Understanding TSP Withdrawal Options - Part II: Rollover to an IRA
After leaving or retiring from federal service, Thrift Savings Plan (TSP) participants should know their options with respect to what they can do with their TSP accounts.
In a second part of a series of columns discussing withdrawal options from a participant's Thrift Savings Plan account, this column discusses the option of doing a one time rollover or transfer of a portion or all of one's TSP account to a traditional IRA or to a Roth IRA.
As noted in a previous column, a TSP participant is permitted to make a one-time partial withdrawal of at least $1,000 from his or her TSP account. If the partial withdrawal is paid directly to the TSP participant, then federal income taxes (20 percent of the gross distribution) will be deducted from the distribution.
A direct transfer or rollover from the TSP to either a traditional IRA or to a Roth IRA is considered to be an "eligible rollover distribution". As such, a direct ("trustee to trustee") transfer of TSP funds from the TSP account to a traditional IRA is not subject to income tax until the funds are withdrawn from the IRA. On the other hand, because a Roth IRA accepts only after-tax dollars, the TSP participant must pay taxes on the funds transferred to a Roth IRA for the year of the transfer.
The following is a general summary of the tax treatment of a one-time rollover or transfer by a TSP participant from the TSP to either a traditional IRA or to a Roth IRA. Note that this one-time rollover or transfer may be performed anytime after leaving or retiring from federal service.
• If the TSP participant elects to do a direct transfer of all or part of the "eligible rollover distribution" to some type of IRA, then: (1) the transfer to a traditional IRA will not be taxed in the current year and no federal income tax will be withheld; and (2) the amount transferred to a Roth IRA will be taxed in the current year. No income tax will be withheld by the TSP at the time of the transfer from the participant's TSP account to a Roth IRA. Since no income tax will be withheld by the TSP, the TSP participant who elects the option of transferring part or all of a TSP account to a Roth IRA will most likely have to pay estimated federal taxes. If the participant lives in a state with an income tax, no state income taxes will be withheld and estimated state income taxes will most likely have to be paid.
• If the TSP sends an "eligible rollover distribution" directly to the TSP participant and the participant elects within 60 days to complete a rollover to a traditional or to a Roth IRA, then the participant will receive only 80 percent of the taxable amount of the payment because in this situation the TSP is required to withhold 20 percent for federal income taxes. Note that the TSP participant will have up to 60 days to complete the rollover to a traditional IRA. The rollover amount includes the 80 percent received and the 20 percent in federal income tax withheld. If any part of the "eligible rollover distribution" is not rolled over within 60 days, then the TSP participant will pay federal and state income taxes on the amounts not rolled over. Any amount transferred to a Roth IRA is subject to federal and state income taxes. Since the TSP automatically withholds 20 percent in federal income taxes in the case of a rollover, the TSP participant is responsible for paying any additional federal taxes due as well as any state income taxes due resulting from the transfer to a Roth IRA.
Besides the income tax consequences of a rolling over or transferring one's TSP account to a traditional IRA or to a Roth IRA, there are other issues to be considered. These issues include the cost consequences and the protection of keeping one's money in the TSP versus rolling over or transferring the monies out to a self-directed IRA.
According to the industry research firm Financial Research Corporation, during 2011 some $350 billion will be rolled over from defined contribution plans (like the TSP and 401(k) retirement plans) into IRAs. That amount is expected to rise more than $20 billion a year for the next few years.
Financial service industry firms who manage these IRAs -- these firms include major brokerages and private investment firms -- are looking forward to capturing these rollover accounts. They envision major sources of income in the form of commissions and fees when these defined contribution plans are rolled into IRAs managed by these firms. Many of these brokerages and investment firms know about TSP accounts belonging to retiring or departing federal employees. Some firms are sending letters or calling federal employees as they leave their jobs or retire.
But retiring and departing federal employees need to proceed with caution in accepting these invitations or offers to rollover their TSP accounts into IRAs that are managed by these financial service industry firms. While for some individuals it may make sense for convenience reasons to consolidate all of one's retirement accounts including a TSP account, a previous employer's retirement account such as a 401(k) or 403(b) plan, or a SEP IRA into one traditional IRA, one needs to consider the costs in making this move.
Another possible reason for rolling over retirement accounts to IRAs is when the retirement accounts owner needs additional help in managing his or her retirement accounts. Nevertheless, all retirement account owners need to careful before giving up total control of their accounts.
The following are some things that financial firms and advisors who send letters and who make phone calls to TSP account owners and other retirement account owners should tell -- but may not tell -- TSP and other retirement account owners:
• Typically, the individuals who send these letters and make phone calls to retirement account owners are "sale representatives" and licensed stockbrokers. But unlike registered investment advisers (RIAs) who act as "fiduciaries" and who must put their clients' best interests first, the sales representatives and licensed stockbrokers must offer investments that are suitable to their clients. Unfortunately, suitable can cover a wide range of less than "ideal" products.
• Most sales representatives and licensed brokers who desire to rollover retirement accounts like to TSP into traditional IRAs or Roth IRA investments work on commission. The more they rollover or transfer, the more commission they earn. Expenses associated with many investments associated with an IRA can be larger than the expenses that are associated with a retirement account. For example, the TSP assesses no commissions to TSP participants, either when they contribute to the TSP or when they withdraw monies from the TSP. Also, since there are five funds associated with the TSP - three stock index and two bond index funds - the internal expenses associated with the TSP are extremely low. The same cannot necessarily be said of many open-ended funds that many sales representatives are pushing.
• In one sense a retirement account like the TSP offers more federal "protection" than an IRA. For example, federal law protects workplace retirement plans like the TSP from creditors in bankruptcy proceedings. It also keeps creditors from tapping into the TSP for lawsuit judgments or for other debts. The same cannot necessarily be said about IRAs. This is because state law and not federal law will determine if an individual's IRA will be protected from bankruptcy proceedings, lawsuits or other debt proceedings. Some states do offer creditor protection, others do not.
• While a rollover or transfer to a brokerage company or to an investment firm may offer more investment choices such as stocks, bonds, closed-ended and open-ended funds, and exchange-traded funds, the more investment choices, the more in potential transactions fees and /or commissions. These fees and commissions can have a definite effect on how much a TSP participant will be able to earn and keep throughout his or her retirement years.
Give the tax consequences, potential transaction fees, possible less than suitable and higher cost investment choices and "protection" issues outside the TSP, TSP participants are strongly advised to proceed with caution should they decide to rollover all or part of their TSP accounts to either a traditional or a Roth IRA.
If a TSP participant elects to make a one-time rollover or transfer to a traditional IRA or to a Roth IRA, then form TSP-77 (downloadable from http://www.tsp.gov) must be completed and submitted. Part IV on form TSP-77 is used to request the rollover or transfer. Identical to a request for a direct payment to the TSP participant, in order for a married TSP participant to request a rollover or transfer to an IRA, for a CSRS-covered employee the participant's spouse must be notified and for a FERS employee the participant's spouse must be notified and sign a consent (which must be notarized) a request for a rollover or transfer.
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 and writes numerous columns and books on federal employee benefits.