Using the TSP to Fund a Roth IRA

This is the fifth of a series of columns discussing withdrawal options for separated Thrift Savings Plan (TSP) participants. Separated TSP participants include civilian federal employees and members of the Uniformed Services who have retired or left federal service or the Uniformed Services, respectively.

Also included in this category of separated TSP participant is a beneficiary participant who is a spousal beneficiary of a deceased federal employee or a Uniformed Service TSP participant and who established a TSP account in his or her name.

SEE ALSO:

• TSP Fixed Payment Option (Part 1)
• TSP Withdrawal Payments Based on Life Expectancy (Part 2)
• TSP Annuity (Part 3)
• Understanding TSP Rollover Rules (Part 4)

This column discusses how a TSP account can be used to fund a Roth IRA. Specifically, the tax-free direct rollover of a portion of a traditional TSP account to a traditional IRA, which in turn is converted to a Roth IRA (a taxable event).

Also discussed is the tax-free direct rollover of a portion of a Roth TSP account to a Roth IRA, thereby funding a Roth IRA with no limitations. The tax problem associated with the TSP’s direct rollover of a traditional TSP account to a Roth IRA is discussed together with what TSP participants are advised to do to avoid this tax problem.

Some Background Information

Before 2010, the Internal Revenue Code (IRC) limited the opportunity to convert a traditional individual retirement account (IRA) into a Roth IRA to individuals whose annual adjusted gross income (AGI) was less than $100,000.

In addition, the IRC prevented all individuals with a married filing separately tax filing status from electing a Roth IRA conversion, regardless of their income levels. In 2006, Congress enacted the Tax Increases Prevention and Reconciliation Act (TIPRA) which prospectively repealed (effective January 1, 2010) both the $100,000 AGI limit for Roth IRA conversions and the Roth IRA conversion restriction applicable to individuals who file their income tax returns as married filing separately. TIPRA’s passage therefore did away with any restrictions for converting traditional retirement accounts to Roth IRAs.

Types of Retirement Accounts Eligible for Conversion

Any individual – no matter his or her age, income level and tax filing status- may elect to perform a Roth IRA conversion of a traditional IRA to a Roth IRA.

Also, any individual may elect to perform an eligible rollover distribution of a qualified retirement plan [as defined in IRC 402(c)(B)] to a Roth IRA. Retirement plans eligible for a direct rollover to a Roth IRA include the TSP for federal employees.

Both the traditional TSP (in which contributions are deducted from an employee’s gross salary) and the Roth TSP (in which contributions are deducted from an employee’s after-taxed salary) can be directly rolled over.

Any TSP distributions to a separated TSP participant are eligible for rollover except:

(1) Required minimum distributions (RMDs) starting at age 70.5, 72, 73 or 75 (the age depends in which year the separated TSP participant was born);

(2) distributions paid at least annually over the TSP participant’s life expectancy;

(3) distributions made as installment payments that are expected to last for at least 10 years; and

(4) return of excess contributions or deferrals.

Note that the TSP must report all eligible rollover distributions from the TSP to an IRA on IRS Form 1099-R (see below for sample 1099-R). These rollover distributions include rollovers from the traditional TSP to a Roth IRA, and from the Roth TSP to a Roth IRA. Note three boxes in Form 1099-R:

(1) Box 1 – Gross distribution;
(2) Box 2a – Taxable amount; and
(3) Box 7 – Distribution code(s).

When a federal employee over age 59.5 or a federal retiree requests a direct rollover of TSP funds either from his or her traditional TSP account or from his or her Roth TSP account,

Box 1 in Form 1099-R will show the gross amount of TSP funds being transferred. What appears in Box 2a in Form 1099-R depends on whether the direct rollover of TSP funds is to a traditional IRA or to a Roth IRA. With a direct rollover of a traditional TSP account to a traditional IRA, the TSP will mail a check to the traditional IRA custodian for the full amount of the rollover.

The amount shown in Box 2a in Form 1099-R will be $0. Also, in Box 7 in Form 1099-R (Distribution code) will be a “G” (see above for explanation of codes). A Code G means a direct rollover of a distribution to a qualified plan, a section 403(b) plan, a governmental section 457(b) plan or an IRA).

Most importantly, there are no tax consequences in the year that a federal employee over age 59.5 or a federal retiree requests a direct rollover of traditional TSP funds to a traditional IRA.

On the other hand, when a federal employee (over the age of 59.5) or federal retiree requests a direct rollover of traditional TSP funds to a Roth IRA, what appears in Box 2a in Form 1099-R (Taxable amount) is different.

This is because direct rollovers to a Roth IRA from a traditional TSP account are fully taxable, and therefore includible in the employee’s or retiree’s income in the year that the direct rollover is performed. The IRS treats such rollovers as if the direct rollover were first made to a traditional IRA that is the employee’s or retiree’s only non-Roth (traditional) IRA, which is then immediately converted to a Roth IRA.

This means that with a direct rollover of traditional TSP funds to a Roth IRA, the amount shown in Box 2a (Taxable amount) of the 1099-R will match the amount in Box 1 (Gross distribution). The TSP participant will be therefore taxed on the full amount of the direct rollover of traditional TSP funds to a Roth IRA in the year of the direct rollover.

However, the TSP reports in Box 7 the same code – Code G – with a direct rollover of traditional TSP funds to a Roth IRA as it does a direct rollover of traditional TSP funds to a traditional IRA. As explained, the latter rollover is not taxable and that is why Code G. But the direct rollover of traditional TSP to a Roth IRA is fully taxable and therefore Code G is not the correct code. The code in Box 7 of the Form 1099-R should be Code “7” (“Normal distribution”) meaning a fully taxable event.

Any federal employee or retiree who has performed a rollover of traditional TSP funds to a Roth IRA in past years and who received a 1099-R showing a code “G” in Box 7 has most likely not paid any federal and state income tax on the amount of the direct rollover to a Roth IRA.

Their Roth IRA therefore was not established with already-taxed dollars which it should have been. These individuals are highly encouraged to notify their Roth IRA custodians to find out what needs to be done. At the very least, the amount of the traditional TSP funds transferred has to be “converted” and the full amount of federal and state income taxes have to be paid.

Going forward, federal employees over age 59.5 and retirees who are considering a direct rollover of traditional TSP funds to a Roth IRA are advised to not perform that direct rollover. They should instead request a direct rollover of traditional TSP funds to a traditional IRA (a “rollover” traditional IRA), which is not a taxable event. Once the funds are in the “rollover” traditional IRA, they should request from the IRA custodian to convert the traditional IRA to a Roth IRA. They will have to pay full federal and state income taxes on the amount of traditional funds converted to a Roth IRA. In so doing, they will properly establish a Roth IRA.