Many Thrift Savings Plan (TSP) participants and federal employees and annuitants who may also own traditional IRAs and Roth IRAs choose to rollover their TSP accounts and/or IRAs. While rollover does not have to be a stressful experience, rollover errors can be costly and annoying.
Fortunately, errors associated with TSP and IRA rollovers can be avoided. Avoiding ten of the most IRA and TSP rollover mistakes is discussed in this column.
When ineligible rollovers occur, two unfortunate things may happen.
First, the funds withdrawn to perform the rollover are usually considered as taxable income and possibly subject to the IRS’ 10 percent pre-age 59.5 early withdrawal penalty.
Second, the funds rolled over may be considered “excess” contributions and possibly subject to the IRS’ 6 percent “excess” contribution penalty. In addition to the 6 percent “excess” contribution and 10 early withdrawal IRS penalties that may have to be paid, regular federal and state income taxes will have to be paid.
The following are ten of the most significant TSP and IRA rollover violations and errors that federal employees and annuitants should be aware of and avoid:
1 – Violations of the once-per-year IRA rollover rule
Under the IRS’ basic rollover rule, an IRA owner does not have to include in income any IRA proceeds distributed to the IRA owner provided the owner redeposits (“rolls over” the IRA proceeds into another IRA or into a qualified retirement plan (such as the TSP) within 60 days of receiving the IRA proceeds.
Under a 2014 Tax Court ruling and IRS regulations that took effect on Jan. 1, 2015, individuals are permitted to perform one IRA rollover every 12 months. If more than one rollover is performed within a 12-month period, then the amounts rolled over in the second or more rollovers performed during the 12-month period must be included in income. The IRA owner may also be subject to a 10 percent early withdrawal penalty with respect to the amounts included in income due to the disallowed rollovers if the IRA owner is younger than age 59.5. Note 12 months means any 12-month period (365 days) and not necessarily the calendar year. Direct (“trustee-to-trustee”) transfers have no limitations regarding the number of direct transfers performed in any 12-month period.
Finally, the once-per-year rollover rule applies only to IRA rollovers IRA to IRA) and not to rollovers of TSP funds to IRAs. This includes rollovers of traditional TSP to traditional IRAs and rollovers of Roth TSP to Roth IRAs. Note that under the new TSP withdrawal rules that took effect on Sep. 15, 2019, a TSP participant who has retired from federal service may perform as many as 12 TSP rollovers to IRAs per calendar year.
2 – Missing the 60-day rollover deadline
Without a waiver or extension of the 60-day rollover period, amounts not rolled over within the 60-day period do not qualify for tax-free rollover treatment. Instead, the amounts not rolled over must be treated as a taxable distribution from the IRA or qualified retirement plan such as the TSP. These amounts are taxable in the year distributed, even if the 60-day period expires 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:
Jack, age 60, received a distribution from his deductible traditional IRA on November 25, 2020. Jack does not rollover his deductible traditional IRA proceeds to another traditional within the 60-day period ending January 24, 2021. The IRA distribution is therefore fully taxable to Jack for tax year 2020 (not 2021) even though the 60-day period did not expire until calendar year 2021.
3 – Losing track of one’s former employer-sponsored qualified retirement plan and failure to rollover the money to the TSP or to a self-directed IRA
Federal employees are busy, and it is easy to understand how employees could forget about their old 401(k), 403(b) or SEP-IRA retirement plans they use to contribute to when they worked for previous employers. Sometimes the company they worked for is sold. Perhaps a federal employee moved when they entered federal service and forgot to update their address with their former retirement plan administrator. For this reason, it is highly recommended for all employees perform an inventory of all of their retirement accounts and IRAs they own and consider consolidating their retirement accounts.
Among the reasons to perform this inventory: To make their retirement life-time savings accounts easier to track. Also, some federal employees may not be aware that they are permitted to transfer any amount of qualified retirement plan assets and traditional IRA assets into their TSP account and may do so as many times as they want. They do so using TSP Form TSP 60. Rollovers or transfers into TSP accounts have no effect on the annual contribution limit made to the TSP via payroll deduction.
4 – Rolling over required minimum distributions (RMDs)
For individuals born before July 1, 1949 (who are now over age 70.5) and who own traditional IRAs, two important rules should be kept in mind.
First, required minimum distributions (RMDs) must be taken each year from their traditional IRAs – even if an individual is still working. As a result of the SECURE Act passage in December 2019, individuals born after June 30, 1949 must begin taking their RMDs starting the year they become age 72.
Second, if the IRA owner has retired from federal service, he or she must take RMDs from the TSP and any other qualified retirement plan (like a 401(k) plan) the individual may have previously participated in. But there is an extremely important rule that TSP participants, other qualified retirement plan and traditional IRA owners must keep in mind: RMDs can never be rolled over (the exception was during 2020 – as a result of the COVID-19 pandemic and the CARES Act passage, RMDs were permitted to be rolled back to their qualified retirement accounts or traditional IRAs; however, this was only for the year 2020).
