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If you want to be financially independent someday, you have to save and invest. Saving 50% of your pay is an excellent place to start and a great starter goal. But where to invest these piles of money you're saving?
Your first investment priority should be your tax advantaged retirement accounts. If you are in the US military and don’t want to read the rest of this article, just do this:
$1458.33/month into your Roth TSP account
$458.33/month into your Roth IRA account (I like to have mine at Vanguard)
Now to explain why…
Types of Retirement Accounts
There are three common types of retirement accounts that you’ll encounter:
- 401k – an employer sponsored retirement account, called a 401k because of the section of the tax code that talks about this account. 401ks are usually offered to employees in lieu of pensions and are common in the private sector.
- IRA – Individual Retirement Account. Available to anyone who earns income in the US.
- TSP – Thrift Savings Plan, an employer sponsored retirement account, in this case only available to federal government employees and US military servicemembers. Similar to the 401k.
So for a US servicemember without a civilian job, you really only have two retirement accounts you can contribute to: the IRA and the TSP. Note that you can contribute to BOTH of these accounts and should do so to enable your financial freedom! The IRS treats employer sponsored accounts (TSP) completely separately from individual accounts (IRA).
The 2014 contribution limit for the IRA account is $5500. For the TSP, you are limited to $17,500 (or up to $51,000 if you're contributing pay earned in a tax-free combat zone). See above for how much you should contribute each month.
That means that you can sock away $23,000/year if you’re single or up to $46,000/year, if your spouse works as well. My spouse’s employer currently does not offer a 401k, so we’re eligible to put away $28,500/year (1 TSP + 2 Roth IRAs).
Deciding When to be Taxed – Now or Later
Now to further confuse you, these three retirement account types can have the word Traditional or Roth in front of them (Traditional TSP, Roth TSP, Traditional IRA, Roth IRA). The difference between the two is when you are taxed on your contributions and withdrawals.
- For the Traditional accounts, you pay no taxes today on your contributions, but do pay taxes when you withdraw the money (contributions and growth) after age 59 ½.
- For the Roth option, you pay taxes today, but when you withdraw from the account in retirement, you pay no taxes on the contributions or growth of your investments.
If you are in the military, you want the Roth option. Your tax rate is insanely low for your compensation. Most entitlements you receive (BAS, BAH, etc.) are allowances and not subject to income tax. Anytime you deploy you earn tax free pay and allowances as well under the Combat Zone Tax Exclusion.
Let’s say you went on a four month deployment this year. During those four months, all of your contributions to your Roth IRA and Roth TSP are untaxed.
That means the money goes in untaxed, the money grows untaxed, and then you can withdraw the money in retirement untaxed because it’s a Roth account. Tax free retirement investments for life! This is an extremely powerful opportunity uniquely available to US servicemembers.
Again, even if you don’t deploy, so much of your military pay is untaxed allowances that your total tax rate is often under 10%. The Roth TSP and Roth IRA make the most sense for the vast majority of military families, unless you have a high-income earning spouse or other sources of income.
Also, if you are making this contributions early in your career, from say age 20-40, your investments will have 20-40 years to grow tax-free in your retirement accounts. Because of compounding interest, the growth of your investments should eventually be more than your contributions. Once again, the Roth option makes the most sense.
Prioritizing Tax Advantaged Investments
Because of the yearly contribution limits, you should maximize your tax advantaged retirement investment accounts before saving into any other investments. Your time in the military is limited, and there will come a time when you won’t have such low-taxed income. By maximizing your Roth contributions while you serve, you can lock in tax free investment growth and distributions for life.
By using the powerful combination of the Roth TSP and Roth IRA, you can set yourself up for an early retirement or financially independence early in life. Investing every month while you are young will yield amazing results for you in your later years.