DoD’s Immediate Retirement Pay – a Wolf in 72(t)’s Clothing

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Sometimes as a Personal Finance blogger I lay awake at night wondering what my next meal ticket post will be.

Then I received this fat fastball- Pitched right over the Plate- From the Navy Reserve Recruiter:

(Side rant: I receive these emails from The Navy Reserve Recruitment system because I am Individual Ready Reservist (IRR), and the Navy is trying to convince me to go back in to a paid (SELRES) status so that I can fly across the country for Drill Weekends.  The Navy recently kicked its IRR reservists to the curb as I have documented here- The Navy does not even permit its IRR reservists to access their online university (Navy Knowledge Online) to earn retirement credit points).

Back the the post.  And it’s a Doozey.  Here’s the ‘Immediate military retirement pay’ announcement I received in my inbox:

Good Morning!

I wanted to share with you something that just came out via Navy times regarding coming changes in reserve retirement. Basically, an immediate retirement pay option is being considered for reservists. That’s huge! I put a quick snippet of the Navy Times story below along with a link to the story. This will make the SELRES much more interesting to a lot more people. If this raises your eyebrows and you want some more info please feel free to shoot me an email or give me a ring. Thanks!

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DoD: Give reservists immediate retirement pay:

” Reservists would be eligible to begin receiving military retirement pay immediately after completing 20 years of part-time service under a new Pentagon proposal for overhauling the retirement system. The plan would blur the lines between active and reserve careers by allowing both to qualify for “working age” retirement checks that for decades have been limited to the full-time active-duty force.

 The fundamental change for reservists – who today must wait until age 60 to collect their first nickel of retirement pay – is one element of a broader set of proposals that the Defense Department unveiled Thursday in a report sent to Capitol Hill and also to the Military Compensation and Retirement Modernization Commission, which is conducting an in-depth study on the issue and preparing recommendations for Congress early next year.

 The new Pentagon proposal would convert both active and reserve retirement packages into a “hybrid” that promises smaller monthly retirement checks supplemented with a 401(k)-style investment account that troops and retirees would own outright. Reservists would get the same annual government contributions equal to 5 percent of basic pay, and ownership of those investment accounts would transfer to service members after six years of service. That would mark the first time that a limited retirement benefit would be provided to troops who do not complete a 20-year career in either component.”

—read the rest at – http://www.militarytimes.com/article/20140306/SPECIAL14/303170012/DoD-Give-reservists-immediate-retirement-pay

 Very Respectfully,

LT I.M. Recuiter, USN

 Wow! An ‘Immediate Partial Retirement’ Option for Reservists! Sounds like a great deal!  (You can read the full text of the proposal here).

Um, no.  It’s not a good deal.  The DoD is assuming that its service members (a) Do not understand the tax code and (b) Do not know how to operate an HP-12c financial calculator or 12c smartphone app (unfortunately, the Pentagon is probably correct on both counts).

 This is a tragedy, because the Pentagon’s ‘Immediate Retirement Pay’ proposal is a rip-off.

Early retirement pioneer John Greaney publicized (and popularized) the 72(t) exemption back in the 1990’s.  This is a loophole in the tax code (Internal Revenue Code Section 72(t), to be specific) that allows ANYONE to draw from their IRA at ANY AGE, PENALTY FREE (not income-tax free), if they declare the withdrawals to be ‘Substantially Equal Periodic Payments’.

In Layman’s terms: You can withdraw small amounts every year from an IRA account- Penalty-Free- If you declare that it is an annuity and you are drawing equal annual payments for life.

Let me start with a simplified example.

 Example 1 – Joe Six Pack:

Joe Six Pack (a private sector civilian) starts work at age 22 and saves $5500 every year in an IRA account. He invests in a Schwab/Fidelity/Vanguard lifecycle fund and earns 7% per year. At age 42, Joe stops and declares he is ‘retired’.

