector of taxes creates conditions such that you’re culpable for comprehension of colossal chunks of tax-related C-Words, but such is the condition of which we must constantly and cautiously conscious!

If you want help with your IRA rules or some other financial topics, consider contacting one of the numerous MFAA financial planners that specialize in helping military clients.

Fight’s On!

Categories
Estate Planning

How to Trust: Considerations for Revocable Living Trusts

Considerations for Revocable Living Trusts

How to Trust: Considerations for Revocable Living Trusts

 

Lots of things are verbs these days. Adult used to be a noun, but now Adulting is a thing, so it’s a verb. For many of us, transitioning from a Last Will and Testament (Will) to a Revocable Living Trust (Trust) also turns Trust into a verb.  So, let’s talk about the considerations for revocable living trusts.

Okay, the grammar police can hit the cancel panic button; I know Trust is already both a noun and a verb, but hang with me here. Many families will conclude that a Will alone is insufficient for estate planning. A time may come when a Trust, such as a Revocable Living Trust, is the best way to care for your family. 

Just as our kids need to learn to be adults to be successful with estate planning, you may need to learn to Trust. 

Estate Planning Ground Ops

Estate planning is not just for wealthy robber barons, with top hats, monocles, cigars and a steady flow of wealth extracted from their fellow citizens. If you take no action on your estate plan, your estate plan is to let the probate court decide what happens with your money, your stuff, and your kids. This is called the No Plan Estate Plan.

Most of us have gone to see the JAG to get a Will, a Living Will (also called an Advanced Directive), a Healthcare Power of Attorney, and maybe a Financial Power of Attorney (PoA). It’s considered good form to have these in place before soaring off to turn enemies into a fine pink mist.

The Living Will gives your surrogate instructions about things like life-prolonging care, and a Health Care PoA allows a surrogate to make healthcare decisions when you’re incapacitated. 

We’ll focus on the Will. A Will is a legal document that tells the probate court how you want your assets to flow, who should be the guardian of your children and other details like who should take care of your final affairs. 

A Will does not necessarily need to be fancy or expensive; it just needs to exist and comply with state laws, which usually implies that it’s appropriately witnessed, signed, and notarized. 

The upside of using a Will as the primary estate planning document is that:

  • A court shouldn’t have to make decisions that you should make.
  • Your heirs and loved ones shouldn’t have to make tough decisions that they may not want to make.
  • There is an orderly close out of your affairs.

The downsides of a Will include the likely need for probate court, attorney’s fees, the public nature of probate court (e.g., lack of privacy), and the delays in probate depending on the jurisdiction. 

The language in a Will is also generally less specific than what is included in trust documents. This can be problematic when trying to create particular outcomes for heirs such as young children. More on this later.

Perhaps the biggest problem with an estate plan based on a Will is that probate will be necessary in any jurisdiction where you own assets.  If you’ve collected properties at each duty station, you could be set up for probate and its costs and delays in many states. This is likely to have a chunky five-figure cost at a minimum.

Trust 101

There are many kinds of Trust documents. We will focus on a Revocable Living Trust here.  You can think of a Trust as a Will on steroids.

A Revocable Living Trust will convey your intent for your assets, but it does not have the downsides of probate costs, time delays, multiple jurisdictions, and public access.

A Revocable Living Trust is a shadow or avatar of you while you’re alive.  It does not have a separate tax ID number, tax filing requirement, or ongoing required maintenance. Much like an LLC, it is an entity that you use to manage your assets.  You can unwind a Revocable Living Trust and move assets into and out of it as desired. It doesn’t bear on your ability to sell a property that you’ve titled to it. 

Some families will have a single Trust for both spouses but it can be common to have a separate Trust for each spouse and own property half in each Trust. This is an area where an experienced attorney’s advice is crucial.  

A Revocable Living Trust does not really protect your assets like an LLC or liability insurance.  It’s more about streamlining what happens after you pass away or become incapacitated. 

