BRS Breakdown, Part 2: Mega Backdoor Roth Conversion for the Military

If you're serving in the military and joined in 2018 or later, you're covered by the Blended Retirement System (BRS); some who joined sooner may have opted-in. That means at least 3 of every 4 Americans in uniform today are covered by the BRS. Yet there isn't a lot of good strategy and advice out there yet, because the 25% of the military who are in the Legacy High-3 system are also the senior leaders who are supposed to train and mentor the next generations. If they have no experience handling Service-Matching Contributions, Continuation Pay, or Lump Sum Payments, they can hardly be expected to offer you decent help.

That can be a problem, because in the Legacy system you could go 20 years in uniform without making a single choice. Not so with the BRS. In fact, with the BRS you need to personally manage it every year -- and if you don't, you can easily miss out on benefits or fall into some serious tax traps. You need a strategy that takes advantage of very specific tax rules and loopholes, some that are only open while you're in uniform. If you do, you can save tens or hundreds of thousands of dollars over a 20-year career.

The key is understanding the tax traps of the BRS:

1. Your service-matching contributions (5%) are ALWAYS deposited into your Traditional TSP, which means you have to pay Federal Income Tax when you take that money out after age 59 1/2
2. You will also be taxed on the gains on those matching funds, and that tax will be at the ordinary income tax rates of 10%, 12%, 22%, 24%, 32%, or higher, instead of lower capital gains rates
3. Over the course of a 20-year career the value of the Service-Matching funds could be:
   1. Enlisted. $47,751 based on 2024 Base Pay Rates, and over $142,000 after 20 years if you invest those funds in the TSP C Fund for your entire career
   2. Officer. $88,734, and over $205,000 after 20 years if invested in the TSP C Fund
4. If you leave the funds in your Traditional TSP for another 18 years until you retire and start withdrawing funds at age 59 1/2, those account balances could be $576,000 to $861,000 or more!

Imagine being a multimillionaire in retirement thanks to your BRS benefits, but finding out that you may owe the IRS $150,000, and potentially much, much more, because such a huge chunk of your savings were in a taxable Traditional TSP? Big yikes! Fortunately, if you have a plan while you're in uniform and earning these matching funds, you can avoid this massive tax headache for Future You: it's a special technique that is totally legal and allowed by the IRS called the "Mega Backdoor Roth Conversion".

In this post we'll explain how you can "convert" all those Traditional TSP dollars into a Roth Individual Retirement Account (IRA) where your retirement savings can grow 100% tax-free. And here’s the kicker: it works best when you're deployed to or stationed in a Combat Zone Tax Exclusion (CZTE) location where you may be able to legally avoid paying tax on the conversion altogether!

 What is the Mega Backdoor Roth Conversion?

At its core, the Mega Backdoor Roth Conversion is a strategy that allows you to convert pre-tax money from your Traditional TSP into a Roth IRA, allowing the money to grow tax-free for the rest of your life. Normally, converting from a Traditional to a Roth account would trigger a tax event and you would have to pay income tax on the amount you convert. It does feel a bit slimy that the BRS bonus matching of 5% could end up more like just 4% after the IRS takes its share . . .

But when you make that conversion early, possibly each year during the last week of December, at least you are only paying tax on the matching funds deposited into your account -- NOT on the investment gains that will also be taxable later if you leave the money sitting there. If you were to simply convert the $2,000-6,000 in matching funds you get each year from the BRS while you are in a 12% tax bracket, this will cost you $240-720 a year in Federal Income Tax. Over 20 years, you may pay $10,000 in tax to do your annual Mega Backdoor Roth Conversion. Compare that to waiting until you have $142,000 at separation and trying to convert that while you are in the 24% tax bracket, which could cost you $34,000!

The key is to do the conversion early and often before either the amount of investment gains or the total balance gets too high. But in the military, this strategy can be transformed into what you might call the Ultra Mega Backdoor Roth Conversion, because if you do it in a combat zone you can do it for free . . . 

Why Is This Strategy So Powerful for Service Members?

While not every overseas assignment is to a combat zone, many are to places that are covered by the Combat Zone Tax Exclusion (CZTE). For any month in which you spend at least one day in a CZTE location, your income for the entire month is tax-free! This will dramatically reduce your income taxes owed on your Base Pay, while also opening windows of opportunity to do your Roth Conversion. Now, you can't do the conversion in the one month of the year that you are in a CZTE and think the IRS will let you get away with it. In that case the tax saved on the excluded income will cancel out the tax paid on the conversion, so it's basically a breakeven situation for you.

But if you're in a qualifying location for at least part of all 12 months, it's a different story. Now 100% of your Base Pay is tax-free, which means you can use your Standard Deduction to cancel out the converted Traditional TSP funds. In 2024, a single tax filer has a $14,600 Standard Deduction and someone who is "married, filing jointly" has a $29,200 Standard Deduction. If your Base Pay is tax-free, you can convert up to that dollar amount from your Traditional TSP and not owe any tax.

