Understanding the “Five-Year Rule” with Respect to Roth TSP In-Plan Conversions

Tax Consequences of Roth TSP In-Plan Conversions

Roth TSP in-plan conversions using before-tax traditional TSP funds are fully taxable in the year of conversion. The traditional TSP participant must pay federal and state income on the amount converted. By contrast, Roth TSP conversions of after-tax Roth TSP funds in a separate account consisting of Roth TSP after-tax contributions and accrued earnings are taxable only in the same proportion that accrued earnings bear to the total balance in that account.

Note that like Roth IRA conversions, Roth TSP in-plan conversions are permanent. That is once a conversion is performed, it cannot be reversed or “recharacterized.” Most importantly, federal employees and retirees who are considering Roth TSP in-plan conversions must have sufficient liquid assets (checking, savings or money market accounts) available to pay the federal state income tax bills. These federal and state tax bills will likely need to be paid via quarterly federal and state estimated payments to the IRS and state revenue tax departments.

When a TSP participant calculates the income tax resulting from the distribution of a Roth TSP in-plan conversion, the funds distributed are considered to have been held within one Roth TSP “bucket” along with previously made Roth TSP contributions. When withdrawals are made from that Roth TSP “bucket,” the entire distribution is income-tax free if the distribution is a qualified distribution.

A distribution from a Roth TSP “bucket” is qualified if the TSP participant meets the following two requirements; (1) The TSP participant is at least age 59.5 or is disabled at the time of distribution; and (2) The TSP participant has satisfied a five-year holding period for accrued earnings. That holding period begins on January 1 of the year of the first Roth TSP contribution, or if earlier, January 1 of the first Roth TSP in-plan conversion or retirement plan distribution of another Roth qualified retirement plan into the Roth TSP.

If the converted Roth TSP distribution is not qualified, then a portion of the distribution will be subject to federal and state income tax under the “pro-rata” rule. In particular, the percentage of distribution that is table is equal to:

Amount of accrued earnings in the Roth TSP “bucket”/Total balance in the Roth TSP “bucket”

The 10 percent early distribution penalty will also apply to the taxable portion (as determined by the pro-rata rule) of a distribution made before the Roth TSP participant is age 59.5. Roth TSP in-plan conversions made before the TSP participant is age 59.5 are never subject to the 10 percent early withdrawal penalty. However, the 10 percent penalty will apply to an allocable portion of the converted Roth TSP funds distributed before age 59.5 unless a five-year period is satisfied. Note that this five-year conversion period is different from the five-year holding period for  accrued earnings. The five-year conversion period for Roth TSP in-plan conversions begins on January 1 of the year of the Roth TSP in-plan conversions and there are separate periods for each year a Roth TSP in-plan conversion is done. If converted TSP contributions and accrued earnings are distributed at age 59.5 or later, there is never a 10 percent penalty. The following example illustrates:

Example 3. Robert started making contributions to the Roth TSP in 2021. Between 2021 and 2026, Robert contributed a total of $120,000 to his Roth TSP account. In 2026 when he was age 50, Robert performed a Roth TSP in-plan conversion of $50,000 from his traditional TSP account. