Potential Drawbacks to the TSP

January 22, 2020 1:09 PM , Updated March 26, 2020 6:31 PM
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A lot has changed with the Thrift Savings Plan lately. Continued improvements from the TSP Modernization Act include a whole new suite of withdrawal options from what once was a very limited offering. 

Highlights to the changes focus on enhanced flexibility and choice for withdrawal. There are now more options available for how and when you can access your TSP account, to include: 

  • After separation from service, you can take multiple post-separation partial withdrawals.
  • If 59.5 or older and still working in federal service, you may take up to 4 in-service withdrawals each year.
  • You can now choose the balance of your withdrawal from between traditional, Roth or a proportional mix of the two. 
  • You no longer need to make a full withdrawal election after turning 70.5 and being separated from federal service. You will still need to receive required minimum distributions. 
  • You can now take monthly, quarterly, or annual payments. 
  • You can stop, start or make changes to your installments at any time.

There is a lot of good here, they are providing participants with the need for income the ability to continue in the plan rather than make rigid choices. We all know that is important with all the changes that life brings along the way.

While the TSP is a nice employer sponsored retirement plan and it offers low administrative costs, there are considerations for change and items to be aware of. 

One of particular note is the beneficiary rules and what happens to your account when you pass on.

Under TSP rules, a surviving spouse is the only participant that may continue with a TSP spousal beneficiary account. However, upon passing of the second spouse, their account must be distributed in full to the named beneficiary of the spouse’s account. That means there is no option for the surviving spouse’s beneficiary to continue with a TSP account or to move the funds into an IRA account. The impact of this is potentially a massive tax bill. 

For instance, your spouse inherits your TSP and decides to continue with a TSP spousal beneficiary account.

At the time of your spouse’s passing, let’s assume the account was worth $2M and your spouse has named your children as beneficiaries. Instead of your 2 surviving children being able to continue with the TSP or move the assets to an IRA account, they must each take their half of the proceeds, equal to $1M, as a full distribution from the plan. This creates $1M in taxable income for each to pay their share on rather than being able to ‘stretch’ the tax-deferral into the future and only take a much smaller required minimum distribution (RMD) amount.

By contrast, a surviving spouse may inherit and move the TSP to their own IRA (or a beneficiary IRA) thus allowing the secondary beneficiaries to retain tax-deferral and stretch the account forward for an extended period of time with distributions based on RMD rules.  

Another consideration is the ability to effectively generate income.

As mentioned, the TSP is a nice plan, but it only carries 5 underlying investment funds, and only 2 of those are fixed income or bond investments designed to be more conservative and potentially generate income. Producing retirement income from investments can be tricky, and having access to a larger set of solutions may be able to help.

Additionally, in the case you are post-separation or still working and over the age of 59.5, the new partial withdrawal options give you the flexibility to try out a new strategy and delegate management responsibility to a professional without having to go “all-in”.

It’s true that many federal employees are approached by sales people to move their TSP funds to annuities, insurance products and higher risk investment strategies. This is why I can’t stress the importance enough of working with a CFP® professional or investment adviser who is subject to a fiduciary standard and will work in your best interest. 

We know many federal employees are knowledgeable and comfortable making big financial decisions. Even in the case that you are, working with a competent financial advisor can help plan for these types of situations as well as providing the benefit of assigning and delegating responsibilities and working together on your financial plan. 

What are you goals for retirement and your TSP and how do you plan to pursue them? If you would like to discuss your plan, I welcome you to reach out. 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice must be obtained on your own separate from this educational material.

“Stretch IRA” is a marketing term implying the ability of a beneficiary of a decedent’s IRA to withdraw the least amount of money at the latest allowable time in order to maintain the inherited IRA assets for the longest time period possible. Beneficiary distribution options depend on a number of factors such as the type and age of the beneficiary, the relationship of the beneficiary to the decedent and the age of the decedent at death and may result in the inability to “stretch” a decedent’s IRA. Illustration values will greatly depend on the assumptions used which may not be predictable such as future tax laws, IRS rules, inflation and constant rates of return. Costs including custodial fees may be incurred on a specified frequency while the account remains open.

This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.

© 2020 Justin Holtz. All rights reserved. This article may not be reproduced without express written consent from Justin Holtz.

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About the Author

Justin Holtz CFP® is a financial advisor with 18 years of experience and is the managing director at District Financial Advisors. He is passionate about helping federal employees reach their financial goals.

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