Unfortunately, military JAG offices will not prepare a Revocable Living Trust for you. You must pay to have that done elsewhere. 

Additionally, Trusts are state-specific and must be supported by a pour-over Will. You’ll generally find that initiating a Trust includes a new Will, Living Will, Healthcare Power of Attorney, and Financial Power of Attorney.  These documents should all dovetail together to achieve your intent.

If your estate plans are based on a Will, you punt the significant costs of estate planning until after you pass away. When you use a Trust-based estate plan the cost is generally upfront while you’re still alive. However, it is often much less expensive over a lifetime to use a Trust rather than a Will.

You can find online services to help you establish a Trust for as little as a few hundred dollars. Using a local attorney will probably range from a few thousand to $10,000 or more if you have a very complex set of estate planning needs or live in a costly area.

How to Trust

Once you decide that you might need to use a Trust for your estate plans, you have to start Trusting— behaving like a person or family that has a Trust.

Step one – begin with the end in mind. A Trust-based estate plan aims to smooth things out for your heirs and have a little bit of control from beyond the grave. 

This looks like deciding at what age your kids should inherit your assets. If you have young children, six-figure retirement accounts, seven-figure life insurance, and one or more properties, leaving these assets all at once to an 18-year-old who just reached the age of majority could be much more of a curse than a blessing.  

Authors note:  I’m quite certain that I would have done things that rhyme with Mamborghini and Mas Vegas Ragefest upon receipt of six-plus figures of wealth at age 18.

A common technique is to stipulate that kids receive what they need through college, a tranche of “getting started” or “twenties” money after college, and the rest between age 25 and age 35.  

If you’re thinking about holding the money in trust much past age 35, consider reading the book Die with Zero by Bill Perkins. He makes a great case that the peak utility of inherited money is before 35.  Holding the funds might limit your ability to positively impact your heirs before their lifetime financial story is pretty much etched in stone.

Other end states that you will want to think through before establishing a Trust include: 

  • Which heirs should receive indivisible property such as heirlooms? 
  • Who will be your trustee(s) and successor trustee(s)? 
  • Should any discretion be withheld from the trustee(s)? 
  • When should your kids start to control the Trust, if ever?  
  • Is the goal to be equal to heirs, or perhaps equitable?

Every family is different. Thinking through the ramifications of these decisions with an experienced, licensed estate attorney can prevent costs, headaches, and heartaches down the road.

!!!CAUTION!!!

Only Attorneys can practice law.  That doesn’t mean you can’t generate your own legal documents and estate plans, and it doesn’t mean you can’t get planning advice from a financial planner. Still, the interpretation of law and preparation of documents for another person is strictly in the AOR of licensed attorneys.

Step two – choose an attorney or online service.

Online services are not bad, especially for families with low complexity, time poverty, and a willingness to work with an attorney down the road for updates or do-overs.  Most online services are offered through financial professionals rather than directly to consumers, but you can find direct options as well.  

If your needs aren’t complex, an online service will have you fill out some questionnaires, review drafts, pay your fee and either print or receive your documents via mail.  Some services will provide great organizational tools like tabbing out the documents with color-coded “sign here” flags to aid the signing process. 

When you have your documents in hand, you’ll need to:

  • Review them (ounce of prevention vs. a pound of cure…)
  • Arrange a notary and witnesses
  • Follow the (hopefully) provided directions for the order of signing, witnessing, and notarizing.
  • Commence with “the fun part”… (more below)

Working with an in-person local attorney has a lot of advantages with only two real disadvantages.  A local attorney will be both licensed and experienced in your state.  The attorney will provide plenty of Q&A time and education about your estate plans and documents.  Even if it’s not a “white glove,” you can expect hand-holding.  Estate attorney offices are usually experts at retitling real estate property and often include this as part of their fees. 

