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 withdrawals from the TSP is more of a challenge. And understanding the tax consequences of TSP withdrawals is perhaps even more challenging. This is the first of two FED-ZONE columns discussing the tax consequences of TSP withdrawals and rollovers. The column will help TSP participants better understand the federal and state income tax consequences of traditional TSP and Roth TSP withdrawals.
Some Important Definitions and Retirement Plan Information
In order to fully understand the tax consequences of withdrawing money from one’s TSP account, it is important to first review some retirement definitions and TSP information and rules.
· “Distribution,” “payment,” and “withdrawal” all mean the same thing, namely: Money a TSP participant receives via check or direct deposit from his or her TSP account.
· “Earnings” means the money that contributions have earned in one’s TSP account. It is the difference between one’s total account balance and the amount of one’s total contributions.
· “Eligible employer retirement plan” refers to various employer-sponsored retirement plans, including those qualified under section 401(a) of the Internal Revenue Code, such as 401(k) plans, profit-sharing plans, defined benefit plans, stock bonus plans, money purchase plans; section 403(b) tax-sheltered annuities; and section 457(b) plans maintained by a governmental employer.
· “Eligible rollover distribution” simply means a type of distribution from the TSP that the IRS allows to be rolled over into another retirement plan or into an IRA.
· “Roth” refers to contributions an employee elected to make to his or her TSP account with pay that has already been taxed. A Roth TSP participant does not pay income tax on the portion of one’s withdrawals that comes from one’s Roth TSP contributions. Note for those employees covered by FERS or uniformed service members enrolled in the “Blended Retirement System” (BRS) who receive automatic or matching contributions: All contributions from one’s agency or service go into the participant’s traditional balance, even those that match Roth TSP contributions. The Roth balance of one’s account is divided between one’s contributions and the earnings on those contributions which may receive a different tax treatment upon distribution than the contributions themselves, depending on whether the distribution is “qualified.”
· Qualified Roth TSP distribution. Two conditions must be met in order for a Roth TSP distribution to be “qualified”, meaning that the Roth TSP accrued earnings are distributed tax-free: (1) It has been at least five years since January 1 of the first year that the Roth TSP participant made his or her first Roth TSP contribution and (2) the Roth TSP participant is at least age 59.5, or is permanently disabled. If either requirement is not met at the time of withdrawal, then the Roth TSP distribution is not qualified. This means that the earnings portion of the distribution will be taxed. In addition, if the Roth TSP participant is under age 59.5, the distribution may be subject to a 10 percent early withdrawal penalty.
· “Traditional” – everything is a participant’s TSP account that is not in the Roth TSP balance is considered traditional TSP. This includes all non-Roth TSP contributions and matching contributions made from a FERS employee’s agency. Accrued earnings on a traditional TSP balance are also treated as traditional.
· “Transfer” and “rollover”. These are two ways of moving funds from one retirement plan to another. A transfer is sometimes called a “direct rollover” and is moved directly between accounts. A rollover is first sent to the retirement plan owner before the owner deposits it into a retirement account, generally within 60 days of receiving it.
· Proportional withdrawals. Except for withdrawals that a TSP participant specifies as all traditional or all Roth, withdrawals are taken proportionally. For example, if the Roth balance makes up 40 percent of a participant’s total TSP account, every TSP withdrawal will be 40 percent Roth. If 60 percent of that Roth TSP account consists of earnings, then 40 percent of the Roth withdrawal will be treated as a contribution and 60 percent as earnings.
· Tax reporting. The TSP reports all TSP distributions to the IRS, the appropriate state tax agencies (if applicable) and to the TSP participant on IRS Form 1099-R (Distributions from Pensions, Annuities, Insurance Contracts, etc.). Distributions from beneficiary participant accounts will be reported as death payments on IRS Form 1099-R.
