Being in the United States Military has some perks. One of those is Combat Pay. If you are earning or have ever earned money while in a combat zone overseas, you will have received combat pay, otherwise known as Tax-exempt pay. Tax-exempt pay is a bit of a misnomer, however. This is because tax-exempt pay is not taxed at a federal income tax level but is subject to social security and Medicare taxes. These amounts are 6.2% for Social Security and 1.45% for Medicare, respectively. This is something to remember if you will earn this money in the future. Ensure that you are keeping a record of any paystubs received while earning this unique pay.
It is highly recommended to keep physical or digital records of your tax-exempt earnings. This is especially true if you defer that income towards your government Thrift Savings Plan, aka TSP. Even though you are not taxed on combat pay funds, you still may have the diligence to save for yourself in retirement by deferring these funds earned in a combat zone. This happens through your TSP account; the contributions can be seen on your combat pay stub for exact numbers. Keep these.
Contributions to TSP from Combat Pay - Regular or Roth?
So, we have combat pay in hand and want to contribute to our TSP—maybe all of it, perhaps some of it. So, what should we do with it?
Traditional funds vs Roth funds. Many have heard that Roth is better, but why? And does it make sense for everybody? First, let's start with the TSP annual limit. Like a 401(k), all Roth or Traditional contributions cannot total more than $23,000 in the year 2024 (subject to change in the future - likely to go up), or $30,500 if 50 and over.
For those without combat pay, a Roth makes sense for those individuals in low tax brackets because you contribute to a Roth with “after-tax” dollars. This means the government withholds a certain percentage of your regular pay that you choose, and they pay you your net income. From the net income, you would contribute an amount that you deem appropriate to the Roth. Because lower earners are taxed at more favorable rates, the money that will be contributed to the Roth portion of your TSP will be taxed at that lower rate. This gives a larger percentage of your money the best chance to grow in the future.
A traditional TSP contribution may make a lot of sense for non-combat pay earners who earn quite a bit, putting them in higher tax brackets. This means they can defer their potentially high tax percentage, like a 28 or 32% tax, to a later time when their income isn’t high, like retirement. It never makes sense for combat pay to go into traditional TSP accounts.
It makes the most sense to contribute combat pay to your Roth TSP. This is because regular non-combat pay Roth TSP contributions generally have federal taxes taken out first, and then contributed with the net amount. At the same time, combat pay has never had federal taxes taken out. This means you are getting tax-free income AND tax-free growth in this account.
One significant aspect of these tax-exempt combat funds is that they do not count toward the contribution limit. So, if you wanted all your combat pay in a given year to go toward retirement, you could make that happen. For example, let’s say you have a 6-month deployment to a combat zone. During those 6 months, you earn $40,000. However, the other 6 months you worked while back home off-base, you earned $70,000. This means you could contribute all $40,000 of tax-exempt combat pay to your TSP in this situation and still contribute to a separate 401(k) up to $23,000 with your other $70,000 of regular earned income.
Rolling TSP Funds Over
TSP can locate combat pay/ Tax-exempt funds. Typically, you would want to call TSP, especially with a financial representative like those at Whitaker Myers, to ask if they have a record of your tax-exempt funds. It’s important to realize that the tax-exempt combat pay, once contributed to your TSP, becomes part of the overall balance to which the tax-exempt pay was contributed, whether traditional IRA or Roth IRA rules.
When making a tax-free rollover to a traditional or Roth IRA held with your financial advisor, make sure your financial advisor is aware of any combat pay before having this call so that they can ensure there is a record being kept of all balances and all contributions made from the income tax-exempt combat source.
You and your financial advisor can call 1-877-968-3778 to speak with a TSP representative to see your current balances and to ensure any combat funds received in the future that are designated for TSP will go to Roth.
Our team can help you identify balances, contribution percentages, and anything else you may have questions about. Your advisor and TSP can also help you upon service and/or retirement separation.
If you have served, we thank you for your service. And if you have questions about your combat pay, feel free to reach out to one of our financial advisors to schedule an appointment to discuss today!