Lately I’ve been fielding questions from individuals who have both Roth and Traditional balances in their Thrift Savings Plan and who plan or retiring and withdrawing from their TSP accounts before they reach the age of 59 ½.
There is a tax trap in the TSP that can result in those people paying tax on their Roth TSP earnings. I’ve decided that it’s time to recycle an article that I wrote four years ago about this Roth tax trap. I made a few changes, but this is pretty much the same article that was originally posted on FedSmith back in August of 2013.
Could funds in your Roth TSP be taxed when you withdraw them? The answer is “yes, if you are not careful.”
Consider the following which is taken directly from the TSP publication Withdrawing Your TSP Account After Leaving Federal Service. “If you have both a traditional (non-Roth) and a Roth balance in your TSP account, any withdrawals you make will be paid proportionally from each balance”. The bold typeface was included in the TSP booklet.
This means that you could have federal income tax to pay on withdrawals from your Roth balance if you have had the account open for less than five years and/or are under the age of 59 ½ at the time of the withdrawal. For example:
Benny is a FERS employee who is eligible to retire at his minimum retirement age (MRA) of 56. He has had a Roth balance in his TSP for five years. The Roth balance represents 20% of his total TSP balance.
Benny elects to begin receiving monthly payments from the TSP shortly after his retirement. The 80% of his payments that is considered to be from the traditional TSP balance is fully taxable. Regarding the portion of his payments that is from the Roth balance, the part that is considered as coming from his contributions is not taxable, but the part that is considered as coming from the growth of his contributions will be subject to federal income tax at his rate for ordinary income. Benny will continue to pay federal income tax on the part of his Roth withdrawals that are due to the growth of his contributions until he reaches the age of 59 ½.
Conversely, Lenny is not retiring until he is age 60, but he has not had a Roth balance in his TSP for five years. He will be paying tax on the part of his payments that are considered as coming from the growth of his Roth contributions until he has had the Roth balance for at least five years.
To recap, when withdrawing money from the TSP:
- If you’re under 59 ½ when taking payments from a Roth TSP – you pay taxes on the growth.
- If you haven’t had the Roth TSP open for at least five years – you pay taxes on the growth.
- If you are both age 59 ½ or older and have had the Roth TSP open for at least five years – the growth is tax free.
Any federal employee who has a Roth balance in their TSP and is planning to retire and begin withdrawals from the TSP either before they reach the age of 59 ½ or before they have had the Roth balance for at least five years needs to be aware of the requirement that withdrawals be made proportionally from both Roth and Traditional balances, and will want to take steps to avoid having to pay unnecessary taxes. (Tax avoidance is perfectly legal; it’s tax evasion that’ll get you in trouble.) What can they do?
They can wait to take money from the TSP until they are 59 ½ and the Roth balance has been open for at least five years; then there will be no taxes on the Roth portion.
They can also roll-over or transfer their TSP to an IRA. The following also appears in a discussion of single or partial withdrawals in the TSP publication Withdrawing Your TSP Account After Leaving Federal Service. “If you have both traditional (non-Roth) and Roth balances in your TSP account, you can direct all or a part of the traditional (non-Roth) portion to one IRA or plan, and all or part of the Roth portion of the payment to either another IRA or plan or to the same IRA or plan…” This allows an individual to separate their Roth and Traditional TSP balances into separate IRAs that can be withdrawn from separately and allows them to leave the Roth account alone until it is entirely tax free.
However, there is a problem with this strategy too. Once money is transferred into a Traditional IRA (remember, even transfers must be proportional), you will be governed by IRA rules which provide for a 10% early withdrawal penalty for anything you take from a Traditional IRA before the age of 59 ½.
If I were a federal employee who was planning on retiring and taking money from my TSP before 59 ½, I would avoid the Roth TSP like the plague.