TSP In-Plan Roth Conversions Are Coming!

My fellow geezers should monitor their pacemakers while reading this one, but the Federal Retirement Thrift Investment Board, the thrillingly named entity that oversees the glacial pace of TSP updates, announced at its recent meeting that the TSP plans to begin to allow in-plan Roth Conversions in 2026. This is actually really big news, and I suspect it’ll affect a lot more than the 7 people who opted into the TSP mutual fund window.

Roth Conversion 101

To understand why in-plan Roth Conversions are the new hotness, we must understand why any Roth Conversion matters.  Recall that a Roth Conversion is the act of moving dollars from a Traditional/pre-tax account to a Roth/after-tax account, paying today’s tax rate, to avoid an expected higher future tax rate.  Pay a low rate today to skip a high rate tomorrow.  Roth Conversions often shave six or seven figures off a lifetime tax bill.

Most people don’t start Roth Conversions until they are either close to retirement or in retirement for several reasons:

• Roth Conversion is like AARP and Medicare… a topic blasted at the more finely aged among us.
• Voluntarily paying more tax today is no one’s idea of a good time.
• Excess cash is necessary to pay more tax today; many families don’t have that cash available.
• It’s a generally terrible idea to pay the taxes from the amount you’re converting unless you’re over 59.5. You’ll pay a 10% penalty on the tax since it’s an early withdrawal.

If you have Traditional/pre-tax dollars in your TSP, it’s worth mathing to see what kind of future tax bill they’re growing for you. Mind your pacemaker…  Far fewer people execute pre-retirement Roth Conversions than probably should.

Why In-Plan Roth Conversions Matter for TSP Participants

Most single-income military families are in the 22% federal tax bracket or lower. But when they “retire,” they’ll likely be in a higher tax bracket and may also pay state income taxes.

Retirement/separation from service is usually the first time a TSP participant can execute a Roth Conversion by moving some Traditional TSP dollars to their Roth IRA.  Until this change, tax-savvy TSP investors had to sit back and watch a latent tax bill grow with no agency to affect it.

Let’s look at some examples assuming a hypothetical 7% rate of return and continuation of current tax rates.

Lt Col Olds started TSP contributions as butter bar before Roth TSP contributions began in 2012…. He has $100K of Traditional dollars in his Roth TSP.  He’s in the 22% marginal bracket and claims a state with no income tax. He expects to retire in 2030 and quickly climb to the 32% bracket. His spouse will also go back to work and the family saves aggressively. Their projections show a minimum federal tax rate of 25% in their 60’s and beyond.

If Lt Col Olds Roth Converts $20K per year until military retirement, he’ll pay $4.4K per year for a total tax bill of $22K. If he converts the same $100K in the years after military retirement, he’ll pay $32K, which is a 45% higher tax.  If he waits until “real” retirement, he’ll pay $25K, 13% higher.

But we said there was a 7% return, right? For simplicity, let’s say that return all piles up in after military retirement. In that case, Lt Col Olds is converting $140,255, not $100K. You can imagine the tax bill is higher–$44.8K or 104% higher.  If Lt Col Olds waits 20 years to execute Roth Conversions, that same $100K is now $387K. Ouch.

If the $387K were in the Roth TSP or Roth IRA, the tax due upon withdrawal would be $0.

Captain Earhart commissioned in 2019, so she’s in the Blended Retirement System (BRS) and receives a 5% Traditional Match on her TSP contributions. She makes Roth contributions, but the Traditional Matching dollars are an un-taxed liability. She’s in the 12% bracket today but will almost certainly climb into brackets that are 2x-3x higher before she would normally be able to Roth Convert or withdraw those dollars.  If she can Roth Convert those Traditional Matching dollars at 12%, she drastically suppresses her lifetime tax bill.

Colonel (ret) Blalf contributed to Traditional TSP from 2002 to 2012, then Roth TSP from 2012 to 2020 when he retired. Even though he contributed fewer dollars in the early years, the effects of compounding create a TSP balance that’s about 69% Traditional and 31% Roth today. If Col (ret) Blalf hovers close to the top of the 24% bracket but expects to be trapped in the high block of 28%+ in his 60s and beyond, he could Roth Convert the amount that tops off the 24% bracket each year to shift the balance from Traditional to Roth over time slowly.

The ability to control what tax rate to pay on dollars in the TSP is a fantastic benefit and most military members will want to evaluate this each year if they have Traditional/pre-tax dollars hanging out in their TSP account.

