Tax-Wise Savings and Distribution Strategies for Feds

With the national debt roaring towards $29 trillion dollars, it is important for federal employees and retirees to understand the basics of protecting their retirement from the risk of higher future tax rates.  Currently our national debt is the highest it has ever been, both in dollars and as a percentage of GDP. In 2020, our fiscal deficit—the difference between government spending and tax revenues collected—was more than twice as high as any previous year in American history and 2021’s deficit is shaping up to be a close 2nd place. The nation’s ratio of debt-to-GDP is also at a record high and future spending projections show it getting worse in the coming years if Congress does not take action. Even at the end of WWII, when the government sold war bonds to help fund the armed forces, we had a lower debt-to-GDP ratio than we have today.  

Congress has difficult options to choose from: either spend less money each year or raise more tax revenue each year. Generally speaking, major spending reductions have not been considered politically viable because our largest expenses are entitlement programs, such as Social Security, Medicare and Medicaid. Major reductions to entitlement programs would break too many promises and impact too many voters in their most vulnerable years. As such, many experts are preparing for future income tax rates to trend significantly higher. That suggests that the biggest threats to a successful retirement today may be dramatically different than those of 15-20 years ago because of how much our debt has ballooned.  

Today, the tax treatment of the financial seeds we plant and hope to harvest in retirement matters more than ever. So it would be wise to spruce up the tax-free portion of your retirement garden by focusing on how to save if you expect taxes to be higher down the road. Taxes are unavoidable; the key question here is, do you want to pay taxes on the seeds or on the harvest? If this question were asked in 1980, the answer would be very different than today. Back then taxes were much higher and our debt was much lower, so tax deferral made sense. Today taxes are low and our debt is much higher, so tax deferral is not as attractive as it once was. With that in mind, let’s talk about how to prioritize where you plant your seeds in order to create a tax-diverse harvest.

Tax-Wise Savings Hierarchy

It’s helpful to think of your retirement savings as existing in four categories:

1. Free Money

• TSP matching contributions
• Gifts and inheritance funds

2. Tax-Free Money

• Roth TSP and Roth IRA contributions 
• A cash-value life insurance policy
• Using Roth conversions to fund a Roth IRA

3. Tax-Deferred Money

• Traditional TSP contributions
• Traditional 401K, 403B, 457B, SEP, and SIMPLE contributions
• Traditional IRA contributions 

4. Taxable Money

• CD’s and money market accounts
• Non-qualified accounts (stocks, mutual funds, etc.)

Obviously, free money is rare and as such, it belongs at the top of the hierarchy and should be prioritized. All too often though we see people skipping over Level 2 (tax-free money) and jump straight to making tax-deferred contributions. If you defer tax liability, you also defer the tax computation determining how much you owe, so if rates increase over the coming years, then you will have a bigger tax bill eroding the spending power of your fixed income in retirement. Taxes are currently “on sale” but we all know that every good sale eventually comes to an end.

Once you have created tax-diversity in your savings efforts, the next step is to optimize the distributions from a tax-diverse portfolio to help mitigate the potential impact of higher future tax rates. This is definitely a situation where professional guidance can be of major benefit but, in general, if you are more concerned about tax rates in 25 years than you are in 15 years then you should plan your withdrawals accordingly. So, let’s talk about how to strategically spend down the different types of assets.

Tax-Wise Distribution Hierarchy

1. Tax-Deferred Money

• Distributions from traditional TSP, traditional IRAs, traditional 401Ks, etc.

2. Non-Qualified Money

• Distributions from brokerage accounts, stocks, mutual funds, CDs, etc.

3. Tax-Free Money

• Distributions from Roth TSP, Roth IRA, cash-value life Insurance, etc.

When taking distributions, the tax rate environment at the time of the distribution is a key consideration.  When taxes are low, you would start by pulling from your tax-deferred money (accounts with the largest tax liability), emphasizing them early in retirement before tax rates increase too much. Then, you may look at non-qualified money, where there is a blend of after-tax principal (called basis) that is returned without additional taxation and taxable capital gains (but remember, long-term capital gains rates are often lower than income tax rates). Finally, once tax rates have become truly problematic, that is when you want to use the tax-free distributions from your tax-free money. Tax-free dollars are most impactful when taxes have increased substantially from the rates originally paid on the contributions. Tax-free money is also the best of these three categories to leave to your loved ones as a legacy. 

This tax-wise conceptual framework is only a general outline of how to manage tax trends and does not consider all of the unique factors of your personal situation, so professional guidance is recommended.

By being smart with how you save while working and with how you employ your money in retirement, you can lessen the impact of taxes if they do indeed trend upwards. For those that have amassed substantial tax-deferred nest eggs, using the tax-wise distribution hierarchy may not be enough. For folks in those scenarios, we recommend working with a team of knowledgeable professionals to help you proactively explore tax mitigation strategies (such as Roth Conversions). If you would like to learn more about how to create tax diversity in your TSP and maximize its positive impact on your retirement, join us for our upcoming complimentary webcast, “The Thrift SPENDING Plan”.  

Tom Walker is a federal employee benefits consultant and founder of Walker Capital Preservation Group.