Unfortunately, you cannot avoid the risks of TSP losses and taxes on Thrift Savings Plan. We’ve all heard it. In this life, two things are inevitable: death and taxes. But unlike death, the effects of taxation can be mitigated.
Income taxes mean something very different for a 35-year-old professional than they do for a 70-year-old retiree. For the professional, they are a nuisance that can be tolerated. After all, the 35-year-old can continue to work and to earn what was lost to taxation.
For the retiree, money that gets lost to taxation amounts to a permanent loss of capital.
This becomes especially important as it relates to retirement dollars, particularly for veterans and federal employees who contribute to a traditional Thrift Savings Plan (TSP). While at the height of their earning potential, professionals often deduct TSP contributions from their taxable income. After all, these deductions can land them into lower income tax brackets while helping to fund their retirement. It seems like a win-win scenario until it comes time to take distributions.
The Sequence of Returns Risk
One of the repercussions of the veterans financial benefits problem we are facing today is that it allows room for too much change.
Consider a couple with $500,000 saved up for retirement in a managed retirement account, which earns on average a 6.5% return per year. Some years are good, some are not, but at the end of the day, there’s plenty left over for the next generation.
But what happens to this couple if they are unfortunate enough to have to start drawing on their retirement funds in a bad market? This is a formula for huge TSP losses.
This is called the sequence of returns risk. Bad luck in the first few years of distribution could cause them to spend their assets down too fast for them to recover when the index recovers. Thus, it is possible for a once-affluent couple to deplete their assets down to destitution in a very short period of time, even though they did “all the right things.”
Are we all hopelessly at the mercy of Lady Luck? What if there was a way to diminish the role luck plays in our ability to attain our goals?
There is, and it starts by making sure we understand the tools at our disposal.
A Hidden Veteran Retirement Tax Bomb
Since every dime contributed to a TSP was contributed pre-tax, every dime that gets distributed gets taxed as ordinary income even before it hits your bank account. Just as there are tax penalties for taking distributions from a TSP before the age of 59 ½, once a TSP account holder turns 70 ½, there are tax laws requiring that the account holder take Required Minimum Distributions (RMDs) so Uncle Sam can get his hands on that tax revenue.
This becomes especially important when retirees liquidate TSP accounts in a bear market. In this case, the retiree has just watched his/her account drop in value and wants to cut bait and run, lest he wind up pouring good money after bad. But now, the cash that the retiree has just removed from the TSP counts as income and the United States Treasury sends the retiree a hefty tax bill. This is a retirement tax trap that leads many people to spend down their lives’ savings to zero long before they planned. Talk about adding insult to injury. The IRS is going to get their TSP taxes unless you do something to protect them. That is another consideration of TSP losses.
How to Avoid TSP Losses? A Simple Solution
Thankfully, this scenario is 100% avoidable. A retiree is allowed to roll as much of a TSP as he/she wants into a Retirement Rescue Plan with no taxation penalty at all to avoid TSP losses. Once rolled into into this plan, the entire value of the TSP is treated as principle, thus guaranteed against loss, so no individual ever has to take distributions as a result of negative returns again. Once the retiree does start to take distributions, the plan begins providing annual payouts that only stop when the he/she and his/her spouse are deceased.
These distributions are taxed as ordinary income, but there will be a steady or growing income payout every single year, regardless of cash value or market performance. This does not completely remove income taxes because Uncle Sam will have his due, but it changes the nature of the retiree’s income taxation. No longer will income taxation result in a permanent loss of capital.
The capital that this retiree lost to income taxation will be replaced the following year, just as it did when this retiree was employed. The only difference is that now the retiree no longer has to work to get paid!!!