Nearly all federal employees participate in the Thrift Savings Plan (TSP). Contributing to the TSP is convenient and easy for employees because contributions are made automatically via payroll deduction. On the other hand, making TSP withdrawals is perhaps more of a challenge. This is the second of two FEDZONE columns discussing the tax consequences of TSP withdrawals and rollovers. This column will help TSP participants better understand the federal and state tax consequences of traditional TSP and Roth TSP rollovers.
It is important to distinguish between a TSP transfer and a TSP rollover. With a TSP transfer, distributions from a TSP participant’s account goes directly from the TSP account to the participant’s IRA or to an eligible employer-sponsored retirement plan. With a TSP rollover, distributions from a TSP participant’s account are made to the participant and the participant has 60 days from the day of receipt to deposit the received funds into an IRA or into an eligible retirement-sponsored retirement plan.
Before transferring or rolling over a TSP account, the TSP participant should find out whether the IRA or retirement plan accepts transfers or rollovers; the minimum amount the IRA or retirement plan will accept; and whether tax exempt or Roth contributions, if applicable, will be acceptable.
Participants should also keep in mind that the retirement plan that the TSP participant wants to transfer or rollover funds may be subject to different tax treatment and retirement plan rules (such as spousal consent rules) from the retirement rules that apply in the TSP. The rules of the IRA or eligible employer plan that receives the TSP transfer or rollover will determine one’s investment options, fees, and rights to payment.
Not all types of TSP distributions are eligible to be rolled over or transferred. The following table entitled “Tax Treatment of TSP Distributions” shows which types of distributions are considered eligible rollover distributions.
Tax Treatment of TSP Distributions
|Type of TSP Distribution||Type of Payment for IRS Purposes||May TSP Participant Transfer or Rollover the Distribution?||Can the TSP Participant Waive Tax Withholding?|
|Single withdrawal (partial or total) by a separated participant||Eligible rollover distribution||Yes||No|
|Installment payments for less than 10 years (fixed dollar amount)||Eligible rollover distribution||Yes||No|
|Installment payments for 10 years or more (fixed dollar amount)||Periodic payments||No||Yes – complete the withholding section of one’s withdrawal request|
|Installment payments based on the IRS life expectancy table||Periodic payments||No||Yes – complete the withholding section of one’s withdrawal request|
|Required minimum distributions||Periodic payments||No||Yes, complete line 1 of IRS Form W4-P|
|Unpaid TSP loan (taxable distribution default by separation)||Eligible rollover distribution||Rollover only (using personal funds)||Not applicable|
|Age-based in-service withdrawal||Eligible rollover distribution||Yes||No|
|Financial hardship in-service withdrawal||Non-periodic payment||No||Yes|
|Death benefit to a non-spouse||Eligible rollover distribution||Only to an Inherited (“death”) IRA||No|
Rollover or Transfer from a Traditional TSP Account Balance
Eligible rollover distributions of a TSP participant’s traditional TSP balance may be transferred or rolled over to a traditional IRA, an eligible employer-sponsored retirement plan, or to a Roth IRA (but only a TSP transfer and not a TSP rollover).
If the TSP participant chooses to have the TSP transferthe traditional TSP balance of all or part of the eligible rollover distribution, the following rules apply:
· The direct transfer of the traditional TSP balance to a traditional IRA or to an eligible employer-sponsored retirement plan will not be taxed in the current year and no federal income tax will be withheld. The TSP participant will not be taxed until the monies are withdrawn from the traditional IRA or the eligible employer-sponsored retirement plan.
· 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 transfer. This means that the TSP participant will likely need to pay estimated Federal and, in many states, state estimated taxes during the year of the transfer.
If the TSP participant chooses to have the TSP rollover all or part of the traditional TSP balance to a traditional IRA or to an eligible employer-sponsored retirement plan, then the following rules apply:
· Since the TSP is making payment directly to the TSP participant and not to the IRA or retirement plan, the TSP is required to withhold 20 percent for payment of federal income taxes. This means that in order to rollover the entire payment from the TSP, the TSP participant must use outside funds to make up for the 20 percent federal income taxes withheld. For example, if a traditional TSP participant wants to rollover $50,000 to a traditional IRA, then the TSP will withhold 20 percent of $50,000, or $10,000, and send the $10,000 to the IRS. The participant will receive a net total of $40,000. However, in order to rollover the entire $50,000 (thereby not having to pay tax on the $10,000), the TSP participant will need to find $10,000 from another source (such as savings) and send it to the IRS within 60 days of receiving the $40,000.
