Reader Question: Traditional TSP Contributions While Under a Combat Zone Tax Exclusion

Wisdom is not a product of schooling but of the lifelong attempt to acquire it.
–Albert Einstein

A reader (who’s an Air Force Academy grad, nonetheless…this shows how nice I am!) wrote me recently to ask the following question:

You were recommended on the military guide and I was just wondering if I could get a CFP answer as to whether traditional TSP contributions while under a combat tax zone exclusion will make your income negative for those months, or if the IRS already knows that money was not taxed and so does not deduct it against your overall income.

Ah, the joys of the Combat Zone Tax Exclusion. I received that for about 15 months (I don’t remember if I got the month’s credit for being there for a day or two in a month on either end of my deployments) while I was deployed to Bosnia.

Back when I was in the Army, we didn’t have the Thrift Savings Plan. We had former company commanders and sergeants major sharing their chart porn from a certain, unnamed “financial service” company that sold high commission front loaded mutual funds and the wrong types of life insurance. This company is not USAA, whom I have a high regard for.

So, this is a situation that would have never occurred for me back when I was in the Army. However, I think that the Thrift Savings Plan is a great way to save for retirement, so this reader is definitely heading in the right direction (even if he made a poor choice for a military academy!).

First off, let’s answer a few questions that this inquiry might bring up for you:

  • What is a Thrift Savings Plan (TSP)? The Thrift Savings Plan is a defined contribution retirement plan for members of the uniformed services, United States civil service employees, and retirees. It’s like a 401(k), 403(b), or 457 plan, but it has better (in my opinion) investmetn alternatives due to the exceptionally low expense ratios of the funds.
  • How much can I contribute to my TSP in 2020? If you are under 50 years old, the maximum that you can contribute to a TSP is $19,500. If you are 50 years old or older, you can contribute an additional $6,500, meaning that the maximum amount you can contribute is $26,000. Your employer can also contribute to your TSP, and the maximum amount that your employer can contribute is $57,000.
  • What are my investment options within a TSP? The Thrift Savings Plan offers six families of funds to invest in. They are:
    • Lifecycle Funds, with target retirement dates of 2020, 2030, 2040, and 2050, as well as an income fund for those members who are already retired
    • G Fund: investments in government securities
    • F Fund: investments in fixed income securities, aiming to match the Barclay’s U.S. Aggregate Bond Index
    • C Fund: investments in common stock to match the S&P 500 index
    • S Fund: investments in small cap stocks to match the Dow Jones U.S. Completion Total Stock Market Index – companies not in the S&P 500 index
    • I Fund: investments in international stocks to match the MSCI EAFE (Europe, Asia, Far East) index
  • What is the combat zone tax exclusion? This is for service members who serve in an active combat zone for any time during a month. Your W-2 will show your take-home pay, but it doesn’t show as taxable income.

So, in this case, if you’re contributing to a traditional TSP, being in a CZTE situation (if you’re there all year), may throw a spanner into the works.

According to the IRS, your ability to contribute is based on a deferral of taxable basic pay (emphasis mine). See their exact wording:

Applies to combined total of traditional and Roth contributions. For members of the uniformed services, it includes all traditional and Roth contributions from taxable basic pay, incentive pay, special pay, and bonus pay, but does not apply to traditional contributions made from tax-exempt pay earned in a combat zone.

But, if you go a little further, there’s an opportunity to take advantage of a Roth TSP:

If you are a member of the uniformed services, you should know that Roth contributions are subject to the elective deferral limit ($19,500 for 2020) even if they are contributed from tax-exempt pay. If you want to contribute tax-exempt pay toward the annual additions limit, you will have to elect traditional contributions for any amount over the elective deferral limit.

In addition, if you are eligible to make catch-up contributions and you are deployed to a designated combat zone, you will not be able to make any traditional catch-up contributions from your tax-exempt pay. However, Roth catch-up contributions from tax-exempt pay are allowed.

Therefore, if you’re in or going to a combat zone, switch to a Roth TSP for your contributions that year.

C.L. Sheldon & Company does a much better job of explaining your combat zone TSP contribution playbook than I can!

Also, check out The Military Guide’s article about maximizing your TSP contributions while in a combat zone.

To answer the question, though, it’s impossible to have negative income for the IRS. Monthly income isn’t factored in. It’s annual income. But, if you had zero income because you were in a CZTE area the entire year, you may wind up with a negative adjusted gross income (AGI), and any tax that you paid would be refunded.

However, to avoid that situation, if at all possible, attempt to harvest capital gains (may be hard to do in a COVID-19 economic environment) so that you have enough income to get to the top of the 0% tax bracket, which is $9,875 if you are single and $19,750 if you are married, filing jointly. Also, keep in mind that TSP contributions are eligible for the saver’s credit and that changes in your AGI may have you encounter the saver’s credit cliff.

I also recommend that you send a secure message to the TSP to make sure that you get the answers that you need.

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Jason Hull, CFP®, was the co-founder of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies. He also was the co-founder of open source search consultancy OpenSource Connections, a premier Solr and ElasticSearch firm. He and his wife FIREd (financial independence retire early) at 46 and 45, respectively. He has a BS from the United States Military Academy at West Point and a MBA from the University of Virginia Darden Graduate School of Business. You can read more about him in the About Page. If you live in Johnson County, Texas or the surrounding areas, he and his wife are cash buyers of Johnson County, Texas houses.

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