TSPs: The Good, the Bad, and the Confusing (Part 2)
by Carolyn T. Walder
There are a number of reasons why Federal employees who have saved into the Federal Thrift Savings Plan (TSP) should seriously consider rolling their balances to an IRA after they have retired or separated from service. LWPM’s previous blog on TSP covered the details of the withdrawal rules and the consequences of making partial withdrawals on your ending account balance due to the pro-rata rules. In this installment covers some of the other aspects to consider when deciding what action to take with respect to your TSP account.
As we have said before, there are few qualified retirement plans that rival the TSP for the average worker. The ability to dollar cost average through regular contributions into extremely low-cost funds that provide a decent level of diversification cannot be overstated. However, that is where it ends. After you retire or separate from service, the flexibility and management options are only available to those who roll their balances to their IRAs.
The ability to manage your retirement funds to take advantage of certain provisions in U.S. tax laws is just not available if you leave your balance in the TSP. For example:
No Ability to Make Qualified Charitable Distributions—Currently Congress has codified the ability for everyone who is required to take a minimum distribution (RMD) from their IRA to instead direct that distribution (in whole or in part) to a qualified 501(C)(3) charitable organization (termed a “QCD”). The beauty of making a QCD is that it reduces the amount of ordinary income that a participant would have to recognize for income tax purposes. This is much better than taking a taxable distribution and then donating the after-tax money to charity because it reduces your adjusted gross income (AGI) rather than just your tax liability (as a charitable deduction does). Reducing your AGI might just save you higher Medicare premiums, particularly if you are close to one of the thresholds. Reducing your AGI is also more powerful as it is used to determine all kinds of benefits, from college tax credits to determining your personal exemption amount(s).
No Option to Stretch Distributions for a Non-Spouse Beneficiary Upon Death—Leaving a TSP account (as opposed to an IRA) to a non-spouse beneficiary sets up another can of worms. If the participant dies and a non-spouse person or a non-person (such as a trust) is named as the beneficiary on the TSP-3, then the TSP will cut a check for the full balance of the account less 20% withheld for taxes to the named beneficiary(ies). Only a spouse has the ability to roll the account over to their IRA. If the money had previously been rolled to an IRA, the beneficiaries would have the option of stretching the distributions over their remaining life expectancy, saving considerably on taxes, particularly if there was a large account balance.
Forced Withdrawals from a Roth TSP—If you have any TSP balances in the Roth TSP option, beware: ANY distributions will be taken pro rata from each account (both Roth and traditional). From the TSP website: “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.” Why is this a concern? The IRS does not require you withdraw from a Roth account … ever! You may wish to keep those funds in an account earning tax-free growth, but you are not allowed if you are making TSP withdrawals (either as an annuity or a series of periodic payments). Furthermore, members of the uniformed services who have made tax-exempt contributions could roll those contributions to a Roth IRA. Those in the military who have made contributions to their TSP while in a combat zone are allowed to make additional tax-exempt contributions into the TSP. If a participant chooses to later roll these contributions to an IRA, he or she may roll the tax-exempt contribution to a Roth IRA and the earnings into a traditional IRA.
However, if you choose to leave the money in the TSP and decide to take a partial distribution, be aware that you cannot “pick and choose” the source of the money. From the TSP website: “Withdrawals from a uniformed services account will be made pro rata (i.e., proportionally) from taxable and nontaxable amounts.” Therefore, you forgo some of the tax-free compounding of the tax-exempt portion that could have been rolled to a Roth IRA. While these funds are not taxed at the time of withdrawal from the TSP, this action negates a powerful strategy of rolling these contributions to a Roth IRA, potentially adding significantly to any Roth IRA balances growing tax-free!
Lastly, if you are in RMD status, you are required to consider all balances when calculating your RMD. This will force you to take a larger RMD than actually would be required if those same funds were in an IRA and a Roth IRA. For example, consider the situation where you have $100,000 in a Roth TSP and $100,000 in a traditional TSP. The combined balance would be $200,000, and in your first year of required distributions, you would have to take an RMD of approximately $7,812. Although only half ($3,906) would be taxed, you still would be forced to take $3,905 from your Roth IRA that you would NOT have to take had it been rolled into a Roth IRA! Remember, you never have to withdraw from a Roth IRA and you do NOT need to take RMDs from a Roth IRA.
Inability to Do a Roth IRA Conversion—When you have funds in the TSP, you are earning tax-deferred growth in these accounts. However, when you ultimately have to withdraw them (and you will have to start when you turn 70½ unless you are still working for the government), you will pay ordinary income taxes on the full distribution which represents a combination of your contributions plus the growth in the account. If you want to reduce your future required distributions by converting some of your TSP balances to Roth TSP balances, you can’t. You can start contributing to the Roth option if you are still working, but you cannot make any conversions. Of course, if these funds were rolled into a traditional IRA, you could make partial or full account conversions at any time. This may be a useful planning strategy, particularly if you end up with a year of less taxable income, or a year in which you have particularly high deductions. You cannot take advantage of this if you retain your funds in the TSP.
Lastly, but most importantly, you could potentially forfeit your TSP account! Many folks move after they have retired and sometimes they have made multiple moves by the time they are 70½ and must start taking distributions from their TSP. However, you must notify the TSP directly of address changes or they will be unable to get your RMD paperwork to you to sign. You will need to complete Form TSP-9, “Change in Address for a Separated Participant.” If you do not properly notify the TSP and they are unable to send the forms to you, you will forfeit your account! From the TSP website: “If you do not begin withdrawing your account by the required deadline, your account balance will be forfeited to the TSP. You can reclaim it; however, you will not receive earnings on it from the time it was forfeited.” For more information, go to https://www.tsp.gov/PlanParticipation/LoansAndWithdrawals/withdrawals/in....
These are just some of the issues to consider if your intent is to leave your account in the TSP after you retire or separate from service. As you can see, there are many factors and traps to be aware of, as well as opportunities that you will be unable to take advantage of. Lifetime Wealth strongly encourages everyone to consider the factors covered in the two blog posts on TSPs when making this important decision. You worked hard to save this money … we want you to be able to have full control and enjoy your golden years! As always, if you have any questions on the TSP in particular or Federal benefits in general, please contact us at Lifetime Wealth Planning and Management and we will be happy to answer your questions!