Military service members know their way around hardship and challenge. Combat tours, deployments, and frequent transfers are just a few of the difficulties they face frequently. Unfortunately, these on-the-job challenges don’t teach much about personal finance.
Over a third (34%) of military service members say they don’t pay their monthly bills on time, according to a 2019 study by the National Foundation for Credit Counseling. Even more troubling, that number shows the trend has grown worse, with the percentage more than doubling since 2014.
Most military members shouldn’t even consider serious investing until they get out of debt and develop a savings cushion. But those who’ve paid off their nonmortgage debt and built an adequate emergency fund are ready to start saving for retirement and even building passive income from investments.
Military pay can’t make you rich, but it does provide excellent saving and investing opportunities, including some unavailable to civilians. By understanding how to take advantage of them, you can secure your future and potentially even retire young.
Military Pension
The military pension system is the single most important financial resource available to service members with 20 years of service or more. Upon retirement, it provides an immediate annual income that corresponds to 50% of the member’s base salary at 20 years and further increases by 2.5% for every additional year of service.
Plus, the retiree receives an annual cost-of-living increase linked to the consumer price index (CPI). Along with an impressive pension, military retirees receive affordable lifetime medical coverage and other benefits, such as base access and exchange shopping privileges.
Despite these benefits, the pension doesn’t always generate as much income as military families would like. Fortunately for service members, their retirement benefits don’t stop there.
Thrift Savings Plan
The United States government’s Thrift Savings Plan (TSP) is a vastly underutilized investment resource. While the military enrolls all active-duty personnel automatically, too few members take full advantage of the perks for contributing.
The Department of Defense rolled out its new Blended Retirement System model in 2018, which combines the legacy military pension model with a 401(k)-like defined contribution model.
As a retirement investment account, the TSP offers a convenient, low-cost, and tax-sheltered option for military personnel. It lets them invest tax-deferred money in the stock market and other investment opportunities to take advantage of the magic of compounding.
Tax Benefits
Like 401(k) contributions, money invested in a TSP is not subject to federal income tax. That gives you an immediate return equal to your tax rate.
For example, if you typically pay 25% in income taxes and contribute $10,000 to your TSP account, you keep all $10,000 rather than losing $2,500 to taxes that year. That money then compounds and grows over the decades between now and your retirement.
That said, once you withdraw funds during retirement, members must pay income tax on the entire withdrawal.
However, members who contribute tax-exempt combat zone pay can withdraw these tax-free contributions in retirement without paying taxes on the withdrawals. That’s an impressive benefit not readily available elsewhere.
Members of the military can alternatively contribute to a Roth version of the TSP, which reverses the tax exemption. You pay taxes on the income now but pay nothing on withdrawals from the Roth TSP in retirement.
Contribution Limits
TSPs follow the same retirement savings contribution limits as 401(k) and 403(b) accounts.
In both tax years 2020 and 2021, service members under 50 can contribute up to $19,500. Those 50 and over can contribute an extra $6,500, for a total annual contribution of $25,000.
This scaled contribution limit enables employees rapidly nearing retirement age to stash more cash for the remainder of their working years.
Matching Contributions
Service members can also take advantage of generous matching contributions from the military.
Starting 60 days after enrollment, all military service members get an automatic contribution from the government of 1% of their paycheck. You get this even if you don’t contribute a cent to your TSP account.
On top of that, you can earn up to 4% more in matching contributions from Uncle Sam. On the first 3% of your paycheck you contribute, the military matches you dollar for dollar. On the following 2% you contribute, the military contributes 50 cents on the dollar.
Thus, if you contribute 4% of your paycheck, you also get a matching 3.5%. Contribute 5%, and you max out the additional matching contribution at 4%.
Combined with the automatic 1% contribution, that comes to a maximum of 5% annual contributions from the military.
Low Expenses
Other benefits to investing with the TSP are the rock-bottom expenses associated with the program. The expense ratio for the TSP is about as low as you can find anywhere, amounting to approximately 0.015%.
With an expense ratio this low, your contributions can compound at a faster rate than in a managed mutual fund, which can carry an expense ratio of 1.5% or higher.
Low expense ratios help members keep more of their hard-earned dollars invested rather than paying that money to expensive mutual fund managers. That proves especially valuable since the TSP also offers target-date funds designed to ramp down risk as you near retirement.
