Tag: taxes

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Taxes

How to Tame Your Tax Dragon: Review Your W-4

It's time to think about your W-4
Photo by Kelly Sikkema on Unsplash

It’s just about tax time and almost nothing drives anxiety more than worrying if you might owe a lot at tax time.  Or, maybe you’re in the camp that looks forward to the big refund at tax time.  But then what if your refund isn’t as big as you’d hoped?  Have you reviewed your W-4 lately?  

Whether you prefer to owe a little, get a little refund, or get a big refund, the number one factor driving your experience at tax time is how you completed your W-4.  It’s that important!  But, you’re only required to complete a W-4 ONCE . That means the biggest driver of your tax season experience might be a form you haven’t even thought about in years!  

What is the W-4

The W-4 is the “Employee’s Withholding Certificate”.  It’s the form that tells your employer how to calculate the amount of Federal tax they should withhold from your paycheck.  The goal of the form is to approximate tax withholding as accurately as possible so that you neither owe taxes nor receive a refund at tax time.  

Breaking it down

Your annual tax bill is primarily driven by four things:  

  1. Filing status – Your filing status drives the tax brackets used to calculate your total tax bill as well as limitations applied to tax credit eligibility and some other things.
  2. Total household income – the more income you and your spouse earn, the higher tax rate you pay.  Keep in mind that income includes: military retirement pay, interest/ dividends earned on savings or investment accounts, and capital gains from the sale of assets (like stocks, property, etc).  
  3. Deductions – deductions lower your tax bill by allowing you to deduct income.  In other words, deductions lower your taxable income. You can either:
    1. itemize your deductions – add up your mortgage interest, all taxes you’ve paid, and some other allowable deductions or, 
    2. take the standard deduction.  The standard deduction for 2023 is $13,850 for single filers/ $27,700 for married filing jointly filers.  Because the standard deductions are so high right now, the majority of people simply take the standard deduction.  
  4. Credits – credits lower your tax bill by subtracting the amount of tax you owe.  A common tax credit is the child tax credit which can be up to $2,000.  Let’s assume you qualify for the child tax credit.  Let’s further assume that your tax bill is $10,000.  With the child tax credit your bill would be $2000 less or $8000. 

How the W4 Works

Your employer only knows one thing about your tax situation – they know how much income you earn with them.  Unless you review and update your W-4, they don’t know your current filing status, if you have a second job, if your spouse earns an income, if you have savings/ investments that pay interest or dividends, whether you plan to sell an asset, whether you have children or are eligible for other types of credits.

The W-4 is meant to provide more of this information to your employer so they can adjust your withholdings appropriately.

Completing/ Reviewing your W-4

There are only two sections you absolutely must complete on the W4: Section 1 and Section 5.  Section 1 includes your name, address, SSN, and filing status (single, married filing jointly, etc)  Section 5 is your signature.  

If you are single, have no children, and no other income sources, Sections 1 and 5 are all that’s needed.

Completing/ Review Your W-4 for More Complex Situations

If you are married filing jointly, have children, or other income sources, then complete Sections 2, 3, and/ or 4.

Multiple Jobs?  Spouse Works?

If you have a spouse with a job or if you have more than one job, Section 2 is for you.  The verbiage in this section can seem confusing so let’s break it down.  

Let’s start with the easiest option.  If there are only two jobs in your household (you have 2 OR you have 1 and your spouse has 1) AND the income from the lower paying job is at least half the income from the higher paying job, then you can just check the box at the end of “c)” in Section 2.

In other words, if your income is $100,000, then it’s easier and more accurate to simply check the box as long as the income from the other job is at least $50,000 or higher.

If you earn much less in your side gig, or your spouse earns much less than you (less than half), then you’ll want to either use the estimator tool at www.irs.gov/W4app or use the Multiple Jobs Worksheet that’s part of the complete W-4 (link here).  Both methods will provide insight on whether you should add an amount to Line 4(c) in Section 4.  This is the amount of additional withholding your employer will withhold from each paycheck.  

The estimator tool is very detailed but it’s accurate and will provide a pre-filled W-4 that you can download and either submit directly to your employer OR, if you’re military, you can use the info to update your W-4 in myPay.  

Dependent Credits and Other Credits

If you have children or other dependents, you will want to complete Section 3.  Thankfully it’s more straightforward than Section 2.  Is your household income more or less than $250,000 (single) or $400,000 (married filing jointly)?  How many dependents do you have under age 17?  How many dependents do you have who are age 17 or older?  Then do some simple multiplication. 

