Tax Strategies When Taking TSP Withdrawals

Tax planning is important when withdrawing money from your TSP account, otherwise you may be paying more in taxes than you have to.

What Are Some Things to Consider Before You Withdraw Money from Your TSP Account?

If you are separated from government service and your age is at least 59 ½, you can begin withdrawing money from your TSP account without restrictions or penalties. Before withdrawing money, however, you need to consider the impact of those withdrawals on your tax liability and your Medicare premiums. To keep more money in your pocket, you should structure and time your TSP withdrawals to do two things:

  1. Minimize the taxes you pay. You should avoid withdrawing too much from your taxable TSP accounts in a tax year to prevent the withdrawals from placing you in a higher tax bracket (i.e. a higher percentage of your income will get paid to the government for taxes). 
  2. Minimize your Medicare premium (if you have Medicare). You should avoid withdrawing too much from your taxable TSP accounts in a tax year to prevent the withdrawals from increasing your Medicare premium. For 2024, your Medicare premium will start to increase if your modified adjusted gross income on your tax return is higher than $103,000 for single individuals and $206,000 for those married and filing a joint tax return. 

What Options Do You Have for Withdrawing Money from Your TSP Account?

If you are separated from government service and your age is at least 59 ½, you have several options for withdrawing money from your TSP account:

  1. Option 1 is to request a total distribution of your entire TSP balance. This will effectively close out your TSP account. 
  2. Option 2 is to purchase an annuity using part of all of your TSP balance through an outside annuity provider/vendor. You will then receive monthly payments for the rest of your life and the life of your joint annuitant if you choose a joint life annuity. This purchase cannot be changed or canceled and the money used to purchase the annuity will no longer be available in your TSP account. 
  3. Option 3 is to request a partial distribution of a specified amount (at least $1000). 
  4. Option 4 is to receive automatic withdrawals from your account on a monthly, quarterly, or annual basis. You still manage the investments in your TSP account and the automatic withdrawals can be changed or canceled. 

What Are the Best TSP Withdrawal Options?

Option 1 usually results in you owing more taxes than you need to pay. You should avoid this withdrawal method, if possible, unless you have a financial emergency or your TSP account balance is extremely small and the withdrawal won’t put you in a higher tax bracket.

Option 2 is seldom the most efficient withdrawal method. The rate of return on your annuity will almost always be lower than managing the investments yourself and you no longer have access to the funds. You also can’t time the withdrawals to minimize your tax and/or Medicare bill. An annuity might be appropriate in situations where you can’t or don’t want to manage your own money and you want a guaranteed monthly income to show up in your account each month. 

Option 3 and/or Option 4 are usually the most beneficial withdrawal methods because they give you options to reduce your tax and Medicare bills. For example, let’s look at a scenario with the following assumptions:

  • You are married, file a joint tax return, and receive automatic monthly withdrawals from your TSP.
  • Your taxable income for 2024 and 2025 is projected to be $74,300 in each year. 
  • In 2024 and 2025, married couples filing joint returns will have a 12% tax rate on income between $23,201 and $94,300 and 22% on income between $94,2301 and $201,050. 
  • You then decide you want to withdraw an additional $40,000 from your taxable TSP account in order to make a large purchase. 

If you withdraw the entire $40,000 in 2024, your federal tax bill on that withdrawal would be: ($20,000 * 12%) + ($20,000 * 22%) = $6800.

However, if you withdraw $20,000 in 2024 and the other $20,000 on 1 Jan 2025, your total federal tax bill would be: $40,000 * 12% = $4,800 ($2,400 paid in 2024 and $2,400 paid in 2025). By wisely timing the taxable withdrawals from your TSP, you would have $2,000 more in your pocket to spend!

The same principles would apply whenever your TSP taxable withdrawals would push your marginal income into a higher tax bracket. You may be able to spread your withdrawals across multiple tax years to reduce your overall tax bill.

Wisely timing your TSP withdrawals is also importable for Medicare. Your Medicare premiums will increase if your taxable income in a year is over $103,000 if single and $206,000 if married filing jointly. Once again, you should avoid that, if possible, by spreading the withdrawals across multiple tax years. 

Another tax-efficient withdrawal strategy involves using a qualified charitable distribution (QCD). If you are at RMD (required minimum distribution) age or over and you want to donate funds to a tax-deductible charity, you should consider using a QCD rather than donating money directly.

Let’s assume you want to donate $10,000 to a charity in 2024. The TSP doesn’t allow QCDs, so you would first need to roll over $10,000 from your TSP account to an IRA which is not a taxable event. You can then distribute the funds directly from your IRA to the charity using a QCD.

This distribution never shows up on your personal tax return and won’t increase your taxable income or taxes. If you don’t take advantage of a QCD, you would withdraw the funds from the TSP, donate the money to the charity, include the withdrawal in your taxable income for 2024, and then include the donation in your itemized deductions for 2024.

It may seem like there would be no impact on the amount of tax you pay in 2024 because your taxable income increased by $10,000 but your itemized deductions also increased by $10,000. In reality, that may not be true.

For example, the standard deduction for 2024 is $29,200 if you are married filing jointly. You would only itemize your deductions on your 2024 tax return if they add up to more than $29,200. Otherwise, you would take the standard deduction for 2024.

Most taxpayers do not have enough itemized deductions and end up taking the standard deduction. In this example, your $10,000 charitable contributions may not increase your itemized deductions above the standard deduction amount of $29,200, but you still have to include the $10,000 TSP withdrawal in your taxable income.

If your federal tax bracket is 22% and you don’t use a QCD, you will owe $2,200 more in federal taxes than if you use a QCD. In other words, using the QCD would allow you to keep $2,200 more in your pocket to spend!

As seen in the examples provided, you must consider how your TSP withdrawals will impact the taxes you owe and the amount you will pay for your Medicare premiums. How and when you withdraw money from your TSP can have a large impact on how much money you will keep in your pocket. Be wise and keep more to spend!

About the Author

Dallen Haws is a Financial Advisor who is dedicated to helping federal employees live their best life and plan an incredible retirement. He hosts a podcast and YouTube channel all about federal benefits and retirement. You can learn more about him at Haws Federal Advisors.