What if you don't have that much in your Traditional TSP from matching contributions? In that case, make sure you are making your own Traditional -- not Roth -- TSP contributions in the years prior to your overseas assignment. You can essentially pull off a "triple tax hack" in the military:

1. Make Traditional TSP contributions yourself while Stateside, taking tax deductions each year and saving generally $240-720 each year you are not deployed.
2. Complete Mega Backdoor Roth Conversions while deployed, converting that Traditional money that was deducted and saved you taxes in previous years without owing any tax when converted.
3. Make Roth TSP contributions while deployed, because that income isn't taxable you don't pay tax up-front -- and you won't have to worry later about paying taxes because it's in your Roth TSP

This "triple hack" has the potential for those service members who are regularly assigned or deployed to qualifying CZTE locations to not just pay zero tax on 100% of their retirement savings, but to actually get higher tax refunds on their TSP contributions. It wouldn't be a stretch to say the IRS is actually paying you to save for retirement! At the very least, it will save you tens of thousands in taxes in your lifetime, and will be able to shield 100% of your retirement savings from taxation in Roth accounts.

Step-by-Step: How to Execute a Mega Backdoor Roth Conversion

Now, let’s walk through exactly how to pull this off.

Step 1: Contribute to Your Traditional TSP

• Start by contributing to your Traditional TSP (rather than Roth) during years when you’re not deployed. The reason for this is simple: Traditional TSP contributions are tax-deductible, meaning you reduce your taxable income in those years.
• If pre-contribution/pre-deduction you are in the 14% tax bracket, contributing $10,000 to your Traditional TSP can save you $1,400 in Federal Income Tax every year.

Step 2: Open a Roth IRA

• Since TSP doesn’t allow in-plan conversions, you’ll need to open a Roth IRA with a financial institution that can accept these transfers.
• Be careful to not open, or at least make contributions to, a Traditional IRA as that can disqualify you from doing the Roth Conversion.

Step 3: Deploy to a CZTE Location

• This strategy is most powerful when you're deployed to a CZTE area, where your income is tax-free. During this deployment, convert your Traditional TSP funds to a Roth IRA.
• Coordinate with your unit and detailer/monitor/career planner to request Individual Augment (IA) deployments, or overseas assignments to CZTE areas. (This is best done while you're single!)

If you can't get to a CZTE, be sure to make conversions early and often. The IRS taxes investment returns in your Traditional TSP as "ordinary income", not as capital gains, so the longer you wait, the more you will owe. Also, the more senior you are the closer they keep you to the "flagpole", meaning those adventurous deployments to far-off places can be harder to come by. You don't want to find yourself in the last year of your service trying to figure out how to convert $100,000-plus from your Traditional TSP and get stuck with a tax bill of $14,000, $22,000, or more!

TSP Walkthrough of a Backdoor Conversion, aka "Rollover Out"

Figure 1. Log into TSP and select "Rollovers Out" from the top menu.

Figure 2. Choose "Partial Distribution" so you can select to Rollover Out only Traditional funds.

Figure 3. Choose "Qualified Employer Plan" and "Roth IRA" for where TSP will send the funds.

Figures 4 + 5. Choose "All Available" -- you don't want them to send you any cash!

Figure 6. Confirm that there is "$0.00" next to "Federal Withholding" (if it isn't, start over).

Figure 7. Enter your Roth IRA account information, and TSP will automatically send the funds!

Figure 8. One last double-check before clicking "Submit."

What To Do If You Can't Deploy or Move to a CZTE Duty Station

Not all branches or communities have easy access to CZTE deployments and assignments. In those cases, you can still offset the dollars of your Mega Backdoor Roth Conversion -- but you'll have to work for it. That's because there are deductions that the IRS allows you take over and above the "standard deduction." There are two highly accessible strategies that you can use to tap into these additional deductions that will offset the Mega Backdoor Roth Conversion and leave you without owing the IRS any extra taxes:

1. Purchase a Business Vehicle: If you have a side hustle or business, you could use part of the bonus to buy a vehicle that weighs over 6,000 pounds, such as an SUV or truck. By using Section 179 of the tax code, you could deduct the entire cost of the vehicle in the first year, or spread it out over multiple tax years, offsetting any conversion amount from your Traditional TSP.
2. Invest in Rental Real Estate: Use another portion of the bonus to purchase a rental property. The expenses of maintaining the property and depreciation are tax-deductible, helping you further offset your tax liability. If you invest in a Short-Term Rental, you'll be able to offset this liability more easily and at a higher level than if you just invest in long-term rental properties.

Key Takeaways

The Mega Backdoor Roth Conversion is an incredible tax strategy that can help military members maximize their retirement savings. By strategically contributing to the Traditional TSP during non-deployment years and converting those funds to Roth retirement savings that are tax-free while deployed to a CZTE area, you can save a substantial amount in taxes. And even if you never contribute a single dollar to your Traditional TSP, all of the service-matching contributions under the Blended Retirement System are Traditional TSP contributions, so you'll have to master this strategy no matter what.

The key is to act early and often, avoid letting your Traditional TSP balance grow too large, and understand the IRS rules around Roth conversions. With the right planning, you can build a tax-free retirement nest egg that sets you up for financial success. We're talking about a strategy that can save or make you tens of thousands of dollars during your career -- so it has to be a "non-negotiable" in your financial playbook.