TSP in-plan Roth conversions: Are they right for you?

The Thrift Savings Plan (TSP) has long served as a cornerstone of retirement savings for federal employees and members of the uniformed services. As retirement planning becomes more complex, TSP participants are increasingly interested in maximizing their accounts’ flexibility and tax advantages. One of the most significant features now available is the in-plan Roth conversion, allowing participants to convert traditional TSP balances to Roth within the plan.

Recently, TSP introduced a new calculator to help participants better understand and evaluate the impacts of such conversions. This new option presents a decision that should involve a consultation with your financial professional, who can help you evaluate how this move might benefit you in tax planning and also caution you when deciding to jump in feet first to take advantage of this new option available to TSP participants.

What do the professionals think?

One such financial advisor whom I’ve had the pleasure of getting to know is Neil Cain, a Certified Financial Planner with Capital Financial Planners. He wrote a column this week about the pros and cons to be aware of when deciding to proceed with a TSP in-plan Roth conversion. I also discussed this new option with Karen Schaeffer, a long-time colleague of mine, who is also a CFP. She has advised clients for over 40 years and has developed a diverse client base, including professional women, Foreign Service officers, foreign nationals, and federal government employees.

Both Karen and Neil have expressed holding up a big caution flag before taking advantage of this new option. 

“We’re being forced to make a deal with the devil of future changes to our tax laws,” Karen said.

In other words, using a pre-tax traditional retirement savings plan allows you to save tax dollars as you are investing today and reminds us to think about tax planning and strategies we can plan for when withdrawing those taxable distributions in the future. Karen also provided the following reminders:

• No one knows what the tax laws will do in four years, let alone over the next 40 years.

• Those who want to do their kids a favor by leaving a tax-free account as an inheritance should consider that they can most likely save more for the future by investing pre-tax dollars, which will allow them to make their retirement more comfortable while possibly still leaving a sizeable legacy for their family. After all, she reminded us, we have already been nice to our kids; we should not sacrifice the comfort we may experience in our retirement thanks to our ability to save and invest during our working years.

• Will your tax bracket really be lower when you are withdrawing these funds in retirement? Federal retirees will have a minimum of three streams of retirement income to consider: the FERS basic retirement benefit, Social Security retirement, and, once over a certain age, required minimum distributions (RMDs) from the TSP and other pre-tax retirement accounts, which can be sizeable, especially if you haven’t been taking distributions earlier in your retirement.

If it is your plan to save these funds to pass on to your favorite charity, remember that they won’t necessarily need the tax-free withdrawals, since distributions to a charity are tax-free anyway—even those that were invested on a pre-tax basis—and provide a deduction for estate tax purposes. If this is your plan, remember that TSP and IRS rules do not allow direct, tax-free charitable transfers, commonly known as QCDs (this is a discussion for another day with your financial advisor).

What is an in-plan Roth conversion?

The concept of an in-plan Roth conversion is that this process enables TSP participants to transfer all or a portion of their traditional (pre-tax) TSP account to a Roth (after-tax) account within the plan. Unlike rolling funds out to a Roth IRA, this process keeps the money within the TSP, allowing participants to continue benefiting from low-cost investment options and the familiar structure of their retirement account.

When you convert traditional TSP funds to Roth, the amount converted becomes taxable income in the year of the conversion. This means you’ll owe federal (and possibly state) income taxes on the converted amount. The taxes are not withheld from the converted investment; instead, you must plan to pay these taxes out of other funds you have available.

However, once in the Roth account, future qualified withdrawals—including earnings—are tax-free, provided certain requirements are met. This trade-off can be appealing for participants who anticipate being in a higher tax bracket in retirement or who value tax diversification.

As any financial professional will tell you, there are some advantages to having a Roth account in retirement:

• Tax-free growth and withdrawals: After converting and paying taxes upfront, Roth balances grow tax-free, and qualified withdrawals in retirement are not taxed.

