Military Retirement: What About My TSP?
As you’re working your way through your pre-retirement checklist, you’ll discover a list of important decisions that require your attention. At the top of the list is a decision about what to do with your Thrift Savings Plan (TSP). This blog answers some of the most common questions about TSP and shares a few important factors that may influence your decision.
Thrift Savings Plan – Do I need to move my TSP?
What is TSP?
The Thrift Savings Plan is the retirement savings plan available to military members. Similar to a private sector 401(k) retirement plan, military members can allocate a portion of their paycheck to TSP where the money is invested in either a tax-free or tax-deferred account until needed in retirement.
TSP invests in a wide range of holdings in both US and international stocks as well as government and corporate bonds through an investment strategy known as indexing. These index funds passively track the components of a major financial benchmark providing ownership in a representative sample of that index and offering diversification across hundreds of stocks and bonds.
This table shows which benchmark each TSP Fund tracks. The G Fund is unique in several ways, including the fact that it is guaranteed by the US Government and does not track an index.
What is the TSP decision?
When you leave military service, your ability to contribute payroll deductions to TSP ends, but that doesn’t mean you lose access to the amazing benefits of your TSP investments. When you retire from the military, you have the option to leave your TSP investments where they are or take them with you to your new employer’s retirement plan. You also have the option to roll your TSP investments into an individual retirement account (IRA).
What’s so special about TSP?
TSP has several factors that make it a unique and valuable retirement savings tool.
Ultra-low fees. TSP’s passive investment strategy ensures broad diversification while minimizing the expenses associated with managing the investments. Instead of diverting a substantial portion of your invested money to pay for analysis, research, transaction costs and other investment expenses; TSP’s passive investment strategy minimizes most of these expenses, allowing the majority of your invested dollars to remain invested.
As an example of these extremely low fees, let’s compare the TSP C Fund, the Common Stock Fund, with an actively managed mutual fund that tracks the same Standard & Poor’s 500 (S&P 500) index. Both invest in a representative sample of S&P 500’s companies like Facebook, Amazon, Apple, Google and even recently listed Tesla.
The TSP C Fund’s expense ratio is just 0.051%, which means for every $1000 you invest, the investment expense is only 51 cents. A similarly invested actively managed S&P 500 fund carries an average expense ratio of 1.0%, where every $1000 of investment incurs a cost of $10. Both the C fund and the actively managed fund invest in companies listed on the S&P 500, but because TSP charges a substantially lower fee more of your money stays invested and grows with the market index over time.
Lifecycle Funds. TSP offers a wide range of lifecycle target date funds known as the L funds. These L funds match the mix of investments with your retirement timeline, from 2025 to 2065. The L funds are fund of funds, meaning they offer access to all five TSP funds within one portfolio, providing not only a diversity of asset types like stocks, bonds, and cash-like investments, but also diversity within each of these asset types by owning hundreds of different stocks and bonds within the individual funds.
The L funds take the guess work out of knowing how to diversify your assets and when to reduce risk by rebalancing. As you move closer to your target retirement date, the goal shifts from growing wealth to preserving wealth. With this in mind, as the target date gets closer, the L fund dynamically reduces the risk in the portfolio by pulling back on more volatile stock investments and replacing them with less volatile assets like bonds and cash.
For example, the L funds based on retirement dates decades in the future allocate investments toward growth by owning a larger proportion of stock investments. For example, the TSP L 2060 Fund allocates 99% of the portfolio to US and international stock (TSP Funds C, S, and I); leaving only 1% invested in the two bond funds (TSP Funds G and F). When an L fund approaches its target date, it reduces the exposure to more volatile investments like stocks. The TSP L 2025 fund currently allocates just 46% of the portfolio to stock (TSP Funds C, S, and I) and 54% to bonds (TSP Funds G and F).
G Fund. The TSP G Fund in unique among investment vehicles in that it guarantees an investor’s principal by providing interest income without the risk of loss of principal. This extremely rare safety net could prove priceless when you’re fully retired and relying on your investments to generate income to cover your expenses.
