New to Government Employment (or new to FI)? Consider Taking these 3 Steps
Whether you are just starting out in your career or are well-seasoned, you may be missing out on some key perks, including tax optimization. I’m amazed every day at the number of Government employees I run into that fill out their initial paperwork, get to work, and never make any future adjustments – even employees that have been with the Government for 10, 15, 30 years! When is the last time you checked your retirement contributions, asset allocation, and tax withholding? Not paying attention to these types of things may be costing you hundreds if not thousands of dollars each year!
When Government workers first approach me about finances, I always ask them about three key items first – TSP contributions, TSP allocation, and tax filing status/exemptions. If you are looking to reach Financial Independence, or simply want to improve your financial position in a massive way with very little effort, the following steps could prove quite beneficial.
1.) Contribute enough to your TSP to get the Government match (at a minimum)
If you are a Federal Employee, the Thrift Savings Plan (TSP) is one of the three legs that will make up your Government retirement income. The TSP is essentially the Government’s version of a 401k. Like many employers that offer 401ks, the Government will match your TSP contributions up to a certain percentage. For Federal Employees under FERS (or Military under BRS), the match is a generous 5%. If you aren’t matching the 5%, you are figuratively leaving money on the table… FREE MONEY! Who doesn’t like free money!? The below chart shows the breakdown of how matching works.
Some of you may be saying you can’t afford to contribute 5% of your pay. To that I say, you can’t afford NOT to contribute 5%! Why? Let’s say your base pay is $40,000. At 5% you contribute $2,000 per year to your TSP and the Government matches you with an additional $2,000 – essentially boosting your base pay from $40,000 to $42,000. Again, FREE MONEY. By contributing $2,000 per year, you are only “sacrificing” $38.50 per week ($2,000/52 = $38.46). That’s the equivalent of eating out one less dinner or a couple fewer lunches or drinks out each week. Are you telling me you wouldn’t forego a few meals out (or happy hours, fancy coffees, etc.) for an extra $2,000 per year? What if your salary is $60,000? That’s an extra $3,000 you’re missing out on! And so on, and so forth, depending on your salary (which tends to increase over time and – by virtue – increases the amount of free money you can gain).
Oh, and I didn’t even factor in that there is a huge tax savings that goes along with that free money (meaning even more free money). Because TSP accounts are tax advantaged (i.e. tax differed), you save even more money! I’ll be doing a more in depth post about tax advantages of Traditional and Roth TSPs in the near future.
Ultimately your goal should be to max out your TSP every year. The maximum you can contribute to a TSP account is $19,000 for 2019 (assuming you’re under age 50). So if you make $60,000 per year and max your TSP at $19,000, you’ll end up with total contributions for the year of $22,000 ($60,000 x 5% = $3,000 + $19,000 = $22,000). Why is the ultimate goal to max out your TSP? Because by maxing out your TSP, you are getting the maximum matching (free money) while simultaneously investing in the most tax efficient manner as it pertains to your Government retirement benefits (more free money). It’s a win-win!
2.) Adjust your TSP allocation to maximize returns (based on your risk tolerance)
Currently, for new TSP members (enrolled on or after September 5, 2015) the default initial allocation is deposited into the Lifecycle (L) Fund “most appropriate for your age” – meaning the L Fund that aligns most closely to your projected retirement date (or the year you turn 57 for anyone born in 1970 or after). This is also known as the Minimum Retirement Age (MRA) which determines when you are eligible to retire.
To give an example, if you recently began Federal Employment at the age of 23, your default allocation would be entirely in the “L 2050” fund. Why is that you may say? Because the L 2050 fund is designed for TSP participants who plan to retire in 2045 or later. The TSP assumes that participants will work until their MRA. If you are 23 years old, you will reach your MRA (age 57) in 2053. As of the date of this writing, the L 2050 fund is the newest Lifecycle fund and is the most “aggressive” of the target date funds as it begins with the heaviest weight of equities (i.e. stocks) and lowest weight of securities (i.e. bonds). I personally allocate 100% of my distributions to the L 2050 fund for a few reasons but mostly because I like the diversity and hands-off reallocation. That being said, it is likely that I will reallocate my distributions to the L 2060 fund when it becomes available – in order to align with my relatively high risk tolerance and desired long-term returns. More about what exactly the Lifecycle funds are and how they work can be found on the TSP website.