A common error happens when a traditional IRA owner over age 70.5 converts his or her traditional IRA to a Roth IRA. Included in the converted traditional IRA is the year’s traditional IRA RMD. When this happens, the RMD converted to a Roth IRA is considered an “excess” contribution to the converted Roth IRA and subject to the IRS’ 6 percent “excess” contribution penalty. But once the annual RMD from the traditional IRA is satisfied, then any traditional IRA balance remaining is eligible to be converted to a Roth IRA.
5 – Rolling over after-taxed traditional IRA assets into the traditional TSP or rolling over Roth IRA assets into the Roth TSP
After-taxed traditional IRA assets should never be rolled into the traditional TSP. Only pre-taxed traditional IRA assets should be transferred into the traditional TSP. Before-taxed traditional IRA assets consist of deductible IRA contributions and accrued earnings.
After-taxed traditional IRA assets consist of contributions that were not deducted on one’s tax return. The after-taxed contributions were therefore considered the traditional IRA’s “cost basis”, as shown using IRS Form 8606 (Nondeductible IRAs) to report any nondeductible contributions made to the traditional IRA during any year. Also, Roth IRA assets are not permitted to be rolled over into the Roth TSP.
6 – Rolling over traditional TSP hardship withdrawals to a traditional IRA
The TSP allows participants with TSP accounts to take hardship withdrawals, assuming the hardship withdrawal is approved. But note the following with respect to TSP hardship withdrawals:
(1) A TSP hardship withdrawal must be applied for and approved by the TSP Service Office and only for a limited number of reasons;
(2) TSP hardship withdrawals are not loans and are therefore not paid back. In fact, a participant who is younger than age 59.5 who is approved for a hardship withdrawal will pay federal and state income tax on the amount withdrawn and a 10 percent IRS early withdrawal penalty; and
(3) TSP hardship withdrawals cannot be rolled over to a traditional IRA.
7 – Deemed distributions from a defaulted TSP loan not paid off or rolled over to a traditional IRA within 90 days
In general, a defaulted (unpaid) TSP loan is considered a “deemed distribution” and the TSP will report the outstanding loan to the TSP participant on Form 1099-R with a code “L” in Box 7 (“loan treated as a distribution”) in the year of default. A deemed distribution is considered taxable income and will be subject to a 10 percent early withdrawal penalty if the TSP account owner is under age 59.5.
An employee who retires from federal service with an outstanding TSP loan has 90 days to pay off the loan in order to avoid taxation, or within 90 days rollover the outstanding loan balance to a traditional IRA.
8 – Rolling over traditional IRA 72(t) distributions into a traditional IRA
72(t) distributions are a series of early (pre age 59.5) traditional IRA withdrawals that are set up to avoid the IRS’ pre-age 59.5 10 percent early withdrawal penalty.
But to qualify for the penalty exception, the IRA withdrawals must consist of a series of substantially equal periodic payments. The IRA owner must be committed to a plan of withdrawals according to the rules set out in Internal Revenue Code Section 72(t)(2)(A). The IRA owner can begin a 72(t)-payment schedule from a traditional IRA at any age, even if the owner is still working.
There are several rules associated with 72(t) payment schedules, the two most important of which are:
(1) The payments must continue for at least five years or age 59.5, whichever period is longer; and
(2) the IRA distributions cannot be rolled over into another IRA. If either of these rules is violated, then federal and state income taxes must be paid (and the 10 percent early withdrawal penalty will apply to all distributions taken prior to age 59.5) on all prior distributions. This is known as the “recapture” penalty. The “recapture” penalty will also be triggered if IRA funds from one IRA are rolled over to another IRA that is subject to an active 72(t) payment schedule. In other words, IRA funds cannot be rolled into, nor rolled out of, an IRA that has an active 72(t) payment schedule.
9 – Same type of investment asset must be rolled back into an IRA that was rolled out of another IRA
If an individual withdraws cash from an IRA for the purpose of a rollover, then only cash can be rolled over into another IRA. If an individual rolls over stock from an IRA, then only that stock 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, bonds) withdrawn and received must be rolled over.
For example, an IRA owner cannot receive a distribution of cash and then rollover shares of stock that he or she purchased with that cash into another IRA. An IRA owner cannot receive a distribution of XYZ company stock and rollover an equivalent value in shares of ABC company stock into another IRA.
10 – Withdrawing IRA funds in case of a divorce settlement rather than directly transferring the funds to the soon-to-be ex-spouse’s IRA
When traditional IRA funds are withdrawn as part of a divorce settlement, those funds are taxable and cannot be rolled over to the soon-to-be ex-spouse’s traditional IRA. If the IRA funds are withdrawn, then the spouse who owns them and who intends to put these funds in the soon-to-be ex-spouse’s traditional IRA will pay federal and state income taxes on the amount withdrawn. If the spouse is younger than age 59.5, a 10 percent early withdrawal penalty will be added.
In summary, federal employees and annuitants are highly encouraged to be familiar and understand the rules regarding which retirement accounts can and cannot be rolled over, important deadlines for rollovers, and when a direct or “trustee to trustee” transfer should be performed rather than a rollover or a withdrawal. By fully understanding these rules, employees and annuitants will hopefully be able to help preserve their traditional IRAs, Roth IRAs, TSP, and other qualified retirement accounts and not have to pay any unnecessary taxes and IRS penalties.