The two disadvantages of working with a local attorney are the upfront costs and the time commitment. If you’re time-starved such that getting to the JAG office for freebies takes lunar rocket-level prescheduling, it won’t be any easier to create time for a couple of trips to the attorney’s office.  You can do an online estate plan in your bunny slippers.  You’ll probably want to get more gussied up for your trip to the attorney’s office. 

Unfortunately, a local attorney can’t do much for you about “the fun part.”

The “Fun” Part of Trusting

To be clear, by “fun,” I mean absolutely not fun. Substitute painful and tedious for “fun”. Once you have signed Trust documents, you have fancy paper.  But you wanted an estate plan and not fancy paper, so you’ll need to deal with the “last mile” problem.  

Whether you get your Trust and other estate documents from an online service or local attorney, you must now begin adjusting beneficiary designations and account/property titles to make your Trust effective.  

!!!WARNING!!!

Beneficiary designations and property/account titles supersede your Trust, your Will, and state laws.  You might want your Trust to hold your assets after you die, but magical thinking alone won’t make it so. 

!!!CAUTION!!!

When designating beneficiaries on accounts or insurance policies, you should have the option for both Primary and Contingent Beneficiaries.  You’ll also have the option to designate “Per Capita” or “Stirpes” (rhymes with burpees). 

Primary Beneficiaries are usually spouses or other humans than we want to get our assets. Contingent Beneficiaries are the “next in line” persons that should get our assets if the Primary Beneficiary has passed away. With a Trust, it’s common to designate a spouse as the Primary Beneficiary of an account/policy and the Trust as the Contingent Beneficiary.  

Per Capita, meaning “by the head” means that if a beneficiary is no longer living, that beneficiary’s children fleet up a generation.  

Per Stirpes, meaning “by the root” means that if a beneficiary is no longer living, that beneficiary’s heirs equally divide their parent’s share. 

Imagine that Mom and Dad had two children (son and a daughter) who each had two children. Dad died several years ago, as did the son. Now mom just passed away. The estate plan called for assets to be split equally between the son and daughter. 

If Per Capita, the Son’s two children each get a third as does the daughter. The grandchildren fleeted up a generation and effectively diluted the amount that the older generation receives. 

If Per Stirpes, the Son’s two children each get a quarter and the daughter gets half. The grandchildren don’t fleet up and the daughter is not financially affected in the estate plan by her brother’s death. 

Per Stirpes is probably more common, but chair-flying how estate plans will play out is a crucial part of “beginning with the end in mind.”

Here are the most common actions families may need to take after signing their Trust:

  1. Re-title real estate in the name of the Trust. The attorney or online service may handle this for you.  Or you can DIY down at the courthouse or county clerk’s office.  Failing to re-title real estate invites probate… potentially in many states. 
  2. Open new taxable brokerage account(s) in the name of the Trust. Transfer investments out of your prior joint or individual brokerage accounts to your Trust account(s). 
    1. It may also be possible to add the Trust as a beneficiary to a taxable account, but it’s going to add work for your heirs after you pass away. 
  3. List all retirement accounts (TSP, 401(k), IRA, etc.) and update the beneficiaries on each account. The most common practice is to name a spouse as the Primary Beneficiary and the Trust as the Contingent Beneficiary. 

!!!WARNING!!!

Because of the SECURE Act, it may not be a good idea to name a Trust as a retirement account beneficiary. Depending on the language of the Trust, it’s possible that the Trust could cause the pre-tax part (e.g., Traditional accounts) to both be taxed at the Trust rates (40% federal over about $15K) and require that the retirement account is emptied 5 years after the owner dies. This can be a massive tip to the tax man.  Wargaming this issue with an attorney and financial planner can help you make the best choices. If retirement accounts aren’t a large part of your estate, leaving them directly to beneficiaries can be a good choice.