Using the HP-12C app, his account value at age 42 is:

 5500 [PMT] , 7 [i] , 20 [n] ; [FV] = $225,475

 Now go to Bankrate.com’s 72(t) Online Calculator and plug in $225,475 as your balance and 42 as your age:

Joe’s lifetime annuity at age 42 from IRA Substantially Equal Periodic Payments is $7,257 per year.

Here’s a current Active Duty/Reserve Career Example using an IRA:

Example 2 – CDR Jane Gish:

Jane Gish is an active duty Coast Guard officer for 12 years, then transfers to the reserves and serves in a Paid Drilling status for another 8 years.

Every year, Jane ignores the fact that she can participate in the TSP, but she puts away $5500 per year in to an IRA each year using either her active duty wages or reserve drill pay.

At age 42, Jane has 20 years of service and wants to tap her IRA for lifetime income.   The math is identical to Joe Six Pack’s – Jane draws $7,257 per year for life from her IRA ‘Annuity’, penalty-free.

Here’s a 3rd Active Duty/Reserves Example, this time using the TSP:

Example 3 – LtCol W.T. Door:

W.T. Door is an active duty Marine for 12 years, then transfers to the reserves and serves in a Paid Drilling status for another 8 years.

W.T. Door is a participant in the TSP. He puts $5500 a year in the TSP (active and reserve years) and earns the same 7% per year. At age 42, W.T wants to draw an annuity from TSP, but he can’t (he’s not age 59 1/2 yet). However, W.T. CAN take his one-time partial TSP withdrawal and does a direct rollover (‘Trustee-to-Trustee Transfer’) to a Schwab IRA account. W.T. then does the same as Joe and Jane and draws $7,257 per year for life using the 72(t) Rule.

Does LtCol W.T. Door’s retirement tactic sound ‘Revolutionary‘? All he did was use the existing TSP rules and existing IRA tax rules- Same as Joe Six Pack the Civilian.  There’s nothing ‘new’ or ‘revolutionary’ about it.

Now, the ‘new’ DoD ‘Immediate Retirement Pay’ Proposal:

The DoD’s proposed retirement system change is geared to entice folks to stay in the reserves and still get some kind of payout between ages 42-60 (It also monkeys with the Active  Duty payout formulas).  The DoD proposal would likely modify military TSP regulations to allow 72(t) withdrawals like LtCol W.T. Door did (without needing the TSP-IRA rollover), but as payback- reduce the Military pension multiplier from its current 2.5% per service credit point (you earn 360 points per year of Active Duty) to 2% – or even as low as 1.75%.

To illustrate the difference, W.T. Door retires as an O-5 with 12 years active (12 x 360 pts) and 8 years reserve (8 x 70 pts) = 4880 total career points.

From the 2014 base pay tables, an O-5 with 20 yrs earns $8422 per month x 12 months per year = $101,064 per year.

• Under the current military retirement system, W.T.’s annual payout at age 60 is 2.5% x (4880/360) x $101,064 = $34,349 per year.
• Under the proposed Partial/Immediate Pay system, At a multiplier of 2.0%- W.T.’s Annual Pension from age 60 drops to $27,399 per year.
• At a proposed multiplier of 1.75%, W.T.’s Annual Pension drops to $23,974 per year.

…This is as much as a 31 percent cut in your Military Pension.

Here’s the Navy Times Graphic showing a similar example.  LtCol W.T. Door would get a few pennies at age 42 in exchange for a reduced annuity at age 60.  Note that the proposed $7200/year withdrawals at age 42 in the Pentagon’s infographic below are remarkably similar to Joe, Jane and W.T. above:

 Does this sound like a great deal? Under the new proposal, DoD would supposedly add a few dollars to an Acvive/Reservist TSP now in exchange for a reduced pension multiplier later, which is giving you a few pennies now in exchange for a LOT fewer dollars at age 60 when you are eligible to draw the military pension.

 In summary, DoD’s ‘Immediate Retirement Pay’ Proposal assumes troops are bad at math and do not understand the tax code.

 

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