How TSP Payments Are Taxed
In general, payments from a participant’s TSP account get taxed depending on whether the participant has traditional TSP money, Roth TSP money, or both. Note that members of the uniformed services may also have tax-exempt pay included in their accounts, as a result of contributing their pay while serving in a combat zone.
Traditional TSP Balance
Any payment from a TSP participant’s traditional balance is considered full taxable income because the participant has deferred paying taxes on this money. This money includes the participant’s contributions via payroll deduction, the participant’s agency or uniform services contributions, and accrued earnings. Note that traditional contributions made from tax-exempt pay (uniform service contributions made while the uniformed service member was serving in a combat zone) are not taxed when withdrawn. The earnings on those contributions are taxed, however.
Roth TSP Balance
A Roth TSP participant’s Roth balance is separated into two pools; namely: (1) Contributions and
(2) earnings. A Roth TSP participant has already paid income tax on the money contributed to the TSP account. This means that the Roth TSP withdrawals are not taxed. With respect to the Roth TSP earnings, these earnings will not be taxed upon withdrawal only if the distribution is qualified (see above “qualified” distribution).
Payments That Include Both Traditional and Roth Money
When a payment includes both traditional and Roth money, the tax rules for traditional balances apply to the traditional portion, and the tax rules for Roth balances apply to the Roth portion. The following example illustrates:
Sheila has a traditional TSP account worth $400,000 and a Roth TSP account worth $100,000. The Roth balance consists of $25,000 in contributions and $75,000 in earnings.
Sheila makes a withdrawal of $1,000 from her account. Sheila is 58 years old and does not have a permanent disability. What portion of the $1,000 distribution is considered taxable income?
Sheila’s account is $400,000/$500,000 or 80 percent traditional, $25,000/$500,000 or five percent Roth TSP contributions, and $75,000/$500,000 or 15 percent earnings on Roth TSP contributions. Applying these percentages to the $1,000 withdrawal means that the $1,000 is made up of $800 (80 percent) from Sheila’s traditional balance, $50 (five percent) from Sheila’s Roth TSP contributions, and $150 (15 percent) from earnings on Roth TSP contributions.
|Sheila’s TSP Account||Sheila’s Withdrawal|
|$400,000 Traditional TSP |
$25,000 Roth TSP contributions
$75,000 Roth TSP earnings
$500,000 TSP account balance
| $800 (80% of $1,000) taxable |
$50 (5% of $1,000) nontaxable
$1,000 Gross income ($950 taxable income)
Explanation of taxable income: The traditional TSP portion is all taxable. So are the earnings in Sheila’s Roth TSP balance. The portion of the $1,000 withdrawal that came from Sheila’s Roth TSP account ($50) is not taxable regardless of Sheila’s age or the amount of time that has passed since Sheila first made a Roth TSP contribution. However, the $950 consisting of the $800 traditional TSP is fully taxable as is the $150 of the Roth TSP earnings since the Roth TSP distribution is not “qualified”. The $150 is also subject to the 10 percent early withdrawal penalty unless Sheila is covered by an exception, as explained below.
Additional 10 Percent Early Withdrawal Penalty Tax
A TSP participant who receives a TSP distribution before the participant reaches age 59.5 may have to pay – in addition to the regular income tax – an early withdrawal penalty tax equal to 10 percent of any taxable portion of the distribution not transferred or rolled over. The 10 percent additional tax generally does not apply to payments that are:
· Paid after a participant separates from federal service during or after the year the participant reaches age 55, or in the case of a public safety employee who retired from federal service at age 50 or older
· Annuity payments
· Made as a result of total and permanent disability
· Made because of death
· Made from a beneficiary participant account
· Ordered by a domestic relations court; or
· Paid as substantially equal payments over the participant’s life expectancy.
Note that the 10 percent early withdrawal penalty never applies to contributions made to the Roth TSP or the qualified distributions of Roth earnings. It does apply to nonqualified distributions of Roth TSP withdrawals.
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.