  1. List all insurance policies, including SGLI, FSGLI, and the abominably-named “Death Gratuity” and all group policies provided by your employer.  Update the beneficiaries based on your intent.  Again, common practice is to name the spouse as the Primary and the Trust as the Contingent Beneficiary. 
  2. Bank accounts are generally a pain, but they’re also a probate risk.  Contact your bank to add a Transfer on Death designation with the name of the Trust as the recipient.  Transfer of Death is basically a beneficiary designation for your bank account(s). Alternatively, you can open bank accounts in the name of your Trust and transfer your cash to the Trust account.

***NOTE***

Transferring assets from your individual or joint accounts is usually not a taxable event. Talk to your financial planner before committing. 

  1. Cats & Dogs.  Remember that savings bonds, Series I Bonds, and other accounts you may have collected probably also have beneficiary options.  Don’t forget those. 
  2. Business Interests. If you have an LLC or shares of a corporation or partnership, you’ll likely want those in your Trust.  This is probably not DIY territory. 
  3. Things with wheels and propellers.  Every state is different in how it handles motorized things upon death.  Frequently, probate isn’t required and it’s not common to title a vehicle to a Trust. Talk to your attorney to be sure. 
  4. College accounts and UTMA/UMGA accounts. Each brokerage is going to have different rules and forms here.  Some may allow a Trust to own a 529 account or UTMA, others may not.  Research options to make an informed decision about re-titling or using successor ownership (common with 529 plans). 

Remember, fun = painful and tedious. 

Cleared to Rejoin

If you own real property, have young children, want more control from beyond the grave, or have concerns that can’t be properly handled with a Will-based estate plan, it may be time to both Adult and Trust. A Revocable Living Trust helps avoid probate, mitigate total estate plan costs, maintain privacy, and smooth out the transition of your assets to your heirs. 

But if you’re going to Trust, you need to get ready for the “fun” part (which if you skimmed to the end is not actually fun). Make sure to follow through on the last mile.  Appropriately title your property and update your beneficiaries to make your Trust effective!

Fight’s On!

Categories
Military Pay

Why Should you Care About the Survivor Benefit Plan Open Season in 2023?

Why Should you Care About the Survivor Benefit Plan Open Season 2023

Why Should you Care About the Survivor Benefit Plan Open Season in 2023?

When a retiree dies, his/her retired pay (and VA disability compensation) also expire. The Survivor Benefit Plan is a continuation of part of retired pay for a surviving spouse and or children. It can also support special needs dependents too.

The 2023 National Defense Authorization Act (NDAA) authorized a rare “open season” for eligible active and reserve retirees to get into or out of the Survivor Benefit Plan (SPB).  This is a big deal as there have been very few other open seasons in history (about one per decade and at the whims of Congress) and retirees end their service knowing that opting out of SBP is generally a one-way door.

Because opting back in is the rarer opportunity, this article focuses on getting back into SPB versus opting back out past the normal 3rd year opportunity.

A Quick SBP Primer

The DFAS website (and countless other blogs) has all the weedy details about SBP, but here’s what you really care about.  We’ll focus on the most common case—a married service member that chooses the Spouse full coverage SBP option. SBP costs 6.5% of retired pay per month. It comes out pre-tax. If the military member dies, the surviving spouse gets 55% of the military member’s retired pay.

The Pros of SBP include:

  • Inflation-adjusted income for the surviving spouse until remarriage (before age 55) or death.
  • The amount received is generally enough for a mortgage but is unlikely to cover 100% of expenses.
  • The surviving spouse does not have to determine how to invest an insurance payout to create lifetime income.

The Cons of SBP include:

  • If feels expensive initially-especially for military members that aren’t sure what their financial situation will look like on the other side of military retirement.
  • It looks expensive compared to sizeable amounts of Term Life Insurance.
  • 55% of say, 50% of basic pay isn’t enough to live on.
  • The benefit is taxable as ordinary income. Insurance payouts are tax-free and returns from invested insurance dollars could be at more favorable capital gains tax rates.
  • It goes away with remarriage before age 55 (but comes back if the new spouse dies or divorces).
  • Except for unpredictable and rare open seasons, it cannot be cancelled after the 3rd year of premiums. The premiums last for 30 years or until death.

