When you retire, you will be faced with many choices as to what to do with your Thrift Savings Plan investments. Many of them have been discussed in previous articles. (See, for example, Turning Your TSP Into an Income Stream and Should You Convert to a Roth IRA?)
In this article we will look at the choice of leaving your money in the TSP, or transferring it into an IRA. The following table identifies the advantages of either keeping your money in the TSP or rolling it over to an IRA.
|The TSP will have lower expenses than virtually any IRA. Some IRA accounts also have annual fees.||An IRA allows a greater variety of investments to be held in the account. In a self-directed IRA, only collectibles and insurance contracts are not allowed.|
|Penalty free withdrawals are allowed as early as age 55 in most situations. In an IRA the early withdrawal penalty will apply up to 59 ½.||IRAs have more flexible withdrawal options. The TSP’s options are relatively restrictive.|
If a financial advisor is suggesting that you roll your money into an IRA, ask why. Is it because the IRA is really a better investment, or is it that he/she will earn a fee from the transaction?
There are specific tax rules about taking money from your TSP and moving it to an IRA or other tax advantaged account. Going all the way back to the inception of the IRA, individuals have been allowed 60 days to roll their money into another tax advantaged account without being liable for federal income tax on the money. Until the mid-1990s that was all anyone needed to know. If an investor withdrew money from an IRA, there was no tax withheld unless they requested it. If, within 60 days, that money was put in another tax advantaged plan, no tax was due.
Unfortunately, many people took the money out and didn’t roll it over. That resulted in tax problems for those who had managed to spend the entire rollover and had no money left to pay the tax that was due. It also created
extra work for the Internal Revenue Service. This resulted in a change to the tax law. Individuals still had the 60 day tax-free period but, if they didn’t directly transfer the money, 20% of the amount was withheld for federal income taxes. If the TSP distribution is sent to me (or my checking account), the money will be withheld. If I have the money transferred directly to an IRA I have established, nothing will be withheld.
If I had $100,000 in my TSP and requested that the TSP transfer it directly to a new IRA I had established, all $100,000 would be transferred to that account.
If I had the $100,000 sent to my checking account while I tried to figure out where to open my IRA, my next bank statement would show a deposit of $80,000. $20,000 would have been withheld for federal income tax. In the event I had $20,000 lying around the house, I could add it to the $80,000 and roll over a full $100,000 within 60
days. If I did that, I would receive a $20,000 refund when I filed my tax return.
What if I didn’t have $20,000 to add to the $80,000 I got from the TSP? I would roll over the $80,000 into an
IRA within 60 days. However, I would not be able to roll over the $20,000 that had been withheld by the
TSP. At tax time, that $20,000 would be treated as a withdrawal (even if I hadn’t been able to get my hands on
it as it had been withheld). I would have to pay tax on the $20,000. If I were in the 25% tax bracket, that would result in an additional $5,000 of federal income tax. Instead of a $20,000 refund at tax time, I would receive $15,000.
I agree with Oliver Wendell Holmes that “Taxes are the price we pay for a civilized society.”, however, there is no reason to pay more than you owe. If you are thinking of rolling your TSP into an IRA remember the words “direct transfer”.