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

Many Thrift Savings Plan (TSP) participants and federal employees and retirees who own traditional IRAs and Roth IRAs choose at some time to rollover their TSP account and/or IRAs. While a rollover does not have to be a stressful experience, rollover errors can be costly. Fortunately, errors associated with the TSP and/or IRA rollovers can be avoided.

This column discusses how federal employees and retirees can avoid ten of the costliest IRA and TSP rollover mistakes.

SEE ALSO:  Understanding TSP Rollover Rules

When an ineligible rollover occurs, two costly tax-related IRS penalties may be assessed.

The first penalty applies to ineligible rollovers of traditional TSP participants or IRA owners who are younger than age 59.5. The withdrawn funds from the traditional TSP or traditional IRA are considered as taxable income and subject to the IRS’ 10 percent early withdrawal penalty.

Second, the funds rolled over may be considered as “excess” contributions and subject to the IRS’ 6 percent “excess contribution” penalty.

It is important to present first the difference between a “rollover” and a “direct rollover.” Each is described:

• Direct rollover

A TSP participant or a traditional IRA owner who is requesting a direct rollover asks that the TSP or the IRA administrator make the payment directly to a qualified retirement plan (such as a 401(k)-retirement plan), or to a traditional IRA. No taxes will be withheld from the transferred amount.

• Rollover

If a distribution from a traditional IRA or from the TSP is paid directly to the traditional IRA owner or to the TSP participant, then the TSP participant has to deposit all of the distribution to a traditional IRA or to a qualified retirement plan within 60 days of receipt of the distribution. Federal income taxes (20 percent) will be withheld from a distribution from the TSP. This means that the TSP participant will have to use other funds to rollover the full amount.

The following are the 10 most costly TSP and traditional IRA rollover errors and violations:

1. One-per-year IRA rollover

Under a 2014 Tax Court ruling and IRS regulations that took effect January 1, 2015, individuals are permitted to perform one IRA rollover (traditional IRA to traditional IRA or Roth IRA to Roth IRA) every 12 months. If more than one rollover is performed within a 12-month period, then the amounts rolled over in the second rollover and any additional rollovers must be included in income. The IRA owner may also be subject to a 10 percent early withdrawal penalty.

Note 12 months means any 12-month period (365 days) and not necessarily the calendar year. The once-per-year rollover applies only to IRA rollovers (IRA to IRA) and not to rollovers of TSP funds to IRAs.

2. Missing the 60-day rollover deadline

Without a waiver or an extension of the 60-day rollover period, amounts not rolled over within the 60-day period do not qualify for tax-free rollover treatment. The amounts not rolled over within the 60-day period will be treated as a taxable distribution from the IRA or qualified retirement plan and is considered taxable income in the year distributed even if the 60-day period expired in the next calendar year. There may be a 10 percent early withdrawal penalty if the IRA owner is younger than age 59.5.

The following example illustrates:

Example 1. Jack, age 65, received a distribution from his traditional IRA on November 28, 2023. Jack fails to rollover the proceeds from the traditional IRA distribution within the 60-day period which ended January 27, 2024. The traditional IRA distribution is therefore fully taxable to Jack for tax year 2023 (not 2024) even though the 60-day period did not expire until calendar year 2024. Jack will receive a Form 1099-R from his IRA custodian for the year 2023 showing a taxable distribution from his IRA. Jack will report the distribution on his 2023 federal and state income tax returns. He will not be subject to a 10 percent IRS early withdrawal penalty because he is over age 59.5.

3. Losing track of one’s former employer-sponsored qualified retirement plan and failing to directly rollover the plan proceeds to the TSP or to a traditional IRA

No doubt federal employees are busy individuals, and it is understandable how an employee can forget about his or her old 401(k), 403(b), 457 or SEP IRA retirement plan that he or she previously contributed to when they worked for a previous employer.

Federal employees are advised to perform an inventory of all of their qualified retirement accounts and IRAs they own and consider consolidating their retirement accounts. Among the reasons for consolidation is to make their retirement lifetime savings accounts easier to track. Many TSP participants are not aware that they can directly rollover any amount of qualified retirement account funds and traditional IRA assets into their traditional TSP account. They can directly rollover Roth 401(k), Roth 403(b) and Roth 457 accounts (but not Roth IRAs) into their Roth TSP account.

They can perform these direct rollovers by going online to their TSP account and completing online Form TSP-60. Direct rollovers into TSP accounts have no effect on the amount that employees can contribute via payroll deductions each year to their traditional TSP and Roth TSP accounts.

4. Rolling over required minimum distributions (RMDs)

Traditional IRA owners and retired TSP participants who will be age 73 or older as of December 31,2024 have reached their required beginning date (RBD) and must take required minimum distributions (RMDs) each year from both their traditional IRAs and their traditional TSP accounts. A traditional IRA owner and a retired TSP participant who has reached his or her RBD is not permitted to directly rollover any portion of an RMD into a traditional IRA or qualified retirement plan. A common error happens when a traditional IRA owner who has reached his or her RBD converts his or her traditional IRA to a Roth IRA. Included in the converted IRA is the year’s traditional IRA RMD. When this happens, the RMD portion converted to a Roth IRA is considered an excess contribution to the Roth IRA and subject to the IRS’ 6 percent excess contribution penalty.