Other Nerdy Details and Considerations

Right now, the ability to execute in-plan Roth Conversions is bumper-sticker deep as far as details go. In-plan Roth Conversions are a feature of many robust 401(k) plans, such as airline 401(k)s, so hopefully, the TSP won’t have many strictures on the process, but we are talking about the TSP. It’s also possible that 2026 is Plan A, and an unconscionably long time after that is Plan B.

In-plan Roth Conversions are also part of the uber-nerdy “Mega Backdoor Roth IRA” strategy. As of now, this is not really part of the upcoming plan for in-plan Roth Conversions in the TSP because the only people who can contribute more than the annual limit ($23.5K in 2025) are those deployed to a combat zone. So few people actually contribute over the annual limit that I’m beginning to think it’s an urban legend, but maybe you’re the one?

The most common TTP for Roth Conversions is to convert modest amounts each year while whittling away at the pre-tax balance. This can soften the blow of “paying more tax than you have to.” However, you could imagine that an oversized Roth Conversion during a low-tax deployment year could make a lot of sense for some steely-eyed killers.

Lifetime tax planning sometimes implies keeping a Traditional/pre-tax TSP, 401(k), or IRA balance as part of a “fill up the tax buckets” strategy. If this is part of your plan, you may not want to go full Leeroy Jenkins with in-plan Roth Conversions. However, a competing school of thought is that Roth Conversions are “tax insurance” in that you know you’ll never pay income tax on those dollars again, regardless of future tax rates.

A 2022 tax law change allows the government and companies to pay Roth matching dollars instead of Traditional. Not many companies do this yet, but if the government does, many younger military members might be able to skip a Traditional TSP balance entirely.

Executing Roth Conversions creates a “spike” of income that can drive the need for an estimated tax payment.  If you do a Roth Conversion in January but don’t settle up with Uncle Sam until April 15^th of the following year, you could have 15.5 months of late payment penalty and interest waiting for you.  It’s possible to increase tax withholdings to pay the Roth Conversion tax bill ratably throughout the year, but this requires careful planning.

Roth Conversions are independent of Roth IRA and Backdoor Roth IRA contributions.  You can Roth Convert as many dollars as you can afford each year regardless of the account type, e.g., TSP, 401(k), or IRA. This does not impact your ability to contribute the annual maximum to your Roth IRA or Backdoor Roth IRA.

Roth Conversions are a one-way door. If you get click-happy and Roth Convert $100K early in the year before realizing that you’ll be in a higher bracket than expected, you can’t reverse the conversion.

Roth Conversions imply some timing choices. One thought is that right after a market decline is a great time for Roth Conversion. If you had a $100K Traditional balance and the Roth Conversion tax bill was going to be $22K, but the market just dropped 30% because of new Smoot-Hawley policies, you could reap the silver lining of paying $15.4K to convert the $70K balance.  Assuming that the $70K eventually recovers, you spent 30% less in taxes. #winning.

All things being equal, most investors will execute Roth Conversions as late in the year as possible to enable the best estimate of taxable income for the year. This helps avoid inadvertently popping up into a higher tax bracket with “too much” Roth Conversion for the year.

We are in uncertain tax rate times. The current rate structure expires 31 December 2025, and rates are set to increase in 2026. “Hey TSP… how about getting this going for 2025?” The incoming administration and Congress have an incentive to keep the current rates in effect. However, the reason these tax rates are set to expire is that they were never paid for in the first place.  By 2026, they will have added trillions to our national debt.  Continuing unpaid-for tax rates implies more borrowing, which means our children and grandchildren will pay for our low taxes.

Even if the 2017 rates return in 2026, or rates trickle up a bit, it’s highly likely that many of us will still be in lower tax brackets in the near term than we will be during our “normal” Roth Conversion windows (e.g., 60’s and beyond). Thus, in-plan TSP Roth Conversions could still make sense.

Congress is likely to continue to enact tax laws that encourage Roth Conversions because they accelerate tax collection without raising taxes.  Clever little devils!  What if they spent all their time solving problems rather than grandstanding about culture-war nonsense?

Cleared to Rejoin

TSP in-plan Roth Conversions, like most TSP improvements, are long overdue but quite welcome. Roth Conversions help most of us suppress our lifetime tax bill and give us the choice of when to pay taxes and now it won’t be after a 20+ year military career.  Roth Conversions can even help with generational tax planning.  However, Roth Conversions require careful planning to avoid leaving an unplanned tip for the tax man, so “measure twice, convert once!”

Fight’s On!