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, Taxes and Your Roth TSP Account.) 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 did not 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 you have the TSP distribution sent to you (or your checking account), money will be withheld for federal income taxes. If you have the money transferred directly to an IRA you have established, nothing will be withheld
If you had $100,000 in your TSP and requested that the TSP transfer it directly to a new IRA you had established, all $100,000 would be transferred to that account.
If you had the $100,000 sent to your checking account while you figured out where to open your IRA, your next bank statement would show a deposit of only $80,000. $20,000 would have been withheld for federal income tax. In the event you had $20,000 lying around the house, you could add it to the $80,000 and roll over a full $100,000 within 60 days. If you did that, you would receive a $20,000 refund once you filed your tax return.
What if you don’t have $20,000 to add to the $80,000 you received from the TSP? You would roll over the $80,000 into an IRA within 60 days. However, you can’t very well roll over money you don’t have (i.e., the $20,000 that had been withheld by the TSP). Upon the expiration of the 60 day period that $20,000 that was withheld would be treated as a withdrawal from your TSP and subject to federal income tax. If you were in the 25% tax bracket, that would result in you owing an additional $5,000 of federal income tax. Instead of receiving the $20,000 that had been withheld as a refund at tax time, you would now receive only $15,000.
In the above example, you paid $5,000 of income taxes that you would not have had to pay if you understood the tax law and utilized a direct transfer from your TSP into an IRA. When it comes to taxes, it’s OK to avoid them. Tax avoidance is perfectly legal; it’s tax evasion that will get you in trouble.