Edward A. Zurndorfer, Certified Financial Planner

Federal employees who retire from federal service before the year they become age 55 can make penalty-free withdrawals from their Thrift Savings Plan (TSP) accounts using one of two methods.

Those employees who may be eligible to retire before the year they become age 55 include: (1) air traffic controllers; (2) law enforcement officers; and (3) firefighters all of whom can retire at any age if they have 25 or more years of such service or at age 50 if they have at least 20 years of such service. There are employees in other job classifications with at least 25 years of federal service who can retire at any age if their agencies have been given permission to offer early retirement to eligible employees. Early retirement opportunities include Voluntary Separation Incentive Payment (VSIP) and Voluntary Early Retirement Authority (VERA).

Many employees who retire before age 55 may need to make TSP withdrawals in order to meet their income needs. The question frequently arises as to how these retirees can make withdrawals from their TSP accounts and not be subject to the IRS' 10 percent early withdrawal penalty. The answer is through one of two methods, namely:

1. by purchasing a TSP annuity; or
2. through payments based on life expectancy [Internal Revenue Code (IRC) Section 72(t)].

When a TSP participant retires from federal service, the participant can at any time purchase with all or part of his or her TSP account a fixed annuity offered by Metropolitan Life Insurance Company. Form TSP-70 is used to purchase a TSP annuity. With a TSP annuity, the TSP account owner is paid a monthly check for the life of the owner. The older the TSP account owner at the time of the annuity purchase, the higher the monthly payment.

There are different types of annuities and additional features from which to choose. Only TSP accounts of more than $3,500 are eligible for a TSP annuity. All TSP annuity payments are subject to federal, and in many states, state income taxes.

A word of caution for potential TSP annuity purchasers: if the lifetime annuity - which pays the maximum lifetime income - is chosen, then any funds remaining in the TSP annuity account at the time of the TSP annuity owner's death will be kept by Metropolitan Life Insurance Company.

The second method of making penalty-free pre-age 55 withdrawals from the TSP is through monthly payments based on life expectancy, as described in IRC Section 72(t). Form TSP-70 is used to request monthly payments based on life expectancy.  Under this method, the TSP owner's initial payment will be based on the owner's account balance shortly before the time of the first payment and the owner's life expectancy at the time of the first payment. The TSP will recalculate the amount of the TSP owner's monthly payments every year, based on the account balance at the end of the current year and the TSP owner's recomputed life expectancy during the next calendar year.

The following are the rules for the life expectancy withdrawal method: (1) there are no age restrictions - a TSP owner could be as young as age 18 and as old as 89 and start receiving payments based on life expectancy; (2) the payments will be recalculated each year based on the participant's account balance as of the previous December 31 and the participant's life expectancy (or over a joint life expectancy if there is a beneficiary); (3) payments must continue for the later of five years or age 59.5. If the participant discontinues payments before the payments are suppose to stop, then an early distribution tax penalty (10 percent) and interest charges will apply retroactively to all payments previously received.

The following is a step-by-step description of the life expectancy payment method:

Step 1.  Determine the life expectancy factor.

Those TSP participants who use single life expectancy will look up their ages each year from the table below. If a participant has a beneficiary; the joint life expectancy may be used to calculate the appropriate factor. The following link will bring up the table of joint life expectancy factors found in IRS Publication 590 (page 91): http://www.irs.gov/pub/irs-pdf/p590.pdf#page=91.

Step 2. Determine the account balance.

TSP participants must use their TSP account balance that is available. The IRS guidelines require that the account balance that is used to calculate the first year payments must be determined in a reasonable manner. According to the IRS, it is reasonable to use the account balance for any date "within a reasonable period before the first distribution". For example, if a participant wants to make a first distribution on Nov. 15, 2010, then the IRS guidelines state it would be reasonable to choose an account balance as of any day between Dec. 31, 2009 and Oct. 31, 2010.

Step 3. Divide the account balance by the factor determined in Step 1.

The result is the amount that must be distributed during the first year. For the second year, the TSP participant will follow a similar procedure, using the account balance as of December 31 of the first distribution year.

The following example illustrates:

Jessica, age 46, retires from federal service after 25 years as an air traffic controller (ATC). When she retired on Oct. 31, 2010, the value of Jessica's TSP account was $387,450.00. As of Dec. 31, 2009, the fair market value of Jessica's TSP account was $310,200. On Nov. 10, 2010, Jessica elects to start receiving TSP payments based on the life expectancy method. Her monthly payments will begin on Jan. 1, 2011. The following is a summary of what Jessica will receive.

Year 1 - 12 payments starting Jan. 1, 2011 and ending Dec. 31, 2011.

Jessica uses a single life expectancy factor from the life expectancy table above. Jessica will be 47 during the year she starts the monthly distribution from her TSP account. The single life expectancy for a 47 year old is 37.0 years.

Jessica's account balance as of Dec. 31, 2009 was $310,200.

Starting Jan. 1, 2011 and ending Dec. 31, 2011, Jessica will receive a total of $310,200/37.0 or $8,383.78, or $698.65 per month for 12 months.

Year 2 - Assume that Jessica's TSP account balance as of Dec. 31, 2010 will be $391,400. She follows these steps for computing her monthly payments starting Jan. 1, 2012 and ending Dec. 31, 2012:

Jessica becomes age 48 during 2012. Her life expectancy factor will be 36.0 as shown in the life expectancy table.

Her TSP account balance as of Dec. 31, 2010 is $391,400. Jessica's total distribution between Jan. 1, 2012 and Dec. 31, 2012 is $391,400/36.0 or $10,872.22 or $906.02 per month.

Subsequent annual/monthly payments will be computed in the same manner. Jessica must continue these payments until she is at least age 59.5.

Additional guidance on the method "payments based on life expectancy":

• Payments must continue for the later of five years or age 59.5. If payments stop for any reason, then all previously received payments will be subject retroactively to a 10 percent early withdrawal penalty and interest charges imposed by the IRS.

• Monthly payments made to the TSP account owner are subject to automatic 20 percent federal income tax withholding. TSP participants are responsible for paying any state income taxes due if they reside in a state that taxes TSP withdrawals.

• Each January following the year that the TSP account owner receives TSP monthly payments, the TSP will send the account owner Form 1099-R, Distribution from Pensions, Annuities and Retirement Plans. The 1099-R will show the gross and taxable distribution for the year as well as the amount of federal income taxes withheld. If the TSP account owner is younger than age 59.5, the 1099-R will be coded so that the taxable distribution will not be subject to an early withdrawal penalty. The taxable distribution will be reported as income on the TSP account owner's tax return as pension income.

Posted: 11/15/2010

About the Author

Edward A. Zurndorfer is a Certified Financial Planner, Registered Health Underwriter, Registered Employee Benefits Consultant and Enrolled Agent in Silver Spring, MD and the owner of EZ Accounting and Financial Services, an accounting, tax preparation and financial planning firm also located in Silver Spring, MD.  He is an instructor at federal employee retirement seminars throughout the country for the National Institute of Transition Planning, Inc. and writes numerous columns and books on federal employee benefits.

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