Other Adjustments

In Section 4, you get to include information about any other income sources, besides jobs.  If you’re retired from the military then you have a taxable pension.  You may have savings/ investment accounts that pay interest and/ or dividends.  

You also get to include information about deductions.  Recall from above that most people use the standard deduction now.  So you’ll enter the standard deduction.  If you itemize deductions on your taxes, then add your estimated itemized deductions instead.

Now is the Time to Review your W-4

If you haven’t looked at your W-4 since 2019 then your W-4 is definitely out of date.  In December 2019 there was a huge change to the W-4.  If you haven’t made changes since then, then your W-4 is most likely nothing more than Section 1 and Section 5.  

If, since 2020, you’ve owed more than normal or get a refund that’s substantially different from what you were used to, the W-4 format change is likely the reason.  Your employer just doesn’t have enough information about your situation to accurately withhold Federal taxes.  Take a look at your W-4 and make updates as needed.  

When you make updates to your W-4 you should expect the net pay that hits your checking account to change.  The amount may be higher or lower depending on your situation.  If you make the changes early in the year, the changes will likely be smaller than if you wait until later in the year.  So now is the perfect time to review your W-4.

Categories
Military Pay Military Retirement Taxes

Is My Military Retired Pay Tax Free if I have a VA Disability Rating? – NO!

Military Retirement Tax Free

Is My Military Retired Pay Tax Free if I have a VA Disability Rating? – NO!

 

Every year I have a handful of clients ask me if their military retired pay (a.k.a. pension) is tax free because they have a disability rating from the Department of Veterans Affairs (VA). When I ask why they believe their military pension is not subject to taxation they forward me “the email.” It is semi-official looking and seems to be from someone who ought to know what they are talking about. The email cites an IRS publication and sometimes (depending on which version you get) a court case.

 

It’s all twaddle. Your military retired pay is taxable income.

 

Like everything involving tax rules there are exceptions to the general rule. That is doubtless where the confusion originates. “The email” makes it seem like many more veterans qualify for the exception than do. The simple test to apply is this – do you have a written determination from the VA or your branch of the service specifying that your disability is combat-related. If that answer is ‘no” then you are paying taxes on your military retired pay. (If the answer is “yes”, you might still have to pay taxes on it, but you have no hope of being tax free without that official determination.)

 

Until recently I had to provide a long explanation to recipients of “the email,” some of whom ardently believe their retired pay was not taxable because they had a VA disability rating. I would have to explain that the court case did not apply, that IRS publications are not legally authoritative, and that the passages cited are being taken out of context. The explanation got much shorter recently, as one veteran took her case to the US Tax Court. The judge ruled against her, and his explanation sheds some light on the tax status of military retired pay.

 

You can read the full Tax Court Memo here.

 

T.C. Memo 2022-42; Tracy R. Valentine v. Commissioner filed April 28, 2022

 

Valentine is an Army veteran who was honorably discharged in 2002 after 22 years of active duty service. She had a disability rating of 60% that was increased to 90% effective May 1, 2016. For the first 4 months of 2016 she received VA disability payments of $1100 per month. For the remaining 8 months of 2016 she received $1700 per month in VA disability payments. The IRS does not dispute that these payments from the VA are tax free (excluded from income).

 

Valentine also received $23,801 from her Army-based retirement plan in 2016. She received a form 1099R from DFAS, reporting the entire amount as taxable. When Valentine filed her 2016 tax return she reported the taxable income from her military pension as $3,158, excluding the remaining $20,643 as not taxable income. The IRS disputed her claim that part of her military pension should be excluded from income and issued a Notice of Deficiency (NOD). Valentine exercised her right to challenge the NOD and petitioned the Tax Court for relief.

 

At Tax Court Valentine testified that IRC Section 104(a) and 104(b) entitle her to use the VA disability rating to exclude both the VA disability payments and a portion of her military pension from taxable income. Valentine represented herself at Tax Court and did not cite specific sub-paragraphs of the IRC to support her claim.

 

In his ruling Judge Gustafson provided some analysis of the tax code. There are two separate provisions in the tax code that could render a veteran’s military retired pay excludible from income. Under section 104(b)(2)(C) a veteran may exclude a portion of the distributions from income if they qualify as “amounts…received by reason of a combat-related injury”. Valentine did not provide any testimony or evidence at trial to indicate her disability rating was combat-related. Therefore section 104(b)(2)(C) does not apply.