There is an excellent, inexpensive, and short book available by a retired naval officer that has even more detail. In my experiences there are a few key reasons why retirees decline or opt into SBP.

Reasons that retirees take SPB:

  • Health conditions prevent attempting to replace it with Term Life Insurance and any other form of insurance is expensive and inadequate to the task.
  • Spouse indicates that s/he feels more secure knowing that there will always be some basic level of inflation-adjusted income.
  • Spouse will be unable to earn an income sufficient to provide for the family’s needs.
  • The family has not built a nest egg at military retirement such that, the nest egg combined with a Term Life Insurance payout could replace the income from SBP.

Reasons retirees decline SBP:

  • The premium is several hundred dollars per month and feels expensive compared to any other insurance the member has encountered.
  • Both spouses will be military retirees, thus one pension will continue if one spouse lives.
  • Both spouses work such that the surviving spouse expects to provide for his/her own needs (plus any children).
  • The family has purchased sufficient Term Life Insurance and believes that:
  • If the retiree dies, the spouse can invest and manage the payout to replace lifetime income needs.
  • The family has a nest egg growing such that the family will be self-insured before the life insurance term expires (which the surviving spouse can invest and manage to replace lifetime income needs).

Keep in mind that what you just read is a low pass over an extremely important topic and it’s vital to your family’s well-being to invest the time and effort required to make a fully informed decision about SBP.

Opting Back Into SBP

While the DOD has yet to announce the devilish details of how the SBP Open Season will work, the NDAA gives us enough information to start exploring the concept.  Let’s examine the case of an O-6 that retired at 23 years in 2020, receives $6,500 per month in retired pay, and chooses to opt back into SBP during the calendar year 2023 Open Season.

The NDAA states that members will need to meet the following criteria to opt back in:

  • Repay missed premiums since retirement (becoming eligible for SBP)
  • Pay interest on the missed premiums
  • Pay any other fees/penalties instituted by DOD

One not-so-small detail in the NDAA is that the calculations on these payments are supposed to be from the date one elects to opt back into the SBP.  If SBP Open Season isn’t already up and ready to as of the NDAA signing (it doesn’t appear to be as I’m typing), then retirees may have to pay for extra months simply because there is no way to opt back in yet.

Sample calculations (holding inflation at 0%) on the costs of opting back into SBP might look like:

  • Months in non-covered status: 36
  • Total premiums not paid: $15,210 (36 months * $6,500 * 6.5%)
  • Interest on premiums: $685 (hypothetical 3% interest compounded monthly from first “missed premium”)
  • Fees: $500 (hypothetical administrative fee)
  • Total upfront payment to opt back into SBP: $16,395
  • Remaining premiums paid over next 27 years if retiree does not die during the normal 30-year payment period: $136,890
  • Total cost of SBP over 30 years: $153,285
  • Total retired pay received over 30 years: $2,340,000

Wow! That’s a lot of Money…

You live in a different financial world if those numbers are budget dust to you. For most readers, separating with six figures of pay for a benefit that may never be used is hard to swallow.  Remember though, opting back into SBP is about taking care of a spouse that doesn’t share your interest in the details of investing such as costs, taxes, asset allocation, timing, account types, custodians, etc.

Still, if you’ve reconciled that you might be willing to make the monthly premium payment going forward (6.5% of your retired pay) but are having a hard time stomaching the upfront cost, it might be good to revisit alternatives.

Perhaps you initially purchased $1.5 million of 20-year term coverage, but now feel as though inflation has eroded the buying power of those dollars. Have you looked at getting more term coverage, perhaps for a longer period?  $16,395 would buy nearly 15 years of an extra $1M term policy at $100 per month.  What additional amount of time and payout to your nest egg would have you and your spouse comfortable trading guaranteed secure income for a one-time windfall?

