When do you stop contributing to tax-deferred accounts?

A reader writes:

How do you know when you have enough assets in retirement accounts so that you can stop contributing and put your money in taxable accounts? We could probably stop now but it’s a hard habit to break.

This is a good question for both military retirees and for servicemembers with only a few years of active duty. It’s tempting to put all your retirement savings in tax-deferred accounts (both the Thrift Savings Plan and IRAs) because those options are only available for that tax year. If you don’t make a contribution before the deadline then that year’s opportunity (and the tax-deferred compounding) is lost forever. If you have a civil-service job (with TSP matching) or if you’re contributing to a civilian tax-deferred savings plan with its own matching, then it’s tough to give up the employer’s matching “free money”.

The question has become even more complicated with the advent of the Roth TSP. Military enrollment in the Roth TSP has quadrupled in the last couple of months,* even leading to rumors of automatic enrollment for new recruits.

In general, when you’re just starting your military career, the Roth TSP is a better deal because you pay taxes on contributions now (when tax brackets are low) rather than on withdrawals later (when tax brackets may be higher). But this strategy still requires predicting your future tax brackets, and it may seem more attractive to avoid paying taxes now.

I’ll discuss the options below, but I’m not going to go into the details of how to execute each one. I’ll link to other references, of course, but otherwise a detailed explanation would be several more blog posts of procedural steps.

The goal of this post is to give you the vocabulary to follow the links and create your own plan— perhaps with a review by a financial professional or a tax accountant.

When you’re just starting your first military obligation, you have no idea whether you’re going to leave after several years or stay until retirement. If you end up with a military pension then your retirement income will quickly bump you up to a higher tax bracket.

Once again the problem is taking advantage of the opportunity– if you contribute to the TSP (regular or Roth) now then you can always roll the money out later. It’s much more difficult to get money into the TSP if you delay until later.

Let’s look at the question from the other direction:

How much do you need to save in taxable investment accounts? Military veterans want enough savings to live on during their transition from the military to a bridge career, or enough savings to live on while getting a college degree, or enough to “bridge the gap” between leaving the military and reaching age 59½– the age at which penalty-free withdrawals can begin from tax-deferred retirement accounts. (See page 55 of the PDF at that link.)

Again, it’s difficult to predict those numbers when you’re just starting out. However as soon as you finish recruit training, you’re going to start tracking your spending and developing a budget.

After you’ve been in the military for a few years, you’ll be able to project your expenses for the transition to civilian life. You’ll know your monthly spending, whether you’ll be drilling in the Reserves/National Guard, and roughly how long your job search should take.

Once you’ve forecast those numbers then you’ll know when to start piling up cash in your taxable accounts and reducing your contributions to retirement accounts.

The GI Bill can certainly eliminate your personal cost of getting a degree when you leave the military, especially if you’ve started classes during active duty on tuition assistance funds. However not every servicemember will have the liberty or the flexibility to obtain a degree on active duty, and some programs (like a MBA) may require a full-time effort.

Again you’ll be able to forecast your spending, estimate any other sources of part-time income while you pursue your degree, and decide when you’ll be starting your bridge career.

Finally, the amount of money you’ll need to “bridge the gap” between military retirement and age 59½ is part of your retirement spending plan. It’s a longer and more challenging prediction because you’ll have a number of unpredictable expenses to support (for example buying a house, raising the family, and saving for the kid’s college fund) but you’ll still be able to build a spreadsheet that you can live with.

So the answer works out to four parts:

  • Forecast your spending for the period when you’ll draw from taxable accounts
  • Figure out how much you’ll need from those accounts
  • Decide how many months you’ll need to contribute those accounts at your current savings rate
  • Stop contributing to tax-deferred accounts and boost your taxable account to reach that goal

There are several “safety net” advantages working in your favor:

  • During your military service, your income will rise faster than the contribution limits to your TSP and your IRA. (You’ll also be aggressively cutting your spending to max your savings rate, right?) A few years after you start your career (and your contributions) you’ll be able to max out those limits and continue saving in taxable accounts. By the time you’re ready to spend from your taxable account, you may already have enough.
  • You can withdraw Roth IRA contributions at any time for any expense. (See page 69 of that PDF.) Ideally you don’t want to reduce the IRA account’s compounding, but you’ll have the ability to tap the contributions if disaster strikes.
  • You can convert your tax-deferred accounts to conventional IRAs and start a withdrawal plan of “substantially equal periodic payments“. This SEPP (or 72(t) withdrawal) is complicated and may require the help of a tax planner, but it’s a long-term solution to bridging the gap between the time you leave the military and age 59½.
  • You can make a hardship withdrawal from your TSP or (if your civilian employer’s plan permits) borrow money from your 401(k). In the absolute worst case you could simply withdraw the money from the account, paying both taxes on this income and a 10% penalty for the early withdrawal. These are all bad expensive options that will hurt your savings. Clearly these should be last-ditch tactics when your plan has been disrupted by unexpected catastrophic expenses, and you’ll cut spending or seek employment income (or even borrow money elsewhere) before taking this step.

There’s another side to the “When do you stop contributing?” question. When your plan works out and you’ve maximized your savings in your tax-deferred accounts: someday you’re going to have to start required minimum withdrawals from those accounts, and you’ll pay taxes on the income. (See page 34 of that link– it’s the “deferred” part of tax-deferred.)

You can minimize the RMD taxes by making your contributions to Roth IRAs (which do not require RMDs) and the Roth TSP (contributions have already been taxed). The solution to the “RMD problem” is to roll the account over to a conventional IRA and convert it to a Roth IRA.

You’ll start to execute the rollover/conversion plan when you can minimize the taxes that you’ll pay on the conversion, and the best way to do that is to start the conversion after you leave the military– and after you no longer have employment income. By the time you’ve left both the military and your bridge career, you won’t be contributing to those tax-deferred accounts anyway. You can spread the conversion out over several years to stay in the lower tax brackets.

Summary: You’ll stop contributing to tax-deferred accounts when you need to draw down a taxable account during a transition out of the military.

However if you’re saving aggressively during your military career then you’ll max out your tax-deferred contributions and already have “enough” in your taxable accounts. When you’re no longer receiving earned income (and can no longer contribute to a tax-deferred account) then you’ll consider converting the account to a Roth IRA by paying conversion taxes when your income (and tax bracket) is lower.

Note: I’ve been asked before if you can convert your existing TSP funds to a Roth TSP. The answer is still “No…“, but it’s been modified to “… not yet“. Here’s the text of the announcement:

TSP examines in-plan conversion option — The President approved the American Taxpayer Relief Act of 2012, on January 2, 2013. This law allows the TSP and other qualified plans to give participants the option to convert their traditional account balances to a Roth balance. The amount converted would be taxable to the participant. We are currently waiting for tax reporting guidance from the IRS and will be studying the actions required to offer a conversion option. After that review, we will make decisions on whether to proceed.

[* But not for the Reserves & National Guard. The Roth TSP may be ready, but DFAS says they need until mid-late 2013 to make their Roth TSP software ready for you.]

Related articles:
Is the Roth Thrift Savings Plan right for you?
Retirement finances: what will I spend?
Retirement budgeting
Asset allocation considerations for a military pension

WHAT I DO: I help you reach financial independence. For free. I retired in 2002 after 20 years in the Navy's submarine force. I wrote "The Military Guide to Financial Independence and Retirement" to share the stories of over 50 other financially independent servicemembers, veterans, and families. All of my writing revenue is donated to military-friendly charities.

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