Overfunding Tax-Benefited Retirement Accounts?

[GrayGhost]

Greetings, Mustachians!

I was reading this article by MMM and it got me to thinking about my own investments. At present, I'm maxing out my IRA and once my pay grade gets bumped up, I'll be maxing out my TSP as well. Both are Roths, as I plan to be fairly wealthy when I'm older.

Soon, however, I'll have excess money on top of that, and that will go into non tax advantaged investments.

The problem, naturally, is that I will shortly have a very well funded age 65 retirement, as the money in my IRA and TSP will have some decades to grow... but the money I invest elsewhere will barely have a few years to collect interest. So even if my assets get to 25x my expenditures at age 35, it won't matter if I only have 5x my expenditures in non-retirement accounts, because that money will almost certainly run out within a decade.

I suppose the best thing to do is to change my investment mix from 90% to tax advantaged accounts and 10% to non tax advantaged accounts, to 10% to tax advantaged accounts and 90% to non tax advantaged accounts. That way, I may very well have just a few thousand bucks in my IRA and TSP by the time I hit FIRE, but that will expand to cover everything by the time I'm 65.

Or, I could keep maxing out my IRA and TSP until it hits a point where I expect it to grow enough to cover my age 65 expenditures, and then I could shift all investments to non tax advantaged stuff, such as real estate, index funds, et cetera.

What do you think of my concerns? I want to have a high margin of safety, and don't worry, I am pretty sure I can avoid inflating my lifestyle to beyond what I can afford.

[MDM]

You will likely be fine with everything in Roth accounts.  Google "substantially equal periodic payments" See http://forum.mrmoneymustache.com/investor-alley/how-to-withdraw-funds-from-your-ira-and-401k-without-penalty-before-age-59-5/ and see http://www.schwab.com/public/schwab/investing/retirement_and_planning/understanding_iras/roth_ira/withdrawal_rules and similar sites.

ETA: replace SEPP suggestion with the more generic sticky thread.

[Cheddar Stacker]

I would keep plugging away with the tax advantaged accounts. You can access it well before 65 via the SEPP or Roth Pipeline. Since a big chunk is already in a Roth you can access the principal portion at any time without penalty. You can never really have too much in a 401k. I understand what the bug guy is saying in his post there, but the tax savings are just too big to pass up IMO.

[GrayGhost]

Hello again Mustachians,

I'd like to update this thread with some news. Now, at the age of 25, I have $70k in my TSP and IRA (both Roth), and by the end of 2016 I will have a hair over $90k depending on the market. A simple calculation suggests that, if my money compounds at a real rate of 7% annually, I will have over $1.2M at the age of 65, so my retirement will be fully and totally funded. Awesome, right?

Here's the problem. $90k in principle is barely enough to live for six years frugally, so even the 5 year pipeline won't help me very much. The only way it will help me is if I roll part of my Roth TSP into my Roth IRA, and that somehow counts as a principle contribution, then I'll have enough to fund an early retirement. The SEPP should give me the ability to withdraw up to 2.5% or so of my Roth TSP per year, which falls well short of what I will need to fund my retirement if I use the 4% rule.

Sure, I could keep putting money into my Roth TSP and Roth IRA until I am at a point where the 4% rule comes into play, but this won't help me much as I will have to pay a 10% tax on any withdrawals of interest from my Roth IRA, and a 10% tax on any withdrawals at all from my Roth TSP.

So, how should I keep contributing money to my Roth TSP and Roth IRA, or contribute to non tax-advantaged funds to hold me over until I'm 65? Should I hold fast to the 4% rule, or should I account for the 10% penalty tax? How helpful is the SEPP really when all it is is effectively a 2.5% withdrawal? And how can I roll Roth TSP into a Roth IRA? I have found precious, precious little information on the last topic especially, and no forms or guidance how specifically it can be done.

Any advice is appreciated. Cheers all.

[MDM]

Similar questions have since been addressed in a sticky post: http://forum.mrmoneymustache.com/investor-alley/how-to-withdraw-funds-from-your-ira-and-401k-without-penalty-before-age-59-5/.  Does that help?