That $16,395 payment would have bought my first new car and most of the price of the cars I’ve bought since.  It’s a bit more than I plan to spend on vacations and travel most years.  What line items from your family’s budget could skinny-down for a year or two to pay for the upfront missed premiums?

Since ultimately, we’re talking about purchasing a feeling of security for a widow(er), what is that worth? Clearly this is a complex question to answer, and each family needs to do both mathematical analysis and wade carefully through what might be an emotional mine field to get to the right answer.

Cleared to Rejoin

SBP is an important part of your retirement benefits. While it may seem expensive, it’s really about buying security for your spouse/family during part of their life they never expected to have to live: without you.  Even if you have what feels like sufficient life insurance, will your spouse be up to the task of turning a life insurance payout into income for life?

If you consider buying back into SBP, it will be important to compare the costs versus alternatives such as even more life insurance. Since you can’t enroll just yet, here are action steps you take today:

  • Review your life insurance and the assumptions behind it
  • Project your nest egg’s growth under varying conditions
  • Plan where the SBP upfront re-enrollment costs might come from
  • Project your new budget with the SBP premium factored in
  • Revisit the DFAS SBP Open Season site (or set up a Google News Alert) weekly
  • Talk to your spouse about the pros and cons of your current choice and the alternatives

Fight’s On!

Categories
Investing Taxes TSP

Which is Better—A Roth or a TSP?

Roth Versus TSP

Which is Better—A Roth or a TSP?

If my math is correct, half of the readers of this article’s title are about ready to blow up my inbox, half would just like to know the answer, and half haven’t read this far.  Clearly my math isn’t correct, but let’s dive into this question, and the real question that’s usually behind it— “Which is better—Roth or Traditional?”

If you’ve been in the military for a minute, you probably have heard that question, “Which is better—a Roth or a TSP?”  It comes from the very real confusion cluster that is the financial world.  Few primary schools teach personal finance and the topic is at best optional in college.  Most of us learn it through trial and error if we learn it at all.

The answer to the question “Which is better—Roth or TSP” is the same as the answer to “Which is better—Tesla or cars?”  There’s no direct comparison because one is a subset of the other.

TSP Basics

Let’s start with the TSP (Thrift Savings Plan) which is an employer-sponsored, qualified (read: tax advantaged) retirement savings plan.  It’s similar to civilian 401(k) plans (Which doesn’t mean much if you’re still back at the Roth or TSP question, I know).  The TSP allows you to defer part of your paycheck each month, receive preferential tax treatment, and grow the dollars through compounding until you need to use them in retirement.

If you joined the service after 2017, then you’re eligible for the government to match your contributions up to 5% after 2 years of service—which is free money!

The TSP limits your contribution to a certain amount each year based on IRS guidelines and it’s $20,500 in 2022.  Participants over age 50 can contribute an extra $6,500.

What is Roth?

Roth is the last name of the senator that sponsored the legislation creating Roth retirement accounts.  Roth is a synonym for “after-tax,” meaning that you’ll pay your typical income tax on the dollars that you contribute to a Roth account such as the Roth TSP.  The benefit of Roth treatment is that contributions grow without being taxed each year.  Then in retirement (generally after age 59.5), you get to access those dollars tax-free.

Roth treatment is incredibly powerful in that it allows savers to pay a generally low tax rate on dollars when they’re young or in the military and not making much and then avoid higher tax rates in retirement when their tax rates are higher after a lifetime of earning and saving.

Roth treatment can also be though of as “tax insurance.”  We don’t know what future tax rates will be.  Many experts predict that they will have to be higher to afford programs like Medicare and interest on the national debt.  Roth dollars won’t be taxed in retirement, so savers can mitigate future tax risk.

What is Traditional?

Before Roth came along, there was just “TSP” and no need for the adjective “Traditional.” Traditional is a synonym for “pre-tax” or even “tax-deferred.”  With a Traditional retirement account like the TSP, savers skip paying taxes on the contributions as the money is earned, but have to pay taxes when they access the money in retirement after age 59.5.