• Tax diversification: Having both traditional and Roth balances can provide flexibility in managing taxable income in retirement.

• No required minimum distributions (RMDs): While traditional TSP accounts are subject to RMDs at age 73, Roth TSP balances are not, allowing participants to keep funds invested longer.

• Estate planning benefits: Roth accounts can be advantageous for heirs, who may inherit funds without immediate tax consequences.

However, the decision to convert is highly personal and depends on factors such as current and future tax rates, age, anticipated retirement income, and available funds to pay taxes on the conversion. It’s important to note that converting a large balance in a single year could push participants into a higher tax bracket, resulting in more taxes owed. Also, for those over 65, this decision can affect Medicare Part B and Part D premiums due to the income-related monthly adjustment amount, better known as IRMAA.

Using the TSP’s Roth conversion calculator

Recognizing the complexity of Roth conversions, TSP recently launched a dedicated calculator. This tool is designed to help participants visualize the financial impact of converting traditional TSP funds to Roth, estimate the tax consequences, and assess how conversions fit into their broader retirement strategy.

The calculator allows users to input their current traditional TSP balance, desired conversion amount, estimated federal and state tax rates, and anticipated future growth rates. Based on these inputs, the tool projects the immediate tax liability, the future value of the converted amount, and potential tax savings over time. It also enables comparisons between keeping funds in traditional versus Roth accounts, providing clarity on the long-term benefits and drawbacks.

The basics to use the calculator:

• Access the calculator: Log in to your TSP account or visit the TSP website to find the Roth conversion calculator under the “Tools and Calculators” section.

• Enter your information: Input your traditional TSP balance, the amount you wish to convert, your current federal and state tax rates, and expected annual growth rate.

• Review the results: The calculator will display your estimated tax bill for the conversion, the projected value of your Roth account at retirement, and the tax-free withdrawal potential.

• Compare scenarios: You can run multiple scenarios, adjusting conversion amounts and tax rates, to see how different strategies affect your retirement outcomes.

• Consult a professional: While the calculator provides valuable insights, it’s wise to consult a financial advisor or tax professional before making a final decision.

Key considerations when exploring an in-plan TSP Roth conversion:

While the calculator is a powerful tool, participants should consider several factors before proceeding with a Roth conversion:

• Future tax brackets are uncertain: The best you can do is run multiple scenarios to prepare for future income and tax fluctuations. Your financial planner is your best resource to forecast your future financial situation.

• Future investment returns are uncertain: The best you can do is rely on historical information and remember that past results do not guarantee future returns.

• Tax impact: Converting large amounts at once could increase your taxable income significantly for the year.

• Ability to pay taxes: Ensure you have funds available outside TSP to pay the tax bill, as withdrawing from the TSP to pay taxes could trigger additional penalties and taxes.

• Age and retirement timeline: Younger participants may benefit more from the extended tax-free growth in Roth accounts, while those nearing retirement should weigh the immediate tax costs against future benefits.

• Required minimum distributions: If you are subject to RMDs, you must withdraw the RMD amount for the year before you can do a Roth in-plan conversion. The IRS doesn’t allow conversion of RMD amounts. You cannot satisfy the RMD amount by converting money from your traditional TSP balance to your Roth TSP balance.

• Future tax legislation: Changes in tax laws could affect the relative benefits of traditional versus Roth accounts.

The TSP’s introduction of in-plan Roth conversions and its new calculator mark a significant step forward in empowering participants to make informed retirement planning decisions. By understanding how conversions work and utilizing the calculator to model their choices, federal employees and uniformed service members can optimize their retirement savings strategy to fit their unique circumstances.

Mark Keen, CFP®, has a webinar that explores Roth conversions, available to members of the National Active and Retired Federal Employees Association. He explains ways to discover how Roth conversions can increase after-tax wealth, lower your lifetime tax burden, and help you avoid stealth taxes. As always, careful consideration and professional guidance are recommended before making major financial moves, but the tools now available make navigating the complexities of Roth conversions easier than ever.