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The Thrift Savings Plan (TSP) offers a unique, low cost, tax advantaged, diversified, and automatic investment opportunity to US government employees and military personnel. Since I’m active duty Air Force, I’ll focus on the military side of the TSP.
TSP is similar to a civilian 401k. The IRS considers the TSP an “employee sponsored retirement plan.” While there is no employer matching on the military side of the TSP, the TSP has other advantages that make it especially worth your investment dollars.
Investing and harnessing the power of compounding interest is the surest and quickest way to achieve financial independence. By investing your military paycheck into the TSP, you put your dollars to work for you in the most efficient way possible.
TSP allows servicemembers to invest in special US Treasury bonds (G Fund), the US bond market (F Fund), international stock markets (I Fund), and the US stock market (C and S Funds). If you’d like to know more about these funds, check out this guide. With these 5 simple funds, you gain access to a whole world of investing and potentially huge gains.
How Much to Contribute to Your TSP
The most important step to investing in the TSP is determining how much of your income you should set aside to invest. If you want to achieve financial independence in the next 20 years, you’ll need a savings rate of 45-50% or more.
A great place to start is maxing out your Roth TSP. You can contribute $18,000 in 2016 ($53,000 if you're in a combat zone), which works out to $1500 per month. If that’s completely out of your league, start by contributing 25% of your after tax pay, or even just $100 per month. If you make investing an automatic priority using your myPay deductions, you won’t even miss the money.
How to Start a TSP Account
Here's an infographic on how to start your TSP account:
Low Cost Investing for the Military
By leveraging it’s massive purchasing power ($358 billion in assets under management) and it’s simple index fund tracking, TSP keeps it’s expense ratios low.
How low? Try 0.027%. For every $10,000 you have invested in the TSP, you will only pay $2.70 a year in management fees. The mutual fund industry average is around 1%, or $100 per $10,000 invested. Even Vanguard and Schwab ETFs, which offer the lowest cost funds publicly available, are still almost double (0.05%) of the TSP cost.
The cost difference between paying 0.027% and 1% becomes extreme given a long enough time. Over 25 years, if your investment returns 8% per year, but your expense ratio was 1% a year, you’ll lose 24% of the gains. Alternatively, if you are invested in a low cost fund like those offered by the TSP, you’ll keep 99.1% of your returns. That’s a massive difference.
Investment returns may be hard to achieve, but when you keep costs low, you’ll be sure that the returns you get stay with you and don’t go to your account manager. Control what you can (costs) and don’t worry about things you can’t (return).
One of the first lessons most people learn when their investing is “diversify, diversify, diversify!” If you have all of your money in a single asset (like Bitcoin, gold, or Enron stock), you’re asking to lose a lot or lose it all. When you spread your money between many assets, like 500 of the largest US companies (S&P 500), you capture all of the losses and gains of all of these companies. In the last 130 years, there have been a lot more gains than losses.
The TSP gives you built in diversification. For instance the C Fund is comprised of all of the S&P 500 companies. When you invest in the C Fund, you buy a small piece of each of the 500 largest companies in America. A little bit of their profits will be fed back to you in the form of dividends and if their share prices go up, your assets will appreciate.
If you were to buy a single share of each S&P 500 company, it would cost you $33,500 ($67 average share price * 500). Instead, you can invest as little as $10 into the C and S fund and gain exposure to every publicly traded company in the US. That’s awesome diversification at an extremely low cost!
Two Tax Flavors of TSP: Traditional and Roth
Military servicemembers can contribute to two different TSP accounts: Traditional or Roth. Any contribution to the TSP has tax advantages. The difference is when you are rewarded with those tax advantages.
For Traditional contributions, the contribution is not taxed when you deposit, but when you withdraw from the account in retirement, your withdrawals are taxed. Even if you contribute tax free income (such as from the Combat Zone Tax Exclusion), your contributions won’t be taxed but your earnings will be. Invested for 30-40 years, this could be a tremendous portion of your portfolio and cut into your retirement income. I do not recommend the Traditional TSP for most personnel.
For Roth TSP contributions, you pay taxes on your income now, but when you withdraw from the account in retirement, all distributions are tax free. Your earnings and contributions can all be withdrawn without paying a dime to Uncle Sam.
This is an awesome option for most servicemembers. Much of your compensation package is tax free (BAH, BAS) and regular pay is often not subject to federal income tax through the Combat Zone Tax Exclusion (CZTE).
Military personnel tax rates are often incredibly low even without CZTE and frequently not above the 10% or 15% bracket. If that’s true for you, I highly recommend exploring the Roth TSP option.
Personally I use the Roth TSP option and love it. My tax rate this year will probably be under 1% and all of the money we’ve managed to contribute to the Roth TSP will grow and eventually be withdrawn tax free forever. Now that’s a tax-advantaged investment!
