When a federal employee retires from federal service, the retired employee has several options to withdrawing their Thrift Savings Plan (TSP) accounts. This is the second of four columns discussing TSP withdrawal options for retired TSP participants. The first column discussed the partial TSP distribution option. This column presents the total distribution option.
Immediately upon retiring from federal service, a TSP participant can request a total distribution of his or her traditional TSP account and/or Roth TSP account. In order to avoid the IRS’ 10 percent early withdrawal penalty, the retired TSP participant would have to retire from federal service sometime during the year, or after the year, the TSP participant becomes age 55 for withdrawing the traditional TSP account distribution, and at least age 59.5 for withdrawing the Roth TSP distribution. Note that Special Provisions Employees – Federal Law Enforcement Officers, Firefighters, Air Traffic Controllers, and Customs Border and Patrol Officers – can make penalty-free traditional TSP withdrawals at any age with a minimum 25 years of service as a Special Provision Employee. If they retire as a Special Provision Employee with between 20 and 25 years of service, they can retire at age 50 and make a penalty-free total distribution of their traditional TSP account.
Income Tax Consequences of a Total Distribution of the Traditional TSP Account
A total distribution of a traditional TSP account is fully taxable. The distribution will be included in the TSP participant’s taxable income in the year of receipt. For most traditional TSP participants with traditional TSP accounts valued more than $500,000, a total distribution will likely result in a huge federal income tax liability. Added to the traditional TSP participant’s other taxable income in the same year of the total traditional TSP account distribution, the likely result is that the traditional TSP participant will be pushed into the highest federal marginal tax bracket of 37 percent. If the traditional TSP participant lives in a state with a state income tax, in which the state income tax marginal tax rate can range from 5 to 10 percent, it is possible that as much as 43 to 50 percent of the TSP participant’s traditional TSP total distribution will be diminished due to federal and state income taxes.
Income Tax Consequences of a Total Distribution of the Roth TSP Account
Assuming a Roth TSP participant is age 59.5 or older, and it has been at least five years since January 1 of the year that the Roth TSP participant made his or her first Roth TSP contribution (the Roth TSP has been in existence sing 2012), a total distribution of a Roth TSP account is fully income tax-free. However, once a Roth TSP account is fully distributed, the account will no longer grow in value, and the years of tax-free compounded growth will cease.
It should also be noted that effective January 1, 2024, a Roth TSP account is not included in the calculation of the TSP participant’s annual required minimum distribution (RMD). This means that a Roth TSP participant never has to withdraw any portion of his or her Roth TSP account. However, in the event the Roth TSP participant needs to withdraw a small portion of the account, the withdrawal will be tax-free.
A Roth TSP account can be advantageous to a retired TSP participant in several ways, one of which is using the account as a way of paying for future long-term care costs. Suppose a federal employee is retiring at age 62 and currently has a Roth TSP account worth $250,000. The federal retiree has not purchased long-term care insurance. Once retired, the Roth TSP participant does not withdraw from the Roth TSP account. Assuming the Roth TSP account is growing in value at an average investment rate of 6 percent per year (past returns are no guarantee of future performance), in 20 years when the federal retiree is age 62 the value of the federal retiree’s Roth TSP account will be equal to $782,655. If the retiree has to go into a nursing home (costing on average anywhere from $150,000 to $200,000 per year depending on location) because of long term care needs, the retiree can withdraw from his or her Roth TSP account tax-free in order to pay for three to four years’ worth of nursing home care.
Direct Rollover of a TSP Account to an IRA
A retired TSP participant also has the option of a direct rollover of the TSP participant’s entire TSP account to a self-directed IRA. The traditional TSP may be directly rolled over to a traditional IRA, and the Roth TSP may be directly rolled over to a Roth IRA. The traditional TSP may not be rolled to a Roth IRA, nor can the Roth TSP be directly rolled over to a traditional IRA.
What are the advantages and disadvantages of a direct rollover of a TSP participant’s traditional TSP account to a traditional IRA? The advantages:
(1) More flexible withdrawal options from a traditional IRA;
(2) More investment options associated with a self-directed IRA ; and
(3) Opportunities to minimize required minimum distributions (RMDs) when the TSP participant reaches his or her required beginning date (currently age 73).
These opportunities include making qualified charitable distributions (QCDs) or purchasing a Qualified Longevity Annuity Contract (QLAC) using traditional IRA funds. The disadvantages include: (1) The higher investment expenses associated with many IRA investment options including open-ended (mutual) funds; (2) In order to make withdrawals from the rollover traditional IRA the former TSP participant (and traditional owner) has to be at least age 59.5, whereas a retired TSP participant can make penalty-free from the traditional TSP if the TSP participant retires from federal service sometime during or after the year the TSP participant becomes age 55.
The other disadvantage of a direct rollover of 100 percent TSP participant’s traditional TSP account to a traditional IRA (and the same disadvantage applies to a direct rollover of a TSP participant’s Roth TSP account to a Roth IRA) is that in the event the IRA owner (the former TSP participant) is not satisfied with the investment performance of the IRA, or is not happy paying the high fees associated with the IRA, and does not wish directly rollover the IRA to another IRA but instead perform a direct rollover back to the TSP, then this direct rollover is not allowed. This is because once the entire TSP account has been withdrawn or rolled over, the TSP participant’s accounts are closed.
For that reason, TSP participants who want to directly rollover their TSP accounts are advised to keep a minimum $3,500 in their TSP accounts (applies to both the traditional TSP and to the Roth TSP). By keeping the $3,500 minimum in their TSP accounts, the TSP participant’s account will remain open, thereby allowing the TSP participant to directly rollover any traditional IRAs and (perhaps any traditional 401(k) or other traditional qualified retirement plan accounts the TSP participant owns) to the traditional TSP account. Any Roth qualified retirement accounts (such as Roth 401(k) , Roth 403(b), and Roth 457 retirement plans) can directly be rolled over to a Roth TSP account, assuming there is a minimum $3,500 in the Roth TSP account.