Note that if ~all your retirement income comes from Roth accounts (e.g., no pension, small amount of SS, all investments in Roth) then you will have missed an opportunity by not investing in traditional accounts.  That's because if everything comes from Roth your taxable income is zero and thus your marginal rate is zero.  In this case you should be using traditional accounts for at least some of your retirement investments.

[Joel]

What is your marginal tax rate? If it is above 15% you should probably be contributing to traditional retirement accounts. You can have almost 1m in tax deferred assets before getting into the 15% tax bracket.

[act0fgod]

I'm not really going to give you any information but I'll talk about my personal choices.  Like you I'm military, my wife is also.  We've always maxed our individual IRA and our TSP.  This year, at age 31, was the first time we had the discussion that we're probably putting too much money into our retirement accounts.  It came about because my wife deployed and had the opportunity to put 53k into her TSP.  Despite the common advice from individuals like us we didn't put all that money into her TSP.

The reason we didn't put the full 53k into the TSP is essentially because we were concerned about overfunding the retirement account, which sounds crazy.  We came to the realization that our retirement accounts plus pensions are going to be more than we can imagine spending after reaching the "retirement age."  We both plan to stop working once we reach 20 years and want to have flexibility in our spending for that time.  It's likely there will be large differences in our spending that SEPP won't account for.  For example if we want to take a year to travel (we hope to move away from budget traveling) the expenses will be higher that year.  Also we see a large down payment if we move back to the DC area in the near future so wanted to have more flexibility.

We definitely lost some potential earnings but were willing to pay for that to increase flexibility (we still plan to max our IRA and TSP at the traditional levels and don't see that changing).

[seattlecyclone]

act0fgod, have you looked into the Roth conversion pipeline? Unlike SEPP, it does allow for more flexibility in withdrawals from year to year as long as you have built up a large enough seasoned Roth balance. Remember also that you can withdraw your Roth principal at any time with no penalty, so if you had gone ahead and made $53k worth of post-tax contributions you could have withdrawn that much during retirement no strings attached. You would only be giving up the ability to withdraw the earnings early without penalty. Depending on your circumstances, that may or may not be a good deal compared to putting the money in a taxable account and paying taxes on dividends every year until you need to withdraw the cash.

I will say that the math can be different for those who are expecting pensions. Most of the advice we give here regarding Roth vs. traditional, tax-advantaged vs. taxable, etc. stems from one simple fact: you generally get to keep the most money for yourself by making your marginal tax rate be as close to constant as possible from year to year. Shifting as much income as possible from high-earning years to retirement is a good way to do that...unless you have a pension that will pay you a good fraction of your salary already. In that case, Roth accounts or even taxable accounts may be a better plan to ensure that your tax bracket doesn't increase during retirement.

[GrayGhost]

Thanks for all the advice, everyone. I think I understand things a bit better now. Here are a few takeaways I've gotten, so please correct me if you think I might be incorrect or confused about any of them.

• I should consider investing in a traditional TSP and IRA. This is because if/when I FIRE, I will probably be in a lower tax bracket, so it makes sense to pay taxes then rather than now. (Currently I am in the 15% tax bracket since military compensation is tax advantaged, so maybe I'll stick to Roth until I'm in a higher bracket.)
• Traditional TSP/IRA holdings I roll into a Roth IRA can be withdrawn without penalty if "seasoned" for five years, even if the holdings that were rolled over include earnings as well as contributions. This is the big sticking point for me, can anyone confirm that it is true? The 10% penalty is a big hit that I'd like to avoid if possible.

By the way, I really doubt that I will spend 20+ years as active duty, so I don't expect a pension. I'm not ruling out doing my 20, but I just don't think it's probable at this point.

If my understanding is correct, I don't really have any action items... just keep maxing out the ol' Roth TSP and Roth IRA, and sweeping any savings beyond that into non tax advantaged accounts. But I really would like confirmation--are Roth TSP contributions AND EARNINGS exempt from penalty fees if I roll them into a Roth TSP and season them for five years?

