How New Jersey and Pennsylvania Tax the TSP

For both Ann and Peter, the good news is that they are able to defer paying federal income tax on their contributions to the traditional TSP and accrued earnings. They will pay federal income tax on their traditional TSP account withdrawals (consisting of their contributions, agency matching and 1 percent agency automatic contributions, and accrued earnings).

The same treatment for state income tax treatment applies with respect to the traditional TSP with two caveats: First, assuming a traditional TSP participant is a resident of a state with no state and local income tax (the states listed above) and contributes to the traditional TSP and withdraws from the traditional TSP while a resident of one of those states, there are no tax consequences when withdrawing from the traditional TSP. Second, if a traditional TSP participant is a resident of a state with an income tax, then the tax treatment of contributions and withdrawals from the traditional TSP is identical to the federal income tax treatment with the exception of at least two states who have a state and local income tax: New Jersey and Pennsylvania.

Those TSP participants who are residents of New Jersey or Pennsylvania who contribute to the traditional TSP are not benefiting from a state income tax deduction when they contribute to the traditional TSP. For example, in Example 1, if Ann was a resident of New Jersey or Pennsylvania, with her $22,500 contribution to the traditional TSP, then her federal taxable wages for the year 2023 are $87,500. But her state taxable wages for the year 2023 are $110,000. That is not good news for a New Jersey or a Pennsylvania resident with respect to saving on current year state income taxes. But the good news is that when a retired New Jersey or Pennsylvania traditional TSP participant withdraws from his or her traditional TSP account, he or she will not have to pay state income taxes on the contribution portion of their traditional TSP account. This is because they already paid state income tax on the contributions.

However, there is an important assumption with regard to a New Jersey or Pennsylvania resident not having to pay state income tax on traditional TSP withdrawals. That assumption is that the traditional TSP participant remains a New Jersey or Pennsylvania resident at the time they withdraw the traditional TSP funds. Suppose they retire to another state, becoming a resident of that state, and they withdraw their traditional TSP funds. If their new state of residence has no income tax (such as Florida or Texas), then they need not worry about paying any state income tax on their traditional TSP withdrawals. But if they retire to a state that has a state income tax, they will have to pay full state income tax on their traditional TSP withdrawals. They will not be eligible for a state income tax credit from the new resident state on the New Jersey or Pennsylvania income taxes they paid on the contributions.

There is another tax challenge for New Jersey and Pennsylvania traditional TSP participants who make withdrawals as New Jersey or Pennsylvania residents. The tax challenge is that when they withdraw their traditional TSP accounts when they are retired and living in New Jersey or Pennsylvania, the TSP does not remind them which portion of their traditional TSP withdrawal consists of their contributions made via payroll deduction with after-taxed (state) salary. The TSP keeps a record of such contributions but does not include the information with a 1099-R (the tax document that shows the gross distribution and the taxable distribution of a traditional TSP distribution made during the year). The traditional TSP participant or the participant’s accountant will therefore assume that traditional TSP withdrawals are fully taxable for both federal and state income taxes when fact the withdrawals are not fully taxable for state income tax purposes. The following example is an actual case of a New Jersey resident (whose name has been changed) and who during 2022 made a lump sum withdrawal from his traditional TSP account. This individual also uses this FEDZONE columnist as his tax preparer. (The name of this individual and traditional TSP withdrawal amounts has been changed to protect my client’s privacy).

Example 3. Alexander entered federal service in 2001 as a FERS employee and retired at the age of 60 in 2021 with 20 years of FERS service. During his 20 years of federal service, he contributed each year as much as he could afford, a total of $120,500. All his contributions were made to the traditional TSP. As a New Jersey resident, he benefited from current year tax savings for federal income tax purposes when he contributed to the TSP, but not for New Jersey state income tax purposes.

Alexander’s traditional TSP account consisted of his contributions made via payroll deduction, his agency’s TSP matching contributions – a maximum 4 percent match, and an automatic 1 percent of his gross pay (SF 50) salary automatic contributions, plus accrued earnings over the years. Note that for federal income tax purposes, Alexander’s entire traditional TSP account consists of before-taxed dollars and therefore fully taxable when withdrawn. For New Jersey state income tax purposes, the portion of Alexander’s traditional TSP account that has been subject to NJ income taxes (his contributions) and therefore are not taxed again when withdrawn.

During 2022, when Alexander withdrew from his TSP account, the value of Alexander’s traditional TSP account was $450,000. At the time, Alexander and his wife purchased a vacation home and needed to withdraw $300,000 from Alexander’s traditional TSP account. With a lump sum payment request, the TSP automatically withholds a minimum 20 percent in federal income taxes, but it does not withhold state income taxes. Alexander knew that the $300,000 TSP withdrawal would push him into a higher federal marginal tax bracket, and he therefore requested 30 percent in federal income taxes be withheld from the lump sum payment. To “net” $300,000 Alexander requests a gross distribution of $300,000/0.70, or $428,571. With 30 percent of $428,571 or $128,571 withheld in federal income tax, this would “net” $300,000. Alexander had set aside a sufficient amount of liquid assets (savings, money market) to pay the New Jersey state income tax due on the withdrawn money, approximately eight percent of $428,571, or $34,286.

When Alexander came to this FEDZONE columnist to have his 2022 Federal and New Jersey income taxes prepared, he included with his 2022 tax documents a 1099-R from the TSP showing a gross distribution of $428,571 and a taxable distribution of $428,571 for both federal and NJ state tax purposes, and $128,571 in federal income tax withheld. I reminded Alexander that because he contributed to the traditional TSP as a New Jersey resident his contributions were made with after-taxed New Jersey dollars and therefore he would not have to pay New Jersey income tax on those dollars when withdrawn.

But in order to calculate how much of the calculate how much of the $428,571 distribution was taxable for New Jersey state income tax purposes, I would need to know how much Alexander contributed to the traditional TSP during his 20 years of federal service. The TSP did not provide that information to Alexander as part of his 1099-R information sent to him in January 2023. Alexander then asked if he should contact the TSP for the information and I said yes. Within a few weeks Alexander received a letter from the TSP showing a breakdown of his traditional TSP account.