 

The other provision is contained in section 104(b)(2)(D). A veteran may exclude a portion of the distributions from income equal to an amount they “would be entitled to receive as disability compensation”. There is legislative history supporting the court’s interpretation of this to mean that it does not apply if one is already receiving disability compensation from the VA. As Valentine was already receiving disability compensation from the VA, section 104(b)(2)(D) does not apply.

 

The Bottom Line

 

Bottom line: The US Tax Court ruled all the retirement distributions Valentine received are “properly includible in her gross income”. Military retired pay cannot be excluded from income solely because one has a VA disability rating. Valentine was also subject to penalties and interest on the tax owed for not reporting the income on her 2016 tax return.

 

I have had clients contact DFAS, explain they have a VA disability rating, and request the tax withholding on their military retired pay stop. When DFAS stops the withholding the veterans assume DFAS agrees that the pay is not taxable. That is not true. It simply means that DFAS will stop tax withholding on your military retired pay if you request it. When the 1099R is issued it will state that all the retired pay is taxable. Since the IRS also receives a copy of your 1099R, they will expect you to declare it on your individual income tax return and pay taxes on it. If you don’t, they will issue you a Notice of Deficiency and charge you penalties and interest for failing to report it.

 

I am a veteran with a VA disability rating. I want my military retired pay to be tax free. I am also a tax professional. If my military retired pay was tax free I’d know about it. If our military retired pay was tax-free I would be writing about it. My colleagues would be writing about it. The VA, VFW, DAV, and the American Legion would all be writing about it. The IRS would have pages of FAQs about it. You wouldn’t find out about it through an old forwarded email that tells a story too good to be true.

 

If you still have questions, the Military Financial Advisor’s Association has both tax professionals and financial planners with tax planning expertise that can help with your unique situation.

 

 

 

 

Categories
Financial Planning Military Pay

10 Financial Opportunities and Challenges Dual Military Couples Experience

Dual Military Couples

When both members of a couple serve in the military, they share a greater understanding of the mission and life demands that come with putting service before self.  They also share the unique financial planning opportunities and challenges created by their double duty lives.

 

While dual military couples enjoy the financial advantage of two incomes and twofold benefits; they also to juggle the challenges that come with two military careers – two missions, two commanders, two demanding work schedules.   Add a couple of kids to the mix and you’ve got a recipe for financial challenges created by tag-team deployments, maintaining multiple households, and paying for sky-high childcare expenses.

 

Across the Department of Defense, seven percent of service members are in a dual military couple; or looked at another way, one in five military women are in a dual military couple.

 

If you’re a member of a dual military couple or a couple considering jumping into military service together, this article will help you understand the unique financial planning opportunities you may experience and the financial and career challenges you may face.

 

Let’s look at the top ten financial opportunities and challenges dual military couples experience.

 

#1: Two Incomes

 

No matter the rank, two incomes make life a little easier – easier to live within your means and easier to avoid debt. Two incomes allow dual military couples to save more aggressively for both short and long term goals, provided they’re able to establish a standard of living more closely aligned with one income, than two.

 

The key for dual military couples is to take advantage of this opportunity from the beginning of their careers.  Demographic data tells us that the number of dual military couples drops off dramatically as rank increases.  Among enlisted ranks, the number of dual military couples peaks at E-6; for officers, the peak is O-3. (DOD Demographic Report.)

 

This data suggests that dual military couples are wise to maximize their savings and investing opportunities in the first ten years of their careers in part to benefit from the power of compounding; but also, recognizing this two income opportunity may be fleeting.

 

#2 Two Housing Allowances

 

In many situations both members of a dual military couple receive a basic allowance for housing (BAH).  Let’s walk through a couple of scenarios –

 

First, if a dual military couple is assigned to the same location and live off base, both members of the couple receive BAH.  If they’re able to carefully manage their housing costs, this is a golden opportunity to ramp up their savings rate by applying their second housing allowance toward their Thrift Savings Plan (TSP) account or other savings accounts.

 

If this same couple lives on post in privatized housing, they both receive BAH, but their rent is based on one BAH at the with dependent rate.   This too can be a great opportunity to maximize their savings rate by applying the additional housing allowance toward savings.  By contrast, if this same dual military couple is assigned government provided housing, neither receives BAH.

 

If a dual military couple has a dependent child, one of the two members receives BAH at the dependent rate.  In the not so rare case that the couple is not assigned together and each of them has a dependent child living with them, then both members could receive BAH at the dependent rate.

