TSPs: The Good, the Bad, and the Confusing
by Carolyn T. Walder
This blog is the first of two that addresses aspects of the Federal Thrift Savings Plan (TSP) for federal employees. Although it is a wonderful retirement plan that allows millions of Federal employees to save for retirement, the TSP has rules and limitations that are important to be aware of when deciding how to tap into this retirement plan when a participant desires (or is required) to withdraw the funds.
There are few retirement plans available that can match the Federal Thrift Savings Plan (TSP) for its extremely low fees and decent lineup of globally diversified index funds. If you are a Federal employee or a member of the military, you have the ability to take advantage of this great retirement plan. During your working career, saving into the TSP and receiving the government match (for Federal Employees Retirement System [FERS] employees) is a “no-brainer,” as you are building retirement savings in a tax-efficient, very low-cost manner. You have the option of saving into the traditional TSP, where you get the upfront reduction in income allowing you to save on your Federal and State income taxes. You also now have the option of saving into a “Roth TSP.” The Roth TSP does not give you a current tax deduction, but it does allow all contributions to grow tax-free, such that your earnings (and contributions) can be withdrawn in the future with no tax consequences.
However, after you have retired and either want to start using some of these savings or are forced to withdraw them as part of a Required Minimum Distribution (RMD) at age 70½, the story changes quite dramatically. Consider the following areas closely if you are planning to keep your funds in the TSP after retirement.
Withdrawal Limitations – Although most participants do not realize this, you have only two options to withdraw money from the TSP: (1) a one-time-only partial withdrawal using form TSP-77 and (2) a full account withdrawal using TSP Form TSP-70. That’s it. However, you do have several ways to take your full account withdrawal. You can (1) purchase an annuity through MetLife and receive monthly checks for life, (2) take a monthly withdrawal based on a specific dollar amount that you set OR based on a calculation of your life expectancy, or (3) take a full lump sum withdrawal that can be distributed to you in cash (minus the 20% mandatory federal withholding) or rolled over to an IRA or other qualified plan that accepts rollovers. If you wish to leave your money in the TSP and only take out money occasionally for specific reasons (for example, to purchase a car or put a downpayment on a vacation home), you will have to rethink your plans. If you happen to need to withdraw money more than once, you will be forced to withdraw your entire account balance. However, if you roll that balance to an IRA or another qualified plan, you will be able to defer the tax bill until you ultimately withdraw the money. You also need to consider if you have chosen to take your account balance in monthly installments and then suddenly need to access your TSP for large expenses (medical bills, for example), you will need to take the remaining balance of your TSP as a lump sum OR change your monthly allotment to cover the increased expenses. However, the allotment change comes with a very significant caveat: You can only file for a monthly allotment change once per year, and you can only file this request from October 1 through December 15. You CANNOT file the form early. Furthermore, the request for an increase (or decrease) in the monthly amount becomes effective in January of the following year! Therefore, this option is fraught with challenges, particularly if you need the extra money and it is early in the year! If that is the case, then a full account withdrawal is your only option. We would stress that you have a plan before going into retirement as to how you will use your TSP account to make the most informed decision regarding your withdrawal options. If you think you may need to make multiple withdrawals. then plan ahead to roll your balance over to an IRA which will allow you much more control and flexibility.
Proportional Withdrawals – However, the most significant issue from a financial advisor’s perspective is the way in which your withdrawals are processed. Most TSP participants have some allocation to the “C”, “S”, “I”, or “L” funds. These funds are either all equity (the “C”, “S”, and “I” funds), all bonds (the “G” fund and the “F” fund), or a combination of stocks and bonds (the “L” funds). When making a withdrawal from your TSP account, either as a partial withdrawal or a series of monthly withdrawals, the funds come from each investment on a pro-rata basis, meaning that they are withdrawn in proportion to the amount of the investment in a particular fund. In addition, the funds are withdrawn proportionally from your traditional TSP and your Roth TSP (if you have one). The language from the TSP website is:
“Proportional Distributions - Withdrawals are paid proportionally from your traditional and Roth balances, and from each TSP fund in which you have investments. If you are a uniformed services member with tax-exempt contributions in your traditional balance, your withdrawal will contain a proportional amount of tax-exempt contributions as well.”
What is the issue with that? This withdrawal strategy may be the single biggest hazard to your wealth and the longevity of your account, and here is why: Consider a scenario where you have 50% invested in the “C” fund which invests in stocks making up the S&P 500 index. You have another 50% invested in the “G” fund. The “G” fund is a short-term “bond” fund that earns interest from the federal treasury as scheduled and announced. If you were to take a partial withdrawal of say $10,000, then $5,000 would come from the “C” fund and $5,000 would come from the “G” fund. However, what if the market was doing very poorly, such as the periods 2000-2002 and 2008-2009, or any of the other historical periods where the S&P 500 was performing poorly? In this case, you would be forced to sell $5,000 from stocks that you would otherwise NOT want to sell. Remember, these represent shares of the fund, so when the share price goes down, you need to sell more shares of the fund to make up that $5,000. Those additional fund shares that you had to sell because the price was down will not be available to recover in balance when the share price goes back up. This is called “reverse dollar cost averaging,” and if you are familiar with the benefits of dollar cost averaging, you can imagine that reverse dollar cost averaging is very bad for your account balance! What you want to be able to do is sell only the G fund and take the $10,000 from this fund. Currently, this option is not available, and from conversations with TSP personnel, that level of flexibility is not planned to be offered in the future. In fact, the TSP Board has this warning on its website:
“Be advised that while your withdrawal request is being processed, the money you have invested in any of the TSP's stock or bond funds is subject to fluctuation due to changes in market prices and interest rates. If you want to completely eliminate your exposure to risk of loss, you can request an interfund transfer to invest your account in the Government Securities Investment (G) Fund.”
We would strongly encourage a participant to review this option closely, because if the market is already down at the time of your transaction, then moving everything into the G fund at that point is too late and you WILL lock in your losses after your withdrawal request is processed! Contrast that with the flexibility you would have if your money is invested in an IRA: you are free to take as much as you want, when you want, and from whatever investment you want! That is true freedom, and it is difficult to put a dollar value on that!
If you have any questions on the TSP or Federal benefits in general, please contact us at Lifetime Wealth Planning and Management, and we will be happy to answer your questions!