· If the TSP participant does not rollover the entire amount of the withdrawn amount (the amount that was sent to the TSP participant) then the portion not rolled over will be taxed and will also be subject to the 10 percent early withdrawal penalty if the TSP participant is younger than age 59.5.
Rollover or Transfer from a Roth TSP Account Balance
An eligible rollover distribution may be transferred or rolled over from a Roth TSP balance to a Roth IRA or to a Roth retirement plan (such as a Roth 401(k) retirement plan) that will accept transfers and rollovers. It is important to note that the amount rolled over will become subject to the tax rules that apply to the Roth IRA or to the Roth retirement plan maintained by the eligible employer plan. These tax rules are not identical to the rules governing the Roth TSP balance. Differences may include the following:
· When a Roth TSP participant transfers or rolls over his or her Roth TSP balance into a Roth IRA, the starting date for satisfying the “five-year rule” for qualified Roth distributions does not carry over. Instead, the five-year starting date starts on January 1st of the first year the Roth TSP participant contributed to a Roth IRA.
· The Roth TSP balance is subject to required minimum distributions (RMDs) when a Roth TSP participant is retired. The first RMD is due no later than April 1 following the year the Roth TSP participant becomes age 70.5 (if born before July 1, 1949) or age 72 (if born after June 30, 1949). But Roth IRA owners are not subject to RMDs.
· Distributions from Roth IRAs can only be transferred to another Roth IRA.
· Distributions from Roth IRAs are paid first from contributions and then for earnings.
If the Roth TSP participant chooses to have the TSP transfer part or all of an eligible rollover distribution from his or her Roth TSP balance, then the following rules apply:
· The transfer of the Roth TSP balance will not be taxed in the current year and no income tax will be withheld. Subsequent distributions from the Roth IRA or Roth eligible employer-sponsored retirement plan may be taxed and subject to the 10 percent early withdrawal penalty.
·If part of one’s Roth TSP balance is taxable (“nonqualified” distribution), then the TSP will only transfer nontaxable money if the taxable portion of the withdrawal does not satisfy the Roth TSP participant’s transfer election. If the Roth TSP participant chooses to have the TSP only a portion of the payment, any taxable portion will be transferred first. This helps reduce the amount of tax one owes on any portion of the distribution received as a direct payment in the current year.
Other Tax Rules Related to TSP Distributions
Repayment of TSP Loans
The TSP must declare a taxable distribution on the entire unpaid balance of a TSP participant’s loan including any accrued interest if any of the following are true:
· The TSP participant failed to repay his or her loan in accordance with the loan agreement.
· The TSP participant missed a loan payment and has not submitted the amount needed to bring the loan payments up-to-date within the required time period.
· The TSP participant did not repay the loan in full within 60 days of leaving federal service.
This means that the IRS will consider the unpaid balance of the loan to be taxable income. In addition, if the TSP participant is under age 59.5, he or she may have to pay a 10 percent early withdrawal penalty on the taxable portion of the loan. Once a taxable distribution has been declared, the loan is closed and the TSP participant will not be allowed to repay it.
If any part of the TSP loan is associated with tax-exempt or Roth TSP contributions, those contributions will not be subject to tax. Earnings on tax-exempt contributions in a traditional balance are taxable. The following conditions apply to Roth earnings:
· If the taxable distribution is declared because the TSP participant separated from federal service, only Roth earnings that are not qualified are subject to tax.
· If the taxable distribution is declared for another reason, such as a default on a loan, then the Roth earnings included will be subject to tax, even if the Roth TSP participant has already met the condition necessary for the distribution to be qualified.
If the taxable loan distribution was declared because the TSP participant separated from federal service, then the participant may be able to rollover the distribution (within 60 days of the distribution date) to an IRA or an eligible employer-sponsored retirement plan. If the loan amount was already spent, the amount can be rolled over using personal funds. In case of additional questions, a qualified tax professional should be contacted.
Receiving Installment Payments
If a TSP participant is receiving installment payments, the following events could result in a change in the withholding rules for the taxable portion of one’s payments:
· The TSP participant changes the dollar amount or frequency of payments.
· The TSP participant changes from payments based on life expectancy to payments of a fixed dollar amount.
· The TSP participant transfers money into his or her TSP account.
· The TSP participant takes a withdrawal in addition to installment payments.
The withholding rules will be determined according to whether a TSP participant’s new payments are eligible rollover distributions or periodic payments, based on the participant’s account balance at the time the payments change, and whether the payment is taxable, tax-free, or a combination of the two.
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.