 

Let’s walk through an example of this last scenario.   A dual military couple with two kids is stationed overseas when the husband receives a one-year stateside school assignment.   He relocates stateside with one of the couple’s children, while the wife extends her assignment overseas and keeps their other child with her.  Both receive a housing allowance at the with dependent rate.

 

This example of multiple households leads to our first challenge –

 

#3 Living Together or Not?

 

The services try to keep dual mil couples together when possible, the Air Force refers to these assignments as a “join spouse” assignment, while the Army calls it a “joint domicile” assignment.

 

Like everything in military life, the needs of the service always comes first. It isn’t always possible to perfectly align two military careers every step of the way, especially as both careers progress into leadership positions.

 

When it all works out, one roof with two BAHs, it’s an amazing opportunity to save, save, save.

 

When it doesn’t work out, when the couple needs to maintain two households because they aren’t stationed together, that’s when they’re really glad they decided to live within the value of one BAH at their previous assignment.

 

Technically a “joint domicile” assignment could assign the spouses to two separate installations within 50 miles from each other.  In this scenario, a dual military couple might decide to live somewhere in the middle and each commute to their duty station.  This scenario is common with dual military couples who are not in the same service.

 

#4 VA Loan Entitlements

 

With all this moving to and from installations, sometimes together, sometimes not; it’s important to understand that each member of a dual military couple earns their own VA Loan entitlement.

 

When they buy a home, they can either use one of the entitlements and save the other for a future home purchase, or they can split the entitlement, leaving each of them with a partial VA entitlement.

 

An important consideration is if one of the spouses is a member of the Reserve Component and has already established a VA disability rating; their VA loan entitlement allows them to avoid paying the VA funding fee, which could substantially reduce their upfront costs for purchasing their primary residence.

 

So far, we’ve looked at several financial opportunities that dual military couples experience which allow them to maximize their savings; but it’s important to consider a few of the common financial challenges.

 

#5 Military Childcare

 

Obviously, quality childcare is critical to all working parents, military or not.  Across corporate America, only 20% of employers provide any assistance or subsidy for their working parents’ childcare needs.  Fortunately, the DOD has invested substantially in installation Child Development Centers (CDCs) and Family Childcare programs.

 

The DOD’s childcare program is the largest employer sponsored childcare program in the US, providing care to over 200,000 military children at a cost of about $1B per year.

 

CDCs provide nationally accredited childcare to our military families at an affordable price, but dual military couples still face several childcare related challenges.

 

Availability.  There are more than 400,000 military kids under the age of 5, yet only half that many CDC slots across the DOD.  Unfortunately, waitlists are the norm at many installations.  Single military parents and dual military families have priority at their installation CDC, but even that advantage is not always enough to guarantee a slot when they need it.

 

Duty Hours.  The typical duty day rarely fits neatly within the CDC’s hours of operation, leaving parents with extended duty days or shift work scrambling for alternatives.  Training exercises and temporary duty assignments stretch dual military parents even further beyond the CDC’s hours.

 

Cost.  To say that childcare is expensive is an understatement, even on two incomes.  Nationwide, parents spend on average more than ten percent of their income on childcare; in high cost of living locations like Washington DC, couples can spend over $2000 a month on a single child’s care.

 

For dual military couples who can’t fit their duty day within the CDC’s workday, they often turn to nannies to provide in home care including early morning and late evening care, or overnight care when necessary.  On average, nanny’s charge $700-800 a week or over $30,000 a year.

 

Subsidized Fees.  In order to keep CDCs affordable, the military subsidizes the program and charges parents on a sliding scale based on their total family income.  These fees can range from just under $300 to almost $800 per month per child; both well below the national average.

 

Fee Assistance.  Additionally, the services now offer financial support to families who cannot find care for their children on the installation, either because of a lack of availability or the distance between the duty station and the CDC.  The Fee Assistance Program is meant to partially cover the difference in cost between what the servicemember would be expected to pay at the CDC and what they are required to pay at an off base childcare facility.

 

# 6 Tag Team Deployments

 

Let’s look at another financial challenge for dual military couples – potential Tag Team Deployments.  When spouses are in separate units, that can mean separate deployment schedules.

 

In some cases, dual military couples with kids intentionally alternate their deployments so that one parent is always home with the kids.  While this is an amazing sacrifice, it can be a strain on their relationship and their wallet.

 

This constant churn of one parent always being deployed can increase childcare expenses, travel costs, and spending on household help to balance the demands on the family.  Fortunately, when the demands of duty keep these couples apart, they may be eligible for the Family Separation Allowance (FSA).