Many servicemembers are still unclear if you can you contribute the max to your Roth TSP and your Roth IRA. The answer is…
The two investment accounts are treated completely separately by the IRS. You are cleared hot to invest $17,500 in the Roth TSP and $5500 in your Roth IRA in 2014. If you’re married, you can put $5500 into his/her account too! That’s $28,500 of tax free forever retirement investments.
Lifecycle Funds: Diversified Investing for the Lazy or Fearful (and that’s okay!)
The Lifecycle Funds are a great product if you don’t have the time, energy, desire, or knowledge to care about your investments. Lifecycle funds are a one size fits all solution and should only be used if you don’t want to take the time to choose your own asset allocation.
When you are decades from retirement, the Lifecycle fund start by investing more in riskier investments (C Fund, S Fund, I Fund) to achieve a higher return.
As you move closer to retirement, more of your assets are moved into low risk and zero risk funds (F and G Fund), to preserve your capital and limit the risk of loss.
Once you reach retirement, your assets are all rolled into the “L Income” fund, which is 74% invested in the G Fund, and 26% invested in the more risky funds. This nearly guarantees that you won’t see a more than 25% drop in the value of your retirement savings.
Personally I don’t use the Lifecycle Funds because I prefer to choose my own asset allocation and manage my risk/reward myself. Pick whatever you are most comfortable with, after doing the proper research.
How I’m Autopilot Investing in the TSP
The best way to grow your investments is by contributing every month. I have heard the arguments for and against dollar cost averaging and I’m convinced that investing as much as possible early as possible is the most optimal solution, but not the most realistic. Most people do not have $17,500 sitting around on January 1st of the year.
What they do have is a bi-monthly paycheck, every 1st and 15th. By setting up a Roth TSP contribution on myPay, you ensure that your money gets invested before it even hits your bank account. This is the best way to save and invest: take yourself out of the equation and make it easier to save the money than spend it.
When part of your paycheck is locked away in the TSP, growing and paying dividends, you are creating the conditions for your own financial independence.
This is how I invest in the TSP. Simply take what you can afford to invest (your goal should be the $17,500 max), divide by 12 months, and contribute that amount every month. If you want to max, it works out to $1458 per month, or $729 per paycheck.
You’ll be amazed at how quickly you can adjust to a smaller budget. If you can’t max your contributions now, increase your contributions every time you receive a time in service pay raise or a promotion. Maybe take only 20% of the pay raise for yourself and contribute the remaining 80% to your TSP. Your contributions will grow quickly towards the max.
Occasionally, you may check your account balances on Personal Capital and you’ll be amazed at how quickly automated monthly deposits add up. If you can max your TSP for 10 years, you’ll save $175,000 (assuming the contribution limit doesn’t go up). But if the market returns it’s long term average of around 8%, you’ll see your money grow to $275,000! That’s a free $100,000 in just 10 years. That’s the power of compounding interest.
My TSP Asset Allocation
My TSP asset allocation is based on the efficient frontier, a concept in modern portfolio theory. As a rule of thumb, I use 120-age to put into stocks and the remainder of the portfolio to put into bonds.
This rule of thumb keeps me risky young (100% stocks at age 20) and then slowly decreases my risk (but also reward) as I approach financial independence.
There are other rules of thumb, like your age in bonds, the rest in stocks, but I find that to be too risk adverse. By age 45 we’ll hit 75% stocks, 25% bonds, which I’ll plan on keeping as my permanent portfolio.
I’m a firm believer in simpler is better when it comes to investing. I use Personal Capital to keep track of my Roth IRA, my wife’s Roth IRA, and my Roth TSP to ensure that my asset allocation is where I want it across my entire portfolio.
Here’s my 2013 TSP allocation and contribution plan. Notice that as funds grow, they'll need to be reallocated at some point. I prefer to reallocate once per year or if the funds get more than 5% out of balance.
In terms of market capitalization the C fund is roughly 4 times larger than the S fund, so if you’re trying to accurately capture the entire US stock market (like Vanguard’s Total US Stock Market Fund VTI), make your C fund allocation 4x your S fund.
The Best 401k in the United States
The Thrift Savings Plan offers tremendous value and opportunity to every US servicemember. The TSP offers:
- The lowest management fees available anywhere
- Automatic diversification with low account minimums
- Easy asset allocation to match any bond/stock ratio you want
- Tax advantages and tax free investing for life in the Roth TSP
All of these factors make the TSP the best plan for achieving financial independence. With the Roth TSP option, servicemembers can realize tax free income for life, an incredibly powerful tool not available to anyone else in the world.
If you’re not investing in the TSP, you need to start today. If you already are investing, you need to work towards maxing your contribution. If you’re maxing, congratulations, have a beer on me! Let me know in the comments at what years of service and rank you started maxing out your TSP.