Ordinarily, these types of funds carry even higher expense ratios when purchased outside a TSP.
Investment Choices
The TSP offers different investment options, depending on your risk tolerance and the number of years until you retire. Participants can invest in one or multiple funds to further diversify across a range of investments.
- G Fund. The default investment fund for the TSP, the G Fund, consists of government securities that offer low volatility and conservative returns over time. If you don’t choose one of the other fund types, all contributions to your TSP default into the G Fund.
- F, C, S, and I Funds. The F, C, S, and I Funds are index funds that invest in bonds, large-cap stocks, small-cap stocks, and international companies, respectively. They strive to match the performance of different open-market index funds and are managed by BlackRock Mutual Funds.
- L Fund. A recent addition, the L Fund works like a target-date fund, allowing investors to choose a date closest to their expected retirement date. The fund then allocates assets according to the length of time you have until retirement and adjusts into more conservative investments as your retirement nears.
Withdrawal Rules
As with 401(k) accounts, you can withdraw contributions and earnings without penalty after age 59 1/2, with all withdrawals taxed as ordinary income. Early withdrawals before age 59 1/2 are subject to a 10% penalty in addition to regular income taxes.
If a member decides they don’t need retirement income until later, they can defer withdrawals until age 72. Or more accurately, April 1 of the year after they turn 72.
At that point, account holders must take required minimum distributions annually to draw down the account balance. Failing to take withdrawals after that point results in stiff IRS penalties.
TSP Loans
If you need money from your TSP while still employed by the military, you can take out a loan you must repay to your TSP account within one to 15 years, depending on the type of loan. Account holders can take advantage of two loan types: a general-purpose loan and a residential loan.
The former features a repayment period of one to five years, and you can use it for any purpose. The latter features a repayment period of up to 15 years, and you can only use it to purchase or construct a primary residence. Residential loans require documentation to prove the intended use.
Note that when you take out a loan, you not only have to pay interest, but you also experience opportunity cost. You give up any earnings the loaned amount would have otherwise accrued.
Plus, you get the pleasure of being double-taxed when you pay the interest on your loan from after-tax funds because you pay income taxes again when you withdraw them during retirement.
Roth IRA
Roth individual retirement accounts (Roth IRAs) offer several benefits to long-term investors seeking tax-free growth. For even more significant tax advantages, consider supplementing your TSP with a Roth IRA, depending on your long-term financial goals.
Tax Benefits
Unlike traditional TSP accounts or IRAs, the tax benefits of investing in a Roth account are not immediate. The TSP reduces your taxable income, which reduces your total tax burden on April 15.
But as attractive as reducing your taxable income seems, tax-free growth can be even more beneficial, depending on your current income tax bracket and where you think it might be in the future. Remember, your income taxes sometimes go up in retirement, not down.
The Roth IRA allows you to invest after-tax funds on which the growth will never be taxed — even upon withdrawal.
Contribution Limits
Federal law allows for an annual contribution of $6,000 to a Roth IRA ($7,000 for those 50 and older).
However, your ability to contribute phases out if you earn a higher income. At a modified adjusted gross income (MAGI) of $125,000 for single filers and $198,000 for married couples filing jointly, the ability to contribute begins phasing out. At $140,000 ($208,000 for those married filing jointly), you lose the ability to contribute at all.
While you must have earned income to contribute to a Roth IRA, one working spouse can contribute to a nonworking spouse’s Roth IRA, enabling a total married contribution of up to $12,000 a year ($14,000 for a married couple age 50 or older).
See the maximum 401(k) and Roth IRA contribution limits for more information.
Withdrawal Rules
Although Roth IRAs don’t offer an instant tax deduction, they do provide one important benefit: absolutely tax-free growth and tax-free distributions. You can receive tax-free distributions of earnings after you turn 59 1/2, and unlike the TSP, Roth IRA rules don’t require mandatory distributions after age 72.
The IRS taxes any earnings withdrawn before age 59 1/2 and imposes a 10% penalty. Note that penalties don’t apply when you withdraw contributions, however, because the IRS has already taxed these monies.
Fortunately, if you make any withdrawals from your Roth before age 59 1/2, the IRS considers them withdrawals of contributions until you’ve withdrawn everything you put into the account.
