In the pre-retirement seminars that I deliver for my firm, Federal Career Experts, I frequently get questions about the early-withdrawal penalty and how it applies to the Thrift Savings Plan (TSP). Generally the question is: “Can I access my TSP without penalty if I retire and begin withdrawing money from my TSP before I reach 59 ½?”
The answer to the question is “Yes, but you must be careful in how you take your money out.”
Before we look at strategies for avoiding the penalty, let’s clear up a misconception that many folks have about the early-withdrawal penalty and the TSP. You are exempt from the penalty if you separate from federal service in the year in which you turn 55 (or later.) That’s age 55, not 59 ½. Employer-sponsored plans, such as the TSP, differ from individual plans, such as an IRA, in many ways; and one of the ways is in when the 10% early-withdrawal penalty applies. Note, if you retire/separate at age 53, for example, at age 55 you do not receive penalty-free withdrawals until you reach 59 ½; you must retire/separate in the year that you turn age 55 to enjoy this benefit.
It’s also a common mistake to retire/separate in your 55th year of age (or later) and then transfer your TSP funds to an IRA. When you do this, you lose the age-55 penalty-free access that you just earned! Your funds must remain in the IRA until at least you are age 59 ½ in order to enjoy this penalty-free status.
Another misconception worth addressing is that tax avoidance is perfectly legal; it’s tax evasion that’ll get you into trouble. Why did Congress put all those loopholes in the tax code if they didn’t want people to take advantage of them?
OK, what if you are going to retire/separate before the year in which you turn age 55? You can avoid the penalty if you follow a life-expectancy-based withdrawal strategy for the longer of 5 years, or the number of years until you reach the age of 59 ½. In tax parlance, this strategy is known as a series of substantially-equal periodic payments (SOSEPP, or just plain SEPP). Some people refer to this as a section 72(t) withdrawal, after the section of the Internal Revenue Code that authorizes these withdrawals. There are three primary methodologies under §72(t):
- Following the IRS life-expectancy table;
- Annuitization; and
The TSP fully supports the strategy based on the IRS life-expectancy table; you’ll have to figure out the annuitization and amortization strategies yourself. If you elect the TSP withdrawal option known as Substantially Equal Monthly Payments Based on the IRS Life Expectancy Table, and continue to follow that withdrawal strategy for whichever is longer, 5 years or the number of years until you reach the age of 59 ½ , you will not have to pay one penny in early-withdrawal penalties. Stray from that strategy, and you’ll owe the penalty on everything you had taken out up to that time, and potentially on everything you take out until you reach age 59 ½. Because the TSP supports this withdrawal choice, the Form 1099 you receive each year will indicate that your withdrawal is not subject to a penalty.
If you were to use the annuitization or amortization methodology, you would have to do the calculations yourself, though there are websites such as www.bankrate.com that have calculators you can use to determine to correct withdrawal amount. In addition, your TSP-issued Form 1099 will indicate that you took an early withdrawal and that no exception to the penalty applies. At tax time, you will have to file Form 5329 to clear that up, along with your Form 1040. Dan Jamison’s FERSGUIDE (subscription fee of $10) has excellent examples of all three calculations.
Generally, the annuitization or amortization method will give a larger payment amount, but the payment amount will not adjust based on either your age or your account balance; the payment amount will be exactly the same every month of every year during the withdrawal period. Following the IRS life-expectancy table will result in your payment being recalculated each year based on your age and account balance. Your payment should generally increase each year, based on the increasing allowable-withdrawal percentage each year and if the account earns a higher return than the percentage withdrawn. Life-expectancy withdrawal rates are general between 3%-4% between the ages of 50 and 60. If you’re like me (that is, not very good in math), you will be better off following the IRS life-expectancy table.
There’s a caveat for special-category employees (law enforcement officers, firefighters, air-traffic controllers, etc.). At the time this article was written (May 2015), legislation (H.R. 2146, 114th Congress) had just passed the House of Representatives that would exempt all special-category employees from the early-withdrawal penalty at age 50. If you’re a special-category employee and you’re reading this article after May of 2015, the rules may have changed. FedSmith would have run an article on the change if it occurred; use the search box at the top of the page to check.
- You will avoid the early-withdrawal penalty on money you take out of your TSP if you separate in the year in which you turn 55, and leave your funds at the TSP.
- If you separate before you reach the year in which you turn 55, you will avoid the early-withdrawal penalty on money you take out of your TSP if you follow a life-expectancy-based withdrawal.
- The TSP choice called Substantially Equal Monthly Payments Based on the IRS Life Expectancy Table, provides the least-confusion and the least hassle of all your options.