Savers are allowed to contribute to either or both Roth and Traditional “sides” of their TSP account in a given year, but they can’t exceed the IRS limit unless they’re in a combat zone.  I.e., you can put $10,250 into Roth TSP and Traditional TSP in 2022, but you can’t put $10,251 into both.

Which is Better—Roth or Traditional TSP?

Now that we’ve got the right question squared away, we’ll look at the indigestible answer… it depends.  The most general way to start answering this question for each taxpayer (or family if filing jointly) is to ask, “Do I want more money in my pocket this year, or in my retirement years?”

A contribution to the Traditional TSP puts extra dollars in your wallet this year.  If you’re in the 22% bracket and you contribute $1,000 this year, you’ll have $220 extra in your pocket because you deferred the tax bill until sometime in retirement.

Moving past the most basic question, some families will want to evaluate, “Am I in a temporarily higher tax bracket this year?” Let’s say you receive a large bonus and will have outsized income in a certain year.  It might be appealing to hold on to more of your pay by making Traditional contributions in a high-income year.

An even more sophisticated approach would be to evaluate whether a Traditional contribution might lower your tax bracket for the year.  For example, in 2022, the cutoff between the 12% tax bracket and 22% bracket for a married-filing-joint couple is $83,550, which is really $109,450 after adding the $25,900 standard deduction.  If income before a TSP contribution is $109,450 and the planned TSP contribution was $5,000, then taxable income becomes:

$109,450 – $5,000 – $25,900 = $78,550

$78,550 is squarely in the 12% tax bracket and the tax savings on the year is $600.  So, by choosing to put at least part of the TSP contribution into the Traditional “side,” it’s possible to lower one’s overall tax bracket and tax bill.

Dialing up the sophist-o-meter a bit, let’s address capital gains.  Capital gains tax is the tax we pay when we sell something for more than we paid for it.  If you sell a stock at $100 per share, but you paid $50, then you have a $50 capital gain per share.

Uncle Sam taxes capital gains in one of two ways—long-term or short-term.  Long-term capital gains receive preferential treatment in that they’re taxed at 0%, 15%, or 20%.  These are lower than ordinary income tax rates for most people paying capital gains tax.  Short-term capital gains are taxed at ordinary income tax rates.

It just so happens that the cutoff between the 0% and 15% long-term capital gains brackets is $83,350 for a married-filing-joint couple…essentially the same as the 12% to 22% transition for ordinary income.

The “so what?” is that by using a traditional TSP contribution to lower taxable income into the 12% bracket, one also can take advantage of the 0% long-term capital gains tax bracket.  If you have stock with capital gains and need to sell some for a goal, you can do so right back up to the top of the 0% long-term capital gains bracket and pay $0.00 on those gains!

The Real Question

While it is important to evaluate the tax opportunities in a given year to assess Roth versus Traditional, the real question is this, “Am I in a higher tax bracket today, or will I be in a higher tax bracket in retirement when I access my TSP savings?”

Let’s say you’re in a 25% bracket this year and you also expect to be in a 25% bracket in retirement when you withdraw money, then there is no mathematical difference between Traditional and Roth TSP.  Want proof?  Plug the following formulas into Excel.

  • =FV(0.1,30,-1000,0,0)*0.75
  • =FV(0.1,30,-750,0,0)

The first is the future value of pre-tax contributions of $1,000 compounding for 30 years at 10% and then taxed at 25% upon distribution in retirement.

The second is the future value of after-tax contributions of $750.  We use $750 to model the effect of a 25% tax as the money is earned.

They both return $123,370.52.  But there’s a hidden twist here—would you really contribute less just because you had to pay tax on the dollars as you earned them?  Probably not.  Most of us will find a way to contribute the same amount regardless of the tax in the year of the contribution.

Thus, =FV(.1,30,-1000,0,0) = $164,494.02 and we can see that we end up with a significantly increased nest egg for choosing Roth.

But how do you know what tax bracket you’ll be in during retirement?  The reality is you’ll need a crystal ball, time machine, or other imaginary tool.  We can only make estimates.  Estimating our income, spending, and savings seems daunting, but it’s likely the easy part.  Estimating future tax rates, including state income tax rates is a bit more difficult.

A common technique is to just use current tax law and then revise projections as tax law changes.  Using that method, let’s look at Figure 1. This example illustration incorporates a family’s projected income, savings, and spending over their remaining life time.  The result is that we can see that the family will pay tax rates from the mid 20% range until retiring early at age 55.   At that point, the expected tax rate is 15% until age 70 when Social Security kicks in and creates a new income floor and higher tax bracket.

Roth versus Traditional 1

This family has a couple of options.  By contributing to Traditional accounts pre-retirement, they can hope to Roth-convert some or all of their Traditional dollars during their low tax years.  They would skip paying 22% to 25% in hopes of paying 15%.

Any Traditional dollars remaining after age 70 would, at-worst, be taxed at about the same rate they would have been at the contribution.  This choice requires an estimation not just of earning, saving, spending, and tax rates, but also how many dollars can be Roth-converted during the early-retirement window before ending right back up in a higher tax bracket.

If instead, the family contributes to Roth accounts prior to retirement, then several additional considerations arise:

  • From age 55 to 70, there could be a missed opportunity to “fill up” low tax brackets like 15%. The family might have unnecessarily paid 25% on some dollars.
  • After age 72, Roth IRA dollars don’t have to be distributed, but Traditional dollars do. These “Required Minimum Distributions (RMD)” create a higher income floor.  (Note that Roth TSP/401(k) accounts do have RMDs.  Roth IRAs don’t. Most people will rollover their Roth TSP/401(k) to an IRA prior to RMD age.)

Figure 2 shows a different family’s profile.  Prior to retirement at age 67, the family earns in the mid-20% to low-30% tax rate range.  They have a small “bathtub” from age 67 to 72 where they can do Roth conversions, but after that, they’ll be trapped in the 30%-plus range for their remaining years.

Roth versus Traditional 2

This family would likely want to mainly contribute to Roth accounts in order to minimize the impact of a high-income floor in retirement.

You can imagine that slight changes in a family’s planned earning, spending, saving, and estimated tax rates have drastic effects on their future tax profile.  This brings us to the key questions that we must answer to make the Roth versus Traditional decision:

  • Do I need extra cash in my pocket this year? Is it worth the risk of higher taxes later?
  • Can I change my tax bracket with a Traditional contribution this year? What benefit do I gain?
  • Do I expect my tax rates to be higher or lower in retirement?
    • If higher, more Roth dollars are your friend.
    • If lower, you leave a tip for the tax man by contributing to Roth today.
  • Do I generally think tax rates will be higher in the future? Roth contributions are an insurance policy against those tax rates.

Cleared to Rejoin

The Roth versus Traditional decision can be complicated.  We have to decide if we want more income this year, or lower taxes in a few decades.  To be as accurate as possible, we need to have reasonable estimates of our lifetime earnings, saving, spending and tax rates.  Ultimately, we have to answer, “What is the effect this year… and all of my retirement years?”  That’s no small task.

A few additional concepts to consider may help:

  • The current tax brackets are very low by historical standards, implying higher rates at some time(s) in the future
  • Interest on the national debt and support of Medicare for the Baby Boom generation will require higher government revenue in the coming years.
  • 30 years after you contributed, are you likely to regret having estimated wrong by a couple percent on your future tax rate, or are you more likely to really like that a sizeable chunk of your retirement income is tax-free?

Fight’s On!

 

Author’s Note:  This article focused almost exclusively on Roth versus Traditional for TSP (and 401(k)) contributions.  There’s a good deal more to know about IRA considerations, so please don’t extrapolate Roth TSP directly to Roth IRA without diving into the nuances.