Only after that point — once you withdraw earnings — does the IRS tax and penalize you for early withdrawals.
Investment Choices
You can open a Roth IRA through almost any financial institution that sells securities and does investments. One of our favorites is M1 Finance. As such, your investment options are virtually endless.
Some investors choose to invest in passive index funds, while others prefer actively managed mutual funds or even individual stock picks within their Roth IRA.
Because you have a wide array of investment options, you can seek the ones that fit your age, risk tolerance, and style of investing while also allowing you to control costs.
Traditional IRA
Military members who like the idea of decreasing taxable income but seek more investment options than the TSP offers can open a traditional IRA in addition to a Thrift Savings Plan.
Like Roth IRAs, you can open a traditional IRA through nearly any brokerage and invest the money as you see fit.
Tax Benefits
Like the TSP, contributions to a traditional IRA are tax-deferred and reduce your taxable income. That can effectively increase the amount you’re able to contribute.
For example, a $5,000 contribution could only cost you $3,750 in income if you’d otherwise pay 25% in taxes on that money.
Contribution Limits
The same contribution limits apply to traditional IRAs as Roth IRAs. You can contribute up to $6,000 if you are under the age of 50, or $7,000 if you are age 50 or older.
You or your spouse must be working to contribute monies, and no matter your income, you can open and contribute to a traditional IRA. However, to get the full tax deduction, you must earn less than $66,000 per year if you’re single or less than $105,000 per year if you’re married.
Between $66,000 and $76,000 ($105,000 and $125,000 for married couples filing jointly), the deduction begins to phase out, and earners above those limits cannot deduct any contributions.
A word of caution if you consider investing in both a Roth and traditional IRA: Federal law prohibits contributing more than the limits discussed above to one or multiple IRAs.
That means you can’t contribute more than a combined $6,000 per year to both a Roth and traditional IRA (unless you are at least 50 years old, in which case you can contribute $7,000).
Withdrawal Rules
Unlike the Roth, you can’t withdraw any money before age 59 1/2 without incurring a 10% early withdrawal penalty plus regular income tax on the withdrawal. The IRS taxes and penalizes both contributions and earnings withdrawn early.
That makes the Roth IRA the wise option if you may need a portion of or all your contributions before retirement. Furthermore, you must begin taking required minimum distributions from a traditional IRA when you turn 72 or face stiff penalties.
Investment Choices
Like the Roth IRA, you can open a traditional IRA at most any financial institution that manages investments. That means your options for investing are as varied as your imagination.
You could, for example, invest in target-date funds, mutual funds, exchange-traded funds (ETFs), equities, bonds, or options. The investment world is your oyster, and you can choose the type of investment strategy and long-term methods that suit your personality and objectives best.
Pro tip: If you have an IRA or other retirement account, make sure you sign up for a free analysis from Blooom. After connecting your accounts, they will assess your asset allocation to make sure it fits with your risk tolerance. They will also make sure you’re properly diversified and aren’t paying too much in fees.
Taxable Brokerage Account
Why would anyone invest in a taxable brokerage account rather than a tax-sheltered account like a TSP or IRA?
In a word: flexibility.
First, flexibility in the timing of your withdrawals. You can’t withdraw money from your TSP or IRA before age 59 1/2 without incurring penalties from the IRS. But some people plan to retire long before that age. To do so, they need penalty-free access to their investments.
Second, your regular brokerage account lets you invest in whatever you like, unlike the TSP’s rigid few investment options.
Finally, tax-sheltered accounts come with contribution limits. But with a taxable brokerage account, you can invest however much you want.
Real Estate
Paper assets make up only a portion of a healthy asset allocation. It’s also worth exploring real estate as an additional asset class.
Real estate simply comes with too many advantages to ignore, including inherent tax benefits, protection against inflation, ongoing passive income, and the ability to leverage other people’s money.
Direct Real Estate Investment
One option is buying a property directly.
You could buy a primary residence and convert it into a rental property after your next PCS transfer. Or you could simply buy a rental property from the get-go through Roofstock.
But first, look into whether buying or renting is right for you since there are special considerations for service members.
If you don’t like the buy-and-hold strategy, you can also explore flipping houses. Although given the labor involved — even if you hire out the renovations — it feels more like a side hustle than an investment.
REITs
Real estate investment trusts, or REITs, come in several varieties.