Why keep your investments in TSP?
Beyond the many advantages of TSP, there are a few more reasons why you may want to leave your investments in TSP when you retire from the military.
Combat Pay. If you contributed to your TSP while deployed to a combat zone, those contributions maintain their combat zone tax-free status as investments. The TSP program is specifically setup to manage this unique and valuable tax-free advantage. It can be difficult to find a commercially available investment that is capable of preserving the special tax advantages gained while earning tax-free income in a combat zone.
Roth Conversions. Converting Traditional IRA savings to Roth retirement savings is a complex, but often tax-wise financial planning tool to lower your tax bill during retirement. Without diving into the specifics of tax law, the important fact to remember is that leaving your retirement savings inside the wrapper of your TSP reduces the portion of your retirement savings that are included in the tax calculation during a Roth conversion. By keeping your investments in TSP funds and not moving them to an IRA, you increase your opportunity to make tax advantaged Roth conversions in the future.
TSP Modernization. Recent improvements to the TSP program have aligned its offerings with those of corporate 401(k) plans. For example, TSP expanded withdrawal options allowing you to control which type of TSP account you withdraw from first. This allows you to take full advantage of the tax diversity of owning Traditional, Roth and combat pay based retirement accounts. TSP also expanded its Lifecycle fund options to offer L-funds based on five-year increments allowing you to more accurately align your investment timeline with your life stage.
Are there situations when I want to move my TSP?
Even with all of these advantages, there is at least one situation where you are better served to roll your investment out of TSP. This instance occurs after a spouse inherits a TSP account.
When establishing your estate plan, it is important to understand the difference in tax treatment of your inherited TSP assets between your original beneficiary and their follow-on beneficiary. In the most common scenario, when your spouse inherits your TSP, he or she will inherit your funds in a TSP account in their own name. This first step in the beneficiary chain of events is appropriate and provides your spouse with tax advantaged distribution options typically available with private sector 401(k) plans.
The challenge occurs at the next step in the estate plan when your spouse’s account is distributed to the next level of beneficiaries, perhaps your child or children. At your spouse’s death, the government will make a single lump sum distribution of the full value of the TSP account to the beneficiaries, creating an extremely negative tax consequence and substantially reducing the value of their inheritance.
To preclude this costly distribution, the tax-efficient choice is for the spouse to roll the inherited TSP assets into an individual retirement account soon after the death of the original owner.
Are there downsides to TSP?
Mind the Gap. If there is one kink in the TSP program it is that it’s utilitarian list of just five investment offerings comes up short in a few categories. The International Fund (I Fund) includes stocks from countries in the developed world’s economies, primarily Western European countries, plus Australia, New Zealand and Japan. Missing from this composite are emerging economies like China, Taiwan, India, Russia and South Korea. Similarly absent from the F Fund bond line up are high yield bonds and an appropriate allocation of international bonds.
Both of these investment categories can serve as valuable diversifiers in your overall portfolio. Their absence from the TSP lineup shouldn’t deter you from taking advantage of the other ultra-low fee investment offerings. The remedy is simply to pick up emerging markets stocks and high yield and international bonds in investments outside of TSP.
Concluding thoughts on TSP
The retirement savings opportunities offered by the Thrift Savings Plan don’t end when you retire from the military. Continued access to these ultra-low fee, broadly diversified passive investments make retaining your TSP investments after your military retirement the smart and efficient easy button at retirement.
Like all financial decisions, the right decision on TSP is unique to each military family’s situation. We recommend working with a financial planner who understands your military benefits from first-hand experience and specializes in serving military and veteran families.
If you’re approaching a turning point in your military career, we would love to partner with you to help you prepare for this major life and financial transition. Please use this link to schedule an introductory call.
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.
To learn more about important financial decisions related to military retirement, check out our articles on SBP or VGLI.
