The Thrift Savings Plan (TSP) and individual retirement arrangements (IRAs) share several common features. But there exist some subtle differences between the two types of retirement accounts.
Not being aware of these differences can possibly result in penalties, tax liabilities and possible loss of retirement assets. With the expanded TSP withdrawal options that started in late 2019 (including more opportunities for transfers of the traditional TSP to traditional IRAs and to Roth IRAs, and direct transfers of the Roth TSP to Roth IRAs), it is important that TSP participants understand the differences between the TSP and IRAs in order to avoid being subject to any unnecessary penalties and paying additional taxes.
Both the TSP and IRAs (traditional IRAs and Roth IRAs) are tax-favored retirement accounts. The TSP is classified as a “defined contribution” retirement plan. It is similar to a private company-sponsored 401(k) qualified retirement plan or non-profit organization 403(b) qualified retirement plan. With the demise of traditional pension plans – defined benefit plans – over the last quarter century, defined contribution plan assets have tremendously grown in the last 20 years. According to the Investment Company Institute, defined contribution plans held $7.9 trillion assets as of March 31, 2020.
Assets in individual retirement accounts (IRAs) totaled $9.5 trillion as of March 31, 2020. The $9.5 trillion includes rollovers and transfers from defined contribution plans including the TSP.
But defined contribution plans such as the TSP and IRAs have different rules and limitations.
The following are some of the most important differences and limitations:
1. Rules for contributing and annual contribution limits
In order to contribute to the TSP, an individual must be either in federal service or a member of the uniformed services. In order to contribute to an IRA, an individual (or the individual’s spouse) must have earned income (salary/wages or be self-employed). Each year, the TSP sets the contribution limits according to the IRS’ annual “elective deferral limit” for all defined contribution plans.
The IRS sets a separate contribution limit for IRAs. For example, during 2021, federal employees and uniformed service members can contribute a maximum $19,500 to the TSP ($26,000 if over age 49 as of December 31, 2021) while any individual with earned income can contribute a maximum $6,000 to an IRA ($7,000 if over age 49 as of December 31, 2021). These contribution limits are separate from one another. The IRS imposes a 6 percent “excess contribution” penalty in any year in which an IRA owner and/or TSP participant exceeds these the retirement account contribution limits.
2. Withdrawals to buy first home
A traditional IRA owner can withdraw up to $10,000 from the IRA to be used to help finance the purchase of the IRA owner’s first home. The IRA owner will pay federal and state income taxes on the amount withdrawn but no 10 percent early withdrawal penalty, even if the IRA owner is younger than age 59.5.
A TSP owner cannot make a pre-age 59.5 partial withdrawal to help buy his or her first home. Instead, federal employees with TSP accounts are allowed to take out a residential loan to help purchase their first home, as explained below.
3. Higher education expense withdrawals
Distributions from traditional IRAs that occur before age 59.5 and that are used to pay for post-high school tuition and fees, books and other higher education -related expenses – while fully taxable – are exempt from the 10 percent early withdrawal penalty. No pre-age 59.5 in service higher education withdrawals can be made from the TSP.
4. Age 55 to 59.5 withdrawals
If a TSP participant retires sometime during the year he or she becomes age 55, then the TSP participant can start making withdrawals from his or her traditional TSP account and not be subject to a 10 percent early withdrawal penalty. But a 10 percent early withdrawal penalty applies to a traditional IRA owner who makes IRA withdrawals before age 59.5, with certain exceptions.
This difference in treating pre-age 59.5 withdrawals between the traditional TSP and traditional IRA can result in some potential problems for a TSP participant who retires from federal service between age 55 and 59.5, and who would like to move some of his or her traditional TSP account to a traditional IRA.
This transfer of traditional TSP assets to a “rollover” traditional IRA could be for a variety of reasons including more investment opportunities with the IRA and more flexible withdrawal options available with the IRA. The problem is that if the TSP participant withdraws any of the transferred TSP funds that are in the traditional IRA before he or she is age 59.5, then the withdrawal is subject to a 10 percent early withdrawal penalty.
On the other hand, if the same funds were left in the traditional TSP and withdrawn, then any withdrawal would not be subject to a 10 percent early withdrawal penalty because the TSP participant is over age 55.
5. Required Minimum Distribution (RMDs)
For both the traditional IRA and the TSP (traditional and Roth TSP account), RMDs begin at age 70.5 for retired federal employees born before July 1, 1949. Under the SECURE Act that was passed into law in December 2019, retired federal employees born after June 30, 1949 must begin RMDS the year they become age 72.
Both a traditional IRA owner and retired TSP participant have until April 1 following the year they become age 70.5 (or age 72 if born after June 30, 1949) to take their first required minimum distribution from the traditional IRA and TSP account (and any other qualified retirement plan they may own). With the TSP, a TSP participant who continues working in federal service past age 70.5 or age 72 (if born after June 30, 1949) does not have to take his or her first RMD until April 1st following the year he or she retires from federal service.
As a result, some federal employees who work past age 70.5 (age 72) for the federal government and who own traditional IRAs may want to consider transferring their traditional IRAs into their traditional TSP accounts. In so doing, they can delay the start of their traditional IRA RMD to April 1st following the year they retire from federal service.
6. TSP loans
The TSP allows TSP participants to take out two types of loans – a TSP “general purpose” loan or a TSP “residential” loan. By contrast, borrowing against an IRA is prohibited and will result in the IRA being terminated and taxed.
Some reasons to transfer TSP account to an IRA
(1) More investment options available with an IRA;
(2) If traditional TSP is transferred to a Roth IRA, income taxes are paid at time of transfer and therefore future distributions will be tax-free. This could be extremely beneficial if individual income tax rates go up in the future (which they probably will).
(3) Once a married FERS TSP participant starts to make withdrawals from their TSP accounts, they need their spouses written consent for any type of withdrawal, transfer to an IRA and TSP fund reallocation. No such requirements or restrictions with an IRA. Married IRA owner can do anything with his or her IRA without the other spouse’s knowledge or consent.
Some reasons to keep TSP retirement savings with the TSP
(1) The TSP is better protected against lawsuits and creditors compared to IRAs. With IRAs, creditor protection will vary from state to state
(2) The TSP has the lowest administrative expenses of any retirement plan in the world. IRAs can have large expenses associated with them including annual custodial fees and maintenance costs.