You can buy publicly traded REITs using your taxable brokerage account or IRA just like you would a stock or ETF. They fall under heavy SEC regulation and must pay out 90% of their profits each year in the form of dividends. In general, that means they offer high dividend yield but low growth potential.
You must buy private REITs directly from the source. For both better and worse, they don’t fall under the same SEC regulation, which means investors don’t benefit from quite the same transparency and oversight.
But it also leaves the fund’s managers far more flexibility to grow the fund’s assets aggressively. I’ve had success with several private REITs, including Fundrise and Streitwise.
REITs also vary based on how they invest in real estate. Equity REITs directly own properties, while mortgage REITs lend money against real estate.
Finally, different REITs invest in different types of real estate. Some invest in residential properties, others in commercial, while still others specialize in industrial properties or even raw land.
Other Indirect Real Estate Investments
Let’s face it. Landlords have a ton of headaches most people simply don’t want. But REITs aren’t the only way to invest in real estate without actually holding a title.
Explore other indirect ways to invest in real estate, including private notes, real estate crowdfunding websites like Groundfloor, private equity funds, and real estate syndications. Just bear in mind that some, such as most real estate syndications and private equity funds, only allow accredited investors to participate.
Through your IRA or brokerage account, you can also invest in ETFs related to real estate. Examples include homebuilder ETFs, hotel ETFs, and other specialty ETFs either related to the housing industry or necessitating broad real estate holdings.
College Savings Accounts
If you have children, you may also want to save and invest money for their college education. Fortunately, you have several tax-sheltered options to do so.
529 College Savings Plans
These college funding plans are operated on the state level, not federally, so they vary widely by state. In general, however, 529 college savings plans come in two varieties: savings and investment accounts and prepaid tuition.
The former typically work similarly to a Roth IRA. You pay taxes on contributions, but you can withdraw them tax-free. That said, some states do let you deduct contributions from your state tax return up to a limit.
Your contributions grow tax-free, but you must use the withdrawals to pay for a very short list of approved education expenses, such as tuition, room and board, and textbooks.
Sadly, the investment options vary by state as well. Some offer a relatively diverse set of investments you can choose from, while others keep it bare bones.
Prepaid tuition works differently. As the name suggests, you pay in advance for your child’s tuition, long before they graduate high school. That locks in a lower price, but it also locks your child into attending a state-funded school in that specific state.
States allow exceptions, but as a general rule, if your child attends school in another state, you have to pay any difference in tuition costs.
As a final note, you set a beneficiary when you open the account. You can, however, change that beneficiary at any time — if your studious eldest child gets a full-ride scholarship, you can transfer their funds to a younger child.
Coverdell ESAs
Coverdell education savings accounts (ESAs) operate at the federal level, which makes them uniform and easier to use. But they also come with their own restrictions.
You can open them through your regular brokerage firm, like an IRA or Roth IRA. You then get to invest in whatever you like rather than choosing among a short list of preselected investments.
Another perk comes in an ESA’s flexibility. You can use the funds for more expenses than 529 plans allow, including equipment like laptops and services like Internet access. You can also withdraw the money for primary or secondary education costs, not just college education.
And, of course, you can use the funds anywhere in the country, rather than a single state’s public university system.
However, the contribution is low at only $2,000 per year, per student. The ability to contribute also phases out for higher earners, similarly to Roth IRAs.
ESAs also come with an age limit not found among 529 plans. The beneficiary must use the money before age 30, or you pay a penalty on withdrawals.
Final Word
The federal Thrift Savings Plan remains the first stop for military members aiming to invest for retirement efficiently. Its low-cost fee structure allows you to save a fortune in management fees and expenses compared to most investments available to civilians.
But service members who want to diversify their retirement portfolio further can also open a Roth or traditional IRA. You can invest individually or in a combination of all these vehicles. All serve as a source of wealth and security in your later years and are work to supplement your military pension.
Beyond tax-sheltered retirement accounts, service members can explore other investment vehicles, including taxable brokerage accounts, real estate investments, and college savings accounts. Which accounts you use ultimately depends on your long-term goals, your tax bracket, your thoughts on future taxes, how much flexibility you want to choose investments, and how much you can contribute.
Regardless of the vehicle, maximize your savings rate to build wealth faster and put yourself in a far better financial position tomorrow than today.