 

The one positive of these dual deployments is that it provides ample opportunity to push up their tax-free Thrift Savings Plan Roth contributions while in a combat zone.  They may also contribute up to $10,000 to the Savings Deposit Program earning 10% interest during their deployment.

 

#7 Estate Planning

 

You can’t talk about dual military couples’ deployments without addressing the importance of proper estate planning.  Because both members could and often do deploy, their estate planning preparedness is even more critical to their overall financial plan.

 

If they have minor children, they have the added requirement to complete their services’ Family Care Plan, which requires among other things, naming short-term and long-term guardians for their children should they need to deploy on short notice.

 

Dual military families frequently list this as their biggest pain point.  Each time they PCS, they find themselves in a new community, a long way from family, asking brand new neighbors they barely know to take responsibility for their kids on a moment’s notice.

 

#8 Two GI Bills

 

One of the most amazing financial benefits dual military families earn is two GI Bill education benefits.  All that money they spent on childcare–they finally get a benefit that can work for them!  For dual military couples, this provides the ultimate education funding flexibility.

 

From a planning point of view, each member of the couple should transfer their benefit to other spouse as soon as they’re eligible, this starts their service commitment clock.  If they have children, they should both transfer at least one month of GI Bill benefit to each child.  This sets them up to take full advantage of this amazing education benefit when their kids are college bound.

 

#9 Two Careers

 

It can’t be overstated how difficult maintaining a marriage and raising a family can be when there are two military careers involved – two separate but important missions to achieve, two commanders to serve, and two deployment schedules to meet.   It’s a lot.

 

Dual military couples face a constant challenge to live together while meeting the needs of their services.  Every career milestone is fraught with possibilities and tradeoffs between the two careers.  Every assignment cycle brings another “should I stay or should I go” conversation.  Whose career will take priority? Will we be able to live together? Where will we find childcare?

 

What frustrates many dual military couples is that they have little or no control over these life changing decisions.  This lack of flexibility leads many dual military couples to decide that one member will step off active duty and into the reserve component to gain more control of their lives.

 

From a financial planning point of view, it’s important to recognize that the competing demands of two careers and raising a family may put achieving two active duty retirements out of reach.

 

 By optimizing your savings opportunities in your early career, you can ensure you’re financially prepared to make decisions when career challenges arise later in your career.

 

#10 – Two Pensions

 

Finally, if a dual military couple survives all the deployments and meets all the competing mission demands, in the end, they earn the best financial opportunity of all, two military pensions.

 

For many dual military couples, if they’ve saved and invested properly all along, this can mean a “BIG R” retirement.

 

They may not need to take on a second career.   They may be able to hop in the RV and travel the county or more likely, chose work that is rewarding rather than focusing on earning power.

 

Looked at from investment portfolio point of view – two military pensions mean double the income floor provided by their inflation protected government pension; which could allow them to carry a higher equity to bond ratio in their portfolio than would be typical for their age or retirement timeline.

 

Also important is that they will have two Survivor Benefit Plan (SBP) decisions to make.  If both members of the couple had careers of equal length and rank, if they don’t have any dependents at home and have saved aggressively, growing a large investment portfolio on which to rely, their SBP decision could be simple.

 

On the other hand, if they have significant career differences, maybe one left as soon as they reached 20 years, while the other continued to get promoted and retired at 30 years; then their SBP decision is a little more complicated.

 

Another factor to consider is that because of the competing work/life demands, dual military couples frequently wait to have children until later in their careers.  This means their kids are younger when they retire from the military and have a longer time horizon until they become financially independent adults.  This can create a scenario where it is important for dual military couples to extend SBP coverage to their children.

 

Follow these links for more insight on the Survivor Benefit Plan and Reserve Component SBP.

 

A Financial Strategy for Dual Military Couples

 

If you’re a member of a dual military couple, what is important to understand is that you will experience opportunities and challenges along the way.  If you’re able to maximize your savings and minimize your debt when your dual military careers align, you’ll be prepared for the inevitable financial and career challenges when your careers don’t align.

 

As a dual military couple, you don’t need to get every financial decision correct, nor do you need to perfectly align your career aspirations at every turn.  If you’re able to maximize your savings opportunities, you’ll have the financial freedom to make decisions that best support your combined professional goals and your family’s priorities.

