The Thrift Savings Plan (TSP) and individual retirement arrangements (IRAs) share many common features but there exist some subtle differences between the two retirement accounts.
Unfortunately, not knowing these differences can result in huge penalties, tax liabilities and possible loss of retirement assets. With the new and expanded TSP withdrawal options (including multi-direct transfers from traditional TSP to the traditional IRAs) taking effect on Sept. 15, 2019, it is important that TSP participants understand the differences between the TSP and IRAs in order to avoid paying unnecessary penalties and taxes.
Both the TSP ad IRAs (traditional IRAs and Roth IRAs) are tax-favored retirement accounts. The TSP is classified as a defined contribution plan. It is similar to a private company 401(k) 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 $16.3 trillion assets at the end of 2018, nearly triple the $5.6 trillion assets held in 2000.
But defined contribution plans and IRAs are not the same.
The following are some differences between the traditional TSP and traditional IRAs:
1. Withdrawals to buy first home
A traditional IRA owner can withdraw up to $10,000 from the IRA to be used to buy 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 The IRA owner will pay federal and state income taxes on the amount withdrawn but no 10 percent early withdrawal penalty, even if the IRA owner is younger than age 59.5.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 (they instead can apply for a TSP Residential Loan, as explained below).
2. Education expense withdrawals
Distributions from traditional IRAs that occur before age 59.5 and that are used to pay for post-high schiool tuition and fees, books and other higher education -related expenses – while fully taxable – are exempt from the 10 percent early withdrawal penalty. Similar withdrawals from the traditional TSP are subject to a 10 percent early withdrawal penalty.
3. 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 elect to 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 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 cause 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 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.
4. Required Minimum Distribution (RMDs)
For both the traditional IRA and the TSP (traditional and Roth TSP account), mandatory distributions begin at age 70.5 under current law.
A traditional IRA owner and retired TSP participant have until April 1 following the year they become age 70.5 to take their first required minimum distribution from the traditional IRA and TSP account.
5. TSP loans
The TSP allows TSP participants to take out two types of loans; namely 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.
6. Creditor protection
The TSP is better protected against lawsuits and creditors compared to IRAs. For IRAs, creditor protection will vary from state to state. It is not uncommon that a bankruptcy lawyer can pierce the legal protection for IRAs in a particular state.