The Top 3 TSP Risks You Should Worry About.

Since its inception, the Department of Defense's Thrift Savings Plan has created an opportunity for active-duty service members to contribute a portion of their income into a retirement savings plan.

In 2015, some significant changes were proposed by the Military Compensation and Retirement Modernization Commission that were adopted that added an employer match to the service members TSP contributions. These changes lead to the creation of the Blended Retirement System (BRS) which now operates like a defined contribution plan, where the employer makes defined contributions toward your retirement account subject to certain conditions. In its most basic form, it works very similarly to a 401(k) like you would see in the private sector.

The main reason behind this effort was to ensure that service members who didn't stay in until retirement eligibility were able to derive some sort of retirement savings benefit without collecting a pension. While it did modernize the retirement savings component, changes were also made to the military pension system to make it more affordable with the intention that those cuts to pensions would be made up for by the employer contributions throughout the service member's career.

While the TSP does give you a very low-fee option to begin saving for retirement, it’s also important to understand a couple of other things about your TSP account while you’re making contributions that can affect you later on when you take money out.

Tax Risk

It’s important to know that understanding how taxes work is probably 10x more important than understanding how investments work because you could risk a significant loss of your money due to taxation when you withdraw those funds later down the road.

One of the main things you need to know is the difference between your marginal and effective tax rates.

Your marginal tax rate is the highest tax bracket that your last dollar touched, for example in 2020, filing as a single person, if your taxable income ended up being $84,524, your marginal tax rate would be 22%, if it were $1 higher, you would jump up to the 24% tax bracket.

But that doesn’t mean that you pay 24% on all of your income, you only pay 24% on that $1 in that bracket, the same goes for the brackets below in their respective ranges (22%, 12%, 10%).

Here is a breakdown of the 2020 tax brackets (Married filing separately is the same as filing single):

Then you have your effective tax bracket, which is the amount of your taxable income that you actually owe the government.

Having worked with a lot of military, about 80–90% of the people I’ve worked have an effective tax rate of between 4–12%.

Our current tax position is most likely about as good as its going to get for a very long time, and when you look at this history of where we’ve been with taxes (see picture below), we’re really not that bad off!

Just for reference, the average rate of the top income tax bracket since its inception is about 58%. I bring this up because one of the important decisions you’re going to have to make is whether or not you want to put your money into the Traditional bucket, where your contributions are made pre-tax and the withdrawals of both your principle and growth are taxable, or the Roth bucket, where you make after tax contributions and withdrawals are made tax-free for all funds.

One important thing to take note of is that regardless of whatever bucket you make your contributions to, your employer match will always go into the traditional bucket.

This decision is so important because most experts agree that given our current circumstances, it is highly unlikely that taxes will only go up in the future, so the main question you have to have to ask yourself is ““How comfortable am I with the possibility of paying significantly more in taxes 20, 30, or 40 years from now, than paying a little bit today?”.

Liquidity Risk

Something else to consider when you’re putting money into the TSP is the fact that you’re not going to be able to touch that money without paying some pretty significant penalties. Of course there are a few exceptions to the rule for certain medical and educational expenses, or first time homebuyers, but for the most part, you can’t touch it without incurring a 10% penalty from the IRS and taxation of your withdrawal.

What does that look like? Great question!

Let’s pretend you’re a 45-year old with $120,000 in your TSP (100% traditional bucket), and you need $50,000 to pay off some debts that have been nagging you, and you’re in the 24% tax bracket.

You don’t have $50,000 just lying around, so you decide you’re going to take it out of your TSP account, but there’s a little problem.

After the 10% penalty and taxes are paid, your $50,000 is actually only about $34,000, and that’s just not enough.

In fact, in order for you to actually get $50,000 out of your withdrawal, you’re going to need to pull more like $74,000, which is almost 150% of what you needed!

Sure, you could just take out a loan from your TSP instead of a withdrawal, but weren't you just trying to get out of debt?

My point with this is that while I absolutely believe in taking advantage of the employer match of 5%, it’s also wise to look at a couple of other options that provide for more liquidity such as a brokerage account or a cash value life insurance policy. Both of these options give you the opportunity to grow your cash, and still have access to it when you need it.

Market Risk

How many people looked at the statement for their TSP accounts in the middle of March 2020, just after the pandemic began and were like ??, ??, ??, or ???

Any of those would be a perfectly acceptable response to watching your retirement savings lose 30% in a week, believe me, you weren’t alone.

With the exception of the G-fund, all of your investment options within the TSP carry a certain amount of market risk, which means if the market is not doing well, neither is your TSP account.

As the saying goes “You’ve got to risk it to get the biscuit” right?

It’s sucks when you’re in your 30s or 40s to watch any of your accounts take a dive that big, but how would you feel when you’re in your 50s or 60s? Or even your 70s and 80s, and you’re counting on those funds to help fund your retirement.

How long does your retirement savings need to last? Well, a lot of it depends on you, and a lot of statistical data about you.

The average length of retirement in the U.S. is between 18–25 years, and in that time you can expect around 4–6 down years in the market. For reference here's a quick breakdown of the annual returns of the S&P 500 over the last 20 years.

If you’re depending on that income and you have to take money out when the market is down, it puts you in a seriously disadvantaged position because now your investments have to perform significantly better than before to get back to the level you started from before the market downturn.

For example, if you lose 30% of your account's value, your investments won’t get back to normal with a 30% return afterwards. Less money makes less money, so now, your depleted investments have to provide a return of almost 43% to get back to where you started!

Sure you have more time to recover the younger you are, but eventually you’re going to want to implement a plan that provides you the opportunity to grow your assets and protect yourself from downturns in the market, and there are a couple of strategies out there that do that.

Decisions, decisions

I know that’s a lot to throw out there all at once, but it's information that you should definitely take into consideration before making an important decision, so I’ll summarize my points, and you can do with them what you will.

1?? Get that employer match!

2?? Roth over traditional!

3?? Build up some liquidity alongside your retirement savings!

4?? Have a strategy that works for you even when things don’t go according to plan!

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