Withdrawing funds from your TSP account? Ed finishes his four-part overview of TSP withdrawals.
Edward A. Zurndorfer
This is the fourth of four FEDZONE columns discussing the withdrawal options that are available to all separated Thrift Savings Plan (TSP) participants and beneficiary TSP participants. A “separated” TSP participant means a civilian federal employee or a member of the uniformed services who has separated from civilian employment or active duty, respectively. A “beneficiary” TSP participant is a spouse beneficiary of a deceased civilian employee or a deceased uniform services TSP participant who has a TSP account established in his or her name.
This column explains the tax consequences of the various TSP account withdrawal options discussed in the three previous FEDZONE columns. It is important that a separated TSP participant or beneficiary TSP participant review the tax rules associated with TSP withdrawals. Since these rules can be complex, TSP participants are strongly advised to consult with a qualified tax professional. While the TSP can assist a TSP participant with is or her withdrawals, the TSP cannot provide tax advice.
Important Definitions and Items to Understand
In order to understand the tax implications of withdrawing money out of a separated TSP participant’s or a beneficiary TSP participant’s account, it is important to review some definitions and tax-related items.
• Distribution, payment, and withdrawal. All mean the same thing – a separated TSP participant or beneficiary TSP participant receives money from the TSP account.
• Earnings. Money that a TSP participant’s account, a participant’s agency, or uniformed services contributions on behalf of the participant if applicable, have earned in a participant’s account. The earnings are the difference between the account balance and the amount of a TSP participant’s total contributions.
• Roth TSP. Refers to contributions a TSP participant has elected to make to his or her account with salary that has already been taxed. No income tax is paid on the portion of the TSP participant’s portion of his or her withdrawals that comes from Roth TSP contributions.
• Qualified TSP distributions. If a Roth TSP distribution is qualified, it means that the Roth accrued earnings are distributed income tax-free. In order for a Roth TSP distribution to be qualified, both of the following requirements must be met: (1) five years have passed since January 1st of the first year since the TSP participant made his or her first Roth TSP contributions; and (2) the Roth TSP participant is at least age 59.5, has a permanent disability, or has died. In case of death, the first requirement (the five-year requirement) remains the same. That is, the Roth TSP beneficiary does not have to wait an additional five years for a withdrawal to be considered qualified.
If either requirement has not been met at the time of the TSP participant’s withdrawal, then the distribution is not qualified. As such, the earnings portion of the TSP payment will be taxed as income, and if the TSP participant is under age 59.5, an early withdrawal penalty (10 percent) will apply. This is unless the payment is transferred to a Roth IRA or to a Roth account maintained by an eligible employer plan.
• Traditional TSP. Refers to everything in a TSP participant’s account that is not in the Roth TSP balance. It includes all traditional TSP contributions made by the separated TSP participant and any automatic or matching contributions made by a FERS employee’s agency, regardless of whether the separated TSP participant’s contributions were traditional TSP or Roth TSP. The TSP participant has deferred paying taxes on this portion of the TSP account. Therefore, all funds withdrawn from the traditional TSP account are treated as ordinary income for federal (and state, if applicable) income tax purposes.
Another important concept to understand is that except for TSP withdrawals in which the TSP participant specified as all traditional TSP or all Roth TSP, TSP withdrawals are taken proportionally. For example, if the Roth TSP balance makes up 50 percent of the total TSP account, every withdrawal made will be 50 percent Roth. And if the Roth balance contains 40 percent contributions and 60 percent earnings, then 40 percent of the Roth TSP portion of the withdrawals will be treated as contributions and 60 percent will be treated as earnings.
The TSP reports all TSP distributions to the IRS and to the appropriate state tax agencies (if applicable) and to the TSP participant on IRS Form 1099-R (Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.). Distributions from beneficiary TSP participant accounts will be reported as death payments on IRS Form 1099-R.
Distributions that Include Both Traditional TSP and Roth TSP
When a TSP distribution includes both traditional and Roth TSP money, the tax rules for the traditional TSP balance applies to the traditional portion, and the tax rules for the Roth TSP balance applies to the Roth portion. The following example illustrates:
Lisa has a TSP account in which $250,000 is in the traditional TSP and $150,000 is in the Roth TSP. The Roth account includes $100,000 in contributions and $50,000 in earnings. Lisa is 57 years old and requests a withdrawal of $1,000 from her TSP account. She is not disabled. Lisa does not request that any of the $1,000 be rolled over or transferred to another retirement account. What portion of the $1,000 distribution is taxable?
Lisa’s account is composed of 62.5% traditional TSP ($250,000/$400,000) and 33.3% in Roth TSP earnings ($50,000/$150,000). Applying those percentages to Lisa’s $1,000 TSP withdrawal, Lisa will receive $625 from her traditional TSP balance and $375 from her Roth TSP balance. Of the $375, $250 from her Roth TSP contributions and $125 (33.3%) from the earnings on her Roth TSP contributions, summarized as follows:.
|Lisa’s TSP Account||Lisa’s $1,000 TSP Withdrawal|
|$250,000 traditional TSP||$625 taxed as Income|
|$100,000 Roth TSP contributions||$250 not taxed|
|+$50,000 Roth TSP earnings||+$125 taxed as income |
(earnings on Roth TSP contributions)
|$400,000 Total TSP Balance||$1,000 Total Withdrawal Amount|
The traditional TSP portion ($625) is all taxable. Also taxable is the portion included in the Roth TSP balance ($125) (earnings on Roth TSP contributions) and in addition, is subject to a 10 percent early withdrawal penalty because Lisa is not yet age 59.5. Therefore $375 Roth distribution is not “qualified”. The $250 potion that comes from Roth TSP contributions is not taxable regardless of Lisa’s age or the amount of time that has passed since Lisa made her first Roth TSP contribution. In short, a total of $750 of Lisa’s $1,000 TSP withdrawal is considered taxable income. In addition, Lisa is subject to a 10 percent of $125, or a $12.50 penalty on her Roth TSP earnings withdrawal, unless she qualifies for an exception to the penalty.