Thanks for the advice, all. Happy holidays.

[MDM]

I should consider investing in a traditional TSP and IRA. This is because if/when I FIRE, I will probably be in a lower tax bracket, so it makes sense to pay taxes then rather than now. (Currently I am in the 15% tax bracket since military compensation is tax advantaged, so maybe I'll stick to Roth until I'm in a higher bracket.)

If you expect many years of income in higher tax brackets, doing Roth for a few years now while in the 15% bracket may be ok.

Traditional TSP/IRA holdings I roll into a Roth IRA can be withdrawn without penalty if "seasoned" for five years, even if the holdings that were rolled over include earnings as well as contributions. This is the big sticking point for me, can anyone confirm that it is true? The 10% penalty is a big hit that I'd like to avoid if possible.

If my understanding is correct, I don't really have any action items... just keep maxing out the ol' Roth TSP and Roth IRA, and sweeping any savings beyond that into non tax advantaged accounts. But I really would like confirmation--are Roth TSP contributions AND EARNINGS exempt from penalty fees if I roll them into a Roth TSP and season them for five years?

No for Roth IRA and 401k/TSP earnings.  Yes for Roth IRA contributions, Roth IRA roll-overs from Roth 401k/TSP contributions, and Roth IRA roll-overs from traditional 401k/TSP and IRA totals.  The common thread on all the "yes" items is that taxes have been paid on those dollars.

See https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/ and the Schwab link above for more details.

[seattlecyclone]

Just to restate what MDM said, whatever amount you convert from your traditional TSP to your Roth IRA can be withdrawn penalty-free in five years. This would include your contributions to traditional TSP, earnings within that account, and any employer matching funds. Once the money has been moved to your Roth IRA, any earnings from that point forward would be subject to income tax and an early withdrawal penalty if withdrawn prior to 59½.

[GrayGhost]

Guys, I think it finally clicked. Let me make a table for my own sake...

Roth IRA: contributions and earnings can be withdrawn after five years of seasoning
TSP: contributions and earnings are taxed when rolled over into Roth IRA, can be withdrawn after five years of seasoning with no further penalty
Roth TSP: Penalty must be paid on earnings if I attempt to withdraw them, regardless if they're in the TSP or IRA.
IRA: I don't have one, but if I did, same conditions as the TSP

My new plan is to continue to max out my Roth IRA, and my traditional TSP. This will increase my flexibility and if I decide to FIRE, I can live off of Roth IRA contributions for five years and then live off of rolled over TSP contributions/earnings.

Or, I could always max out my TSP contributions and roll everything in it over to my Roth IRA at the end of the year. The tax rate I'd pay then would be a bit higher than desirable, but I'd be extremely well prepared to FIRE in only a few short years.

Thanks for the clarifications, all.

[Allen]

Guys, I think it finally clicked. Let me make a table for my own sake...

Roth IRA: contributions and earnings can be withdrawn after five years of seasoning
TSP: contributions and earnings are taxed when rolled over into Roth IRA, can be withdrawn after five years of seasoning with no further penalty
Roth TSP: Penalty must be paid on earnings if I attempt to withdraw them, regardless if they're in the TSP or IRA.
IRA: I don't have one, but if I did, same conditions as the TSP

My new plan is to continue to max out my Roth IRA, and my traditional TSP. This will increase my flexibility and if I decide to FIRE, I can live off of Roth IRA contributions for five years and then live off of rolled over TSP contributions/earnings.

Or, I could always max out my TSP contributions and roll everything in it over to my Roth IRA at the end of the year. The tax rate I'd pay then would be a bit higher than desirable, but I'd be extremely well prepared to FIRE in only a few short years.

Thanks for the clarifications, all.

Error on Roth IRA, you can only pull CONTRIBUTIONS (not earnings).  You can pull those contributions anytime.  The 5 years of seasoning is on an ira rolled over into a Roth IRA.  After you let that rollover season for 5 years you can pull out whatever you rolled over, but not the additional earnings since the rollover.

I don't know anything about TSP plans.