by Brian Swerdlow

Federal employees who participate in the Thrift Savings Plan (TSP) often ask me about the best strategies for managing their retirement savings. One question I get regularly is whether it makes sense to pay taxes on retirement funds sooner rather than later.

If you are considering a Roth Individual Retirement Account (IRA) conversion, the answer to that question could be “Yes.”  There can be many potential benefits of a Roth IRA conversion, particularly for federal employees with TSP accounts.  In this article, I’d like to take a look at when a Roth conversion strategy might—or might not—be appropriate.

Why should a government employee consider a Roth IRA Conversion?

A Roth IRA is funded with after-tax dollars, and qualified withdrawals are entirely tax-free. Additionally, Roth IRAs are not subject to required minimum distributions (RMDs), which provides you much greater flexibility in managing your taxable income during retirement.

However, not everyone can contribute to a Roth IRA directly. Income limits restrict a person’s ability to contribute to Roths.  In 2024, the income limit for a full Roth contribution is less than $146,000 for single filers and less than $230,000 for married couples. A Roth IRA conversion allows anyone, regardless of income, to transfer funds from a traditional IRA into a Roth. This brings federal employees with TSPs into the equation, as they can indirectly benefit from Roth IRA conversions when they use a multi-step process.

What are some of the benefits of Roth IRA conversions for federal employees?

Several scenarios might make a Roth conversion attractive to those with TSPs:

  1. You might be in a higher tax bracket in retirement: If you anticipate being in a higher tax bracket during retirement, converting now could save you from paying more in taxes later. This situation is especially relevant if you expect your income to increase in the future or if you haven’t yet reached your peak earning years. By converting today, you lock in current tax rates, potentially avoiding higher rates later. Most economists believe that taxes are more likely to go up than down in the future.
  2. You might want to leave a larger legacy: For federal employees who do not need to tap into their retirement funds, a Roth IRA conversion could maximize the estate they leave behind. Roth IRAs are not subject to RMDs, allowing the account to continue growing tax-free, benefiting your heirs, who can also generally withdraw the funds tax-free.
  3. Diversification of tax treatment: Many people hold most of their retirement savings in tax-deferred accounts. By converting a portion of your TSP or IRA to a Roth IRA, you’ll have both taxable and tax-free income sources during retirement. This diversification can help manage your tax bracket more effectively, allowing for greater control of when and how much tax you’ll owe.
  4. Help with irregular income.  If you’re experiencing a low-income year, now could be a prime opportunity to execute a Roth conversion. The tax impact would be minimal, providing a chance to convert at a lower rate.

Roth conversions are not ideal for everyone. 

While a Roth IRA conversion has its advantages, it’s not the right move for everyone. For some federal employees, sticking with a traditional IRA or TSP might be a better strategy, particularly in the following cases:

  • Approaching Retirement: If you’re close to retirement and plan to rely on your traditional IRA or TSP for living expenses, a Roth conversion might not make sense. You would need enough time to recover from the tax hit that comes with conversion, which may not be feasible if you need the funds soon.
  • Social Security and Medicare: A Roth conversion increases taxable income for the year it is executed, which could trigger higher taxes on Social Security benefits or raise Medicare premiums. These effects can significantly reduce the overall benefit of converting.
  • Paying Taxes on the Conversion: Ideally, you would use cash on hand to cover the taxes from the conversion rather than dipping into retirement accounts. Selling assets or using IRA funds to pay taxes could negate the benefits of the conversion, especially if it triggers capital gains taxes.

How Federal Employees Can Convert Their TSP to a Roth IRA

Federal employees can’t directly convert their TSP into a Roth IRA. Instead, the conversion process requires a two-step approach: first, you would have to transfer your TSP funds to a traditional IRA.  Then. You would convert that IRA into a Roth IRA.  Remember that this is a taxable event, and the amount you convert will increase your taxable income for the year.

There are also some considerations that are unique to federal employees.

  • Vesting Requirements: If you’re a FERS employee, make sure you’ve fully vested in your TSP before converting. Typically, this takes three years of service.
  • Agency Contributions: Federal employees can contribute to the Roth TSP, but any automatic agency contributions go to your traditional TSP balance and cannot be converted to a Roth IRA.

You should take a systematic approach to Roth conversions

If you have a substantial retirement balance, a systematic Roth conversion plan may be ideal. Instead of converting your entire balance at once, you can spread conversions over several years. This approach helps minimize tax liability and keeps you in lower tax brackets. For federal employees, executing this strategy early in retirement—before RMDs kick in—can be especially beneficial.

However, caution is needed if you are close to receiving Medicare or Social Security, as conversions could affect your premiums and taxable benefits.

Consulting with a Professional

Converting to a Roth IRA is a complex decision with lasting consequences. Working with a tax advisor and financial planner is essential to create a conversion strategy tailored to your unique financial situation. They can help you weigh factors like current and future tax brackets, estate planning goals, and other sources of retirement income.

In conclusion, Roth IRA conversions can provide significant benefits for federal employees looking to diversify their retirement portfolios and manage future tax obligations. While the process requires careful planning, it may lead to more financial flexibility and potentially lower tax burdens in retirement.