Adjusting allocation is perhaps even more important if you began your Government career prior to September 5, 2015. If you fall in this bucket (which is a lot of current employees), then 100% of your contribution was automatically contributed to the Government Securities Investment, or G Fund when you came on board and is still invested in the fund – unless you have changed it. Why is this a problem? Because the G Fund is made up entirely of Government Bonds which (while extremely low risk) offer very, very low returns – especially not the type of return you will likely be seeking if you intend to build wealth quickly and efficiently or plan to retire early. A 100% bond allocation does little more than keep up with inflation. You’ll need to diversify and add a heavy dose of equities if you want to take advantage of market gains for years to come. If you are just starting out, I suggest moving your funds into a Target Date fund that corresponds with a more traditional retirement age (i.e. one of the L Funds). If you are more savvy or have a higher/lower risk tolerance, go ahead and adjust your allocation manually as you see fit. You likely aren’t going to be tapping into these funds for many years to come, so sage wisdom is to have a higher exposure to equities to maximize market gains. If you can’t stomach the volatility that comes along with a stock heavy portfolio, then do what you are comfortable with while understanding how it may impact your returns.
If you have a high risk tolerance or want to maintain a consistently aggressive approach (like many advocate for when pursuing FI/FIRE), you may want to avoid the L Funds and instead contribute heavily to the C, S, and/or I Funds. However, if you are extremely risk adverse, then maybe having a moderate portion of your portfolio in the G Fund is the right approach. For more Pros and Cons of each of the funds and some recommended TSP strategies, read this post from RichOnMoney. At the end of the day, it’s up to you to decide what allocation best fits your risk tolerance and investment strategy. Remember, higher risk means higher returns, but also higher volatility.
3.) Adjust your tax withholdings for both Federal and State taxes to optimize tax efficiency
I don’t mind paying my taxes; after all, tax dollars are what fund my paycheck (and likely yours if you are reading this). But I also don’t want to pay more taxes than necessary, and I like to keep as many pre-tax dollars at my disposal as possible in order to invest and grow wealth. If you just started or are relatively new to Government (or any employment for that matter), you recently filled out Federal and State tax forms. These forms can be somewhat confusing, and I won’t get into them line by line, but the number of tax exemptions you claim will have an impact on the amount of money you receive in each paycheck. The more exemptions, the more money you’ll see in your bank account. A lot of folks recommend that you claim zero exemptions, or claim a lower number of exemptions that you are eligible for so that you don’t end up paying too little in taxes and, as a result, wind up owing money to the Internal Revenue Service (IRS) at the end of the year. To that advice, I say… Not so fast. Hear me out, if you are on the journey to FI, then you are likely saving (or starting to save) and investing a pretty decent chunk of money relative to your income, right? If that’s the case, you’ll have money to pay the tax man when the taxes come due. Why pay more in taxes than necessary when you could take those dollars and put them to use by investing them in the market or a high yielding savings account? If you set aside those dollars that would have gone to the IRS, you are able to gain a full year of gains on that money that you would otherwise miss out on. Again, everyone has a different tax situation, so do what makes the most sense for you.
So there you have it! These are the three things I recommend doing first if you are just starting out in government service (or if you haven’t adjusted these 3 things in a while) in order to help you on the road to FI. As Betty and I continue to publish content, we’ll be adjusting some of the early articles to add in links to other articles and resources that expand upon some of the topics covered in the early posts. In the meantime, feel free to drop us a line at email@example.com. Stay tuned, and thanks for reading!