What the TSP Withholds for Taxes
In most cases, the TSP is required to withhold part of the taxable portion of a TSP participant’s distribution for federal income taxes. With certain types of payments, the participant may request an increase or decrease in the percentage of federal income taxes withheld or a waiver of federal income tax withholding altogether.
The TSP does not withhold for state or local income tax. But this does not mean the TSP participant do not have to pay state and local income tax on TSP distributions. For TSP participant who are residents of states with a state income tax, the TSP reports all distributions to the state of residence at the time of the payment.
Transferring or Rolling Over TSP Distributions
Before a TSP participant can decide to transfer or rollover his or her TSP account, the TSP participant should find out whether his or her IRA or employer-sponsored qualified retirement plan accepts transfers or rollovers, the minimum amount it will accept, and whether Roth TSP accounts can be transferred.
TSP participants should also keep in mind that the employer-sponsored qualified retirement plan the TSP participant chooses to transfer or rollover TSP funds may be subject to certain tax treatment and certain retirement plan rules (such as spousal consent) that are different than those rules that govern the TSP.
From a Traditional TSP Balance
Eligible rollover distributions of a traditional TSP balance may be transferred or rolled over to a traditional IRA, to an eligible employer-sponsored qualified retirement plan, or to a Roth IRA.
• Transfer. If a TSP participant transfers part or all of an eligible rollover distribution, the following rules apply:
₋ the transfer of a traditional TSP balance to a traditional IRA or to an eligible employer-sponsored qualified retirement plan will not be taxed in the current year and no federal income tax will be withheld.
₋ any part of a traditional TSP balance that is transferred to a Roth IRA will be taxed in the current year. No federal income tax will be withheld at the time of the transfer.
• Rollovers. If the TSP makes an eligible rollover distribution from a TSP participant’s traditional TSP balance to the TSP participant and the TSP participant decides to perform a rollover to a traditional IRA, Roth IRA or eligible employer plan himself or herself, the following rules apply:
₋ since the TSP is making a payment directly to the TSP participant and not to another qualified retirement plan or to an IRA, the TSP is required to withhold 20 percent in federal income taxes. This means that in order to successfully rollover the entire TSP payment, the TSP participant must use other funds to make up for the 20 percent withheld in federal income taxes.
₋ if the TSP participant does not rollover the entire amount of the TSP payment within 60 says, the portion not rolled over will be subject to federal and state (if applicable) income taxes. If the TSP participant is younger than age 59.5, the 10 percent early withdrawal penalty will also apply on the portion not rolled over to the traditional IRA or to a qualified retirement plan.
₋ Any amount of the traditional IRA rolled over to a Roth IRA will be fully taxed for federal and state, if applicable, income tax purposes in the current year.
From a Roth TSP Balance
A Roth TSP participant may transfer or rollover an eligible rollover distribution from the Roth TSP to a Roth IRA or Roth account maintained by an eligible employer plan that will accept transfers and rollovers. It is important that the amount rolled over will become subject to the tax rules that apply to the Roth IRA or the Roth account maintained by the eligible employer plan. These tax rules are not necessarily identical to the tax rules governing the Roth TSP participant’s Roth balance. Differences include the following:
• When a Roth TSP participant transfers or rolls over his or her Roth TSP account into a Roth IRA, the starting date for satisfying the five-year rule for qualifying distribution does not carry over. Instead, the Roth TSP participant counts from January 1st of the first year the Roth TSP participant contributed to any Roth IRA.
• Distributions from a Roth IRA can only be rolled over or transferred to another Roth IRA
• Distributions from Roth IRAs are paid first from contributions, then from earnings.
₋ if a Roth TSP participant chooses to have the TSP transfer all or part of an eligible rollover distribution from his or her Roth TSP account, then: (1) the transfer of the Roth balance will not be taxed in the current year, and no federal income tax will be withheld; and (2) if a part of the Roth TSP account is taxable (“nonqualified” TSP money), the TSP will only transfer nontaxable money if the taxation portion of the withdrawal does not satisfy the transfer election.
₋ if the TSP makes an eligible distribution directly to a Roth TSP participant and the Roth TSP participant decides to do a rollover to a Roth IRA or Roth account maintained by an eligible employer plan, the following applies: (1) if the TSP payment to the Roth TSP participant is not a qualified Roth distribution, the TSP is required to withhold 20 percent of the earnings portion for federal income tax; and (2) the taxable portion of a nonqualified distribution is treated the same as a distribution of a traditional TSP participant’s balance. That means that whatever portion of the distribution is not rolled over is taxed and, if the Roth TSP participant is under age 59.5, an early withdrawal penalty (10 percent) most likely will be imposed.
Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those, Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.