A reader writes:

Nords, I’ve been tracking you across a few blogs and appreciate the military perspective. I just bought your book as well so I am looking forward to flipping through that. Anyway I am trying to set mine and my wife’s savings to combine the 40% you mention here with the pension for a cushy retirement. Do you have any advice on how to allocate savings across accounts? My numbers give me a higher average standard of living if I contribute about 30% to taxable accounts and 10% to the Thrift Savings Plan, which goes against all advice to max out retirement accounts. As you are currently living in the gap between retirement and TSP withdrawal, do you wish you had allocated one way or another?

Before we talk about accounts, here’s a minor emphasis on one point: if you maintain a 40% savings rate for 20 years then you’ll reach financial independence without the pension. The advantage of the high savings rate is that you don’t have to count on gutting it out to 20 for the pension. If you’re no longer challenged and fulfilled by active duty, you can choose to leave for the Reserves. It’s far better than grimly hanging on for 20 years (and sitting on a slightly larger pile of money) while risking your health and burning out.

I’m not sure where your numbers are coming from, and feel free to share them here or e-mail them to me. Frequently this difference arises when the taxable portfolio has a substantially different risk/return asset allocation from the TSP. Your first check on your analysis would be to make sure that those high-return taxable accounts are using benchmarks identical to the C, S, and I funds. Your second check would be that the fund performance is assessed over as long a period as possible (at least the lifetime of the fund). Too many fund companies will cherrypick the dates for their performance claims.

The reason I suggest this is because a passive equity index fund with low expenses will almost always outperform the vast majority of actively-managed funds (and their higher expenses) over a decade. There are a handful of exceptions to this generalization (like Berkshire Hathaway), but even then you’d have to be able to pick out those exceptions from over thousands of funds.

Here’s a link comparing the TSP’s funds to their equivalent Vanguard & Fidelity funds. Check their long-term performance against the TSP, and decide which you’d rather invest in.

From the tax perspective, the Roth TSP and Roth IRAs generally win again because military compensation is very lightly taxed. (Allowances aren’t taxed at all.) With income-tax deductions and tax credits, it’s possible for junior military families to pay almost no taxes. You’ll save more money during your investing life if you pay taxes now and invest in the Roth TSP and Roth IRAs before investing in taxable account. The same logic applies to a civilian employer’s Roth 401(k), especially when you maximize the employer’s contributions to those retirement accounts.

When you’re just starting out on active duty, especially with dual incomes and a high savings rate, you can invest in a high-equity portfolio. The TSP’s L2050 fund or any combination of the C, S, and I funds will do just fine.

Admittedly in the junior ranks it’s tough to max out the Roth TSP plus two Roth IRAs. However, you have to make the most of the Roth TSP (and the Roth IRA) contributions every year before that year’s opportunity is lost forever. When you promote to the next rank (and have a big pay raise) yet continue to live on your lower expenses, then you’ll be able to max out those contributions much more easily.

When my spouse and I were contributing to our TSPs, we contributed the maximum amount and invested in the S and I funds.  (Small-caps and international funds generally have higher expense ratios than other funds, so we used the TSP for those assets and put the rest of our asset allocation in our Roth IRAs and taxable accounts.)  I wish we could have contributed even more to the TSP:  for the last decade our taxable accounts have been >90% invested in equities at an average expense ratio of about 0.25%/year, at least 8x the TSP’s expense ratio. In the 1980s-90s (before the military could invest in the TSP) it was even worse: we paid fund expenses of 1%-2% in our taxable accounts. Yet even at those high expenses we still saved enough to reach financial independence.  Despite two recessions over my 14 years of retirement, today that’s grown to “way more than enough”.  Life is definitely cushy.

If your spouse’s income includes a 401(k) then you should try to contribute enough to least maximize the employer’s match. 401(k)s have higher expenses than the TSP, but the employer’s match will probably overcome even a higher expense ratio.

Click on the image for a larger view.

So the priority for your 40% savings rate is TSP, 401(k) to the match, Roth IRAs, perhaps the rest of the 401(k) to the limit, and then even more in taxable accounts. Your asset allocation can be high in equities using passive index funds with low expense ratios.

When the military’s new blended retirement system starts in 2018, newer servicemembers might benefit from converting to it. In that case, you’d absolutely want to maximize your contributions to your Roth TSP account to obtain all of the DoD match.

You’ve asked a great question.  Keep reading and learning all you can about investing. Your asset allocation (and your entire investing plan) also has to help you sleep comfortably at night despite stock-market volatility. The best way to do that is to read about investing and the markets so that you can confidently stick to your plan when the media is screaming about selling everything.

Continue that learning by checking the “Related articles” section below to learn more about your TSP and Roth IRA options while you’re in uniform and afterward.

Related articles:
How Many Years Does It Take To Become Financially Independent?
Financial Advice To Start Your Military Career
Tailor Your Investments To Your Military Pay And Your Pension
Saving base pay and promotion raises
REVEALED: Our Asset Allocation During Financial Independence
Should You Choose The Military’s Blended Retirement System?
How (And Why) To Transfer Your TSP To An IRA
Early Withdrawals From Your TSP and IRA After The Military
TSP Tax-exempt Rollovers and Withdrawals