5. Rolling over after-taxed traditional IRA assets into the traditional TSP

After-taxed traditional IRA assets should not be rolled over into the traditional TSP. Only before-taxed IRA assets should be rolled into the traditional TSP. Before-taxed traditional IRA assets consist of deductible traditional IRA contributions that were deducted on the traditional IRA owner’s federal income tax returns as deductible traditional IRA contributions (as an “adjustment to income”) and accrued earnings.

After-taxed traditional IRA assets consist of traditional IRA contributions that were not deducted on a traditional IRA owner’s federal income tax return. The after-taxed contributions are therefore considered as the traditional IRA’s “cost basis.” The traditional IRA owner should have reported any nondeductible traditional IRA contributions on IRS Form 8606 (Nondeductible IRAs) in any year a nondeductible traditional IRA contribution was made.

6. Rolling over traditional TSP hardship withdrawals to a traditional IRA

If a TSP participant younger than age 59.5 is in need of money, the TSP participant can apply for a “hardship” withdrawal. If the participant qualifies for a hardship withdrawal, the hardship withdrawal is not considered a loan and therefore not paid back like a TSP loan.

A TSP hardship withdrawal cannot be rolled over to a traditional IRA. TSP participants who are approved for a hardship withdrawal must pay federal and state income taxes on the amount withdrawn. Since the TSP participant is younger than age 59.5, the withdrawal may be subject to a 10 percent early withdrawal penalty.

7. Deemed distributions from a defaulted TSP loan are not paid off or rolled to a traditional IRA within 90 days

A defaulted (unpaid) TSP loan is considered a “deemed distribution.” The TSP will report the outstanding balance of an unpaid loan – a TSP “general purpose” loan or a TSP “first-time home buyer” loan – on IRS Form 1099-R in the year that the TSP participant defaulted on the loan.

The Form 1099-R will have a Code “L”, (loan treated as a distribution) in Box 7 in the year of default. An employee who retires from federal service with an outstanding TSP loan has 90 days from the day he or she retires to pay off the loan in order to avoid paying federal and state income tax on the unpaid balance of the loan. The other option is to rollover the outstanding loan balance to a traditional IRA.

8. Requesting a direct rollover of the traditional TSP to a Roth IRA

TSP participants over age 59.5 are permitted to request a portion of their traditional TSP be directly rolled over to a traditional IRA. This direct rollover is not taxable.

On the other hand, if a traditional TSP participant requests a direct rollover of a portion of their traditional TSP to a Roth IRA, this is not a rollover but rather a fully taxable distribution. A traditional TSP participant should instead request a direct rollover to a traditional IRA and then convert the rollover traditional IRA to a Roth IRA.

9. Same types of investment capital assets must be rolled back into an IRA that was rolled out of another IRA

For example, if an individual rolls over cash from an IRA, then only cash can be rolled over into another IRA. For traditional IRA to traditional IRA or Roth IRA to Roth IRA 60-day rollovers, the same class of property (for example, cash, stock of bonds) withdrawn and received by the IRA owner must be rolled over into another IRA. The following examples illustrate:

Example 2. Felice requests a $10,000 distribution of cash from her traditional IRA. Felice cannot rollover $10,000 worth of XYZ stock she purchased with the $10,000 cash withdrawn from the IRA into another traditional IRA.

Example 3. Peter requests 100 shares of ABC stock to be withdrawn from his traditional IRA. The 100 shares of ABC stock are worth $5,000. Peter owns 250 shares of DEF stock also worth $5,000 that he wishes to rollover into his IRA. This is not a proper rollover. In order to be a proper rollover, Peter must rollover all 100 shares of ABC stock into another traditional IRA within 60 days of receiving the 100 shares of ABC stock.

10. As part of a divorce settlement, request a withdrawal of traditional IRA funds rather than directly transferring the IRA funds to the soon-to-be ex-spouse’s traditional IRA

When traditional funds are withdrawn from one spouse’s traditional IRA as part of a divorce settlement, the withdrawn funds are fully taxable. This is true even if the funds are subsequently rolled over to the soon-to-be ex-spouse’s traditional IRA within 60 days.

If the spouse who withdraws the funds is younger than age 59.5, a 10 percent early withdrawal penalty will have to be paid in addition to the federal and state income taxes due. The transferring spouse should instead request a direct transfer (“trustee-to-trustee”) of the spouse’s IRA to the soon-to-be ex-spouse’s IRA, in order to avoid paying taxes and a penalty.

Federal employees and retirees are encouraged to be familiar with and understand the rollover rules that apply to traditional IRAs, Roth IRAs, the TSP and other qualified retirement accounts. In particular, being aware which retirement account can and cannot be rolled over, deadlines for rollovers and when a direct transfer (“trustee-to-trustee”) transfer should be performed rather than a rollover.

By fully understanding these rules, employees and retirees will be able to help preserve their traditional IRA, Roth IRAs, TSP and other qualified retirement accounts, and not have to pay unnecessary taxes and IRA penalties.