Pre-Age 55 Penalty-Free TSP Withdrawals: Partial Rollover of a Traditional TSP Account to a Traditional IRA

With perhaps thousands of federal employees having to leave federal service as a result of reductions-in-force (RIFs), the question becomes for many of these departing employees: How to access their Thrift Savings Plan (TSP) accounts? Many of these employees will be under age 55 and will not be able to get new jobs immediately. They have bills to pay, and accessing their TSP accounts in a penalty-free way is perhaps a short-term solution while they seek new employment.

This is the second of two columns discussing how separated federal employees younger than age 55 can make penalty-free withdrawals from their traditional TSP accounts. Presented in this column is the partial rollover of a traditional TSP account to a traditional IRA and then the use of Internal Revenue Code (IRC) Section 72(t) to make penalty-free withdrawals from the traditional IRA in one of three methods: (1) Amortization method; (2) Minimum distribution or life expectancy; or (3) Annuitization.

SEE ALSO:

• Pre-Age 55 Penalty-Free TSP Withdrawals: Partial Rollover of a Traditional TSP Account to a Traditional IRA

• 10 Costly TSP and IRA Rollover Errors Federal Employees and Retirees Should Avoid

Rolling Over a Portion of the Traditional TSP to a Traditional IRA

A federal employee who leaves federal service has a few options with respect to what they can do with their TSP account. One option is to request that a portion of their traditional TSP account be directly rolled over to a traditional IRA. A direct rollover of a portion of TSP participant’s traditional TSP to a traditional IRA is not a taxable event nor subject to an early IRS withdrawal penalty.

Calculation for Payment Amounts Under Rule 72(t)

The amount of monthly payment a traditional IRA account holder can receive by use of IRC Section 72(t) depends on the account holder’s life expectancy, which can be calculated through one of three IRS-approved methods:

• The amortization method.
• The life expectancy or the minimum distribution method, or
• The annuitization method.

The amortization method determines yearly payment amounts by amortizing the balance of the IRA owner’s account over single or joint life expectancy. This method will result in the largest and most reasonable amount that the IRA owner can receive. The amount is fixed annually.

The life expectancy or the minimum distribution method takes a dividing factor from the IRS’ single or joint life expectancy table and divides that factor into the IRA account balance. The major difference between the minimum distribution method and the amortization method is that the resulting withdrawal amount with the minimum distribution method (as the name implies) is the lowest amount that can be withdrawn. The minimum distribution method is nearly the opposite of the amortization method (in which the annual payments are fixed), as the annual withdrawal payments are likely to vary from year to year.

The annuitization method uses an annuity factor method provided by the IRS to determine equivalent or nearly equivalent payments in accordance with the substantially equal periodic payment (SEPP) regulation. This method offers an IRA owner a fixed annual payment with the amount of the annual payment typically falling somewhere between the highest and lowest amount the IRA owner can withdraw.

The following discussion elaborates on the three methods:

1. Amortization method. The fixed amortization method spreads an IRA owner’s account balance over the IRA owner’s remaining life expectancy (as estimated by IRS mortality tables) at an interest rate no more than 120 percent of the federal mid-term interest rate. Once the annual payment amount is calculated, the amount cannot be changed until age 59.5. Otherwise, an IRA owner will pay a penalty of 10 percent per year, beginning with the year the distribution began, up until the year of the change.

2. Life expectancy or minimum distribution method. The life expectancy or minimum distribution method is the way that most IRA custodians recommend that IRA owners use their IRA balance to make pre-age 59.5 penalty-free withdrawals. The amount calculated annually is the minimum amount of money that the IRA owner can withdraw each year in order to avoid incurring any pre-age 59.5 early withdrawal penalty.

According to the IRS, the life expectancy or minimum distribution method uses the IRA balances as of January 1 of the year, divided by the IRA owner’s life expectancy that year. Life expectancy is divided into three categories: (1) Single life. This is used by married IRA owners whose spouses do own IRA accounts; (2) Uniform life. This is used by IRA owners who are unmarried and determining their own withdrawals. It also includes IRA owners who are married to a spouse who is less than 10 years younger than them; and (3) Joint life and last survivor – made up of IRA owners whose spouses are more than 10 years younger than them and are the sole beneficiary of the IRA account.

Each of these methods uses attained age(s) in the distribution calculation year with the annual payment redetermined each year.

3. Annuitization method. The fixed annuitization method divides an IRA owner’s beginning account balance by an annuity factor taken from IRS tables in order to determine an annual payment amount. The annuity factor is based on IRA mortality tables and an interest rate of no more than the greater of 5 percent or 120 percent of the federal mid-term rate. Once the payment amount is determined, it cannot be changed. While the fixed annuitization method is complicated, it sometimes offers the highest annual payments depending on interest rates.

The following is an example of withdrawing money from an IRA using IRC Section 72(t):

A 53-year-old IRA owner owns an IRA earning 1.5 percent annually with a balance of $250,000. The IRA owner wants to withdraw money from the IRA and not be subject to an early withdrawal penalty. Using the amortization method, the IRA owner will receive approximately $10,042 in yearly payments. With the life expectancy on minimum distribution method, the IRA owner will receive during the first year $7,962 and something greater or less in subsequent years. Using the annuitization method, the IRA owner will receive $9,976 annually.

Is IRC Section 72(t) a Good Idea?

For those federal employees who are forced to leave federal service before they are eligible to retire, using IRS Section 72(t) to make penalty-free withdrawal from a rollover IRA is not recommended. The risk to their future retirement income needs may be too great to justify rolling over a portion of their Thrift Savings Plan account and starting to receive distributions before retirement.

Employees are encouraged to talk to their financial advisors to make sure that using the IRS Section 72(t) strategy will in fact be the only way for the employees to temporarily meet their financial needs. Other ways of paying one’s bills should definitely be explored. If employees have additional questions about IRC Section 72(t), they are advised to speak with a tax professional who is familiar with the rules associated with IRC Section 72(t).