Every military family’s situation is unique and presents its own challenges and opportunities.  We recommend working with a financial planner who understands your military benefits from first-hand experience and specializes in serving military and veteran families.  The advisor members of MFAA understand your life, your challenges and your benefits because they’ve walked in your shoes.

The information provided in this blog is simply that, information.  It is not intended to serve as an individual recommendation and should not be relied on as investment or tax advice.

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.

Categories
Taxes

Military Payroll Tax Deferral

military payroll tax deferral

Military Payroll Tax Deferral Explained

On August 8, 2020, President Donald Trump issued a memorandum allowing the military payroll tax deferral for any employee earning less than $4000 every two weeks. The $4000 limit refers to gross, or pre-tax earnings. It is important to notice the memorandum defers the taxes, it does not eliminate, revoke, or waive these taxes.  In essence, the government could collect any non-paid taxes at a future date.  Right now, the repayment date is scheduled for early 2021.  But before we tackle that issue, let’s cover some of the important information surrounding payroll taxes.

Understand Your Military Payroll Taxes

Payroll taxes, also referred to as FICA (Federal Insurance Contributions Act) pay for Social Security and Medicare. These taxes are listed as FICA Social security and FICA Medicare on military Leave and Earnings Statements (LES) and are also often abbreviated on employee paystubs. FICA taxes are split between the employer and the employee. These taxes are levied at 15.3% of earnings up to $137,700. Read more about the Social Security wage base here. There is no wage base for Medicare taxes. In fact, if you are a high-income household, there is an Additional Medicare Tax rate of .90% to wages, salaries, and tips.  Employees pay 6.2% for Social Security and 1.45% for Medicare, with matching amounts paid by employers. For military service members, Social Security and Medicare taxes are paid on all entitlements earned.

Employers are already eligible to defer payroll taxes under the CARES Act.

The Presidential memorandum defers payroll taxes (just the Social Security portion of 6.2%) from September 1, 2020 through December 31, 2020 for all federal employees. Under the CARES Act employers are already eligible to defer payroll taxes through December 31, 2020. Some self-employed individuals are also eligible to defer their SECA (Self-Employed Contributions Act) taxes. For now, the memorandum does not address employee options for participation if the employer does not choose to participate. There may be further clarifications to come. You can read more about IRS guidance on payroll tax deferral here.

Per the official memorandum, there will be no penalties or interest charges to deferred taxes. The Secretary of the Treasury has been directed to explore options for forgiving the deferred taxes. This means there is a potential that the deferred amounts will not have to be repaid. At this time there is no guarantee that forgiveness of deferred amounts will happen. Deferred taxes owed may have to be repaid in 2021. Currently, deferred taxes must be repaid in full between January 1, 2021 and April 30, 2021. Essentially, your payroll tax deductions would double for the first 4 months of 2021.

Military members have no choice

For civilian employers the program is voluntary. For federal employees, including the military, information published by DFAS indicated that deferral of employee taxes (6.2% of earnings) will not be optional. Currently, there is no way to opt-out of the deferral and no indication that an opt-out option is being considered. For now, federal employees and military service members will see more money in their mid-month pay.  But they may be forced to pay back the increase over the first four months of 2021.

If you are a civilian employee, check with your employer to see if they are participating in the payroll tax deferral. Many are not.  Many employers are concerned about the ramifications of payroll tax deferral.

If you are a military service member or federal employee, there is an easy way to calculate the increase in pay due to the payroll tax deferral. Let’s work through a quick example for a hypothetical September paycheck. The calculation would look like this:

Military Payroll Tax Half-Month Example

Earnings from 9/1-9/15: $4000.00
Monthly payroll tax 6.2%: X .062
Taxes deferred: $248

 

Military Payroll Tax Full Month Example

Earnings from 9/1-9/30: $8000.00
Monthly payroll tax 6.2%: X .062
Taxes deferred: $496

What do you do if you see your calculated increase in pay in your next paycheck? Set the money aside and don’t spend it!
Right now, there is no guarantee of any legislation to forgive the deferred taxes. Repeat for each paycheck through the end of 2021 or until there is more clarification on this issue.

For employees, whether you are civilian, federal, or military, save the payroll taxes for now. If you are military, you have likely experienced being over-paid only to have DFAS reach back months (or years) later with large extra deductions from your paycheck. Consider the payroll deferral like another DFAS error. Save the overpayment. You know they will come for it eventually.

The Bottom Line

As financial advisors, members of the MFAA help people just like you navigate the questions, challenges, and planning opportunities related to your taxes. We would love to be of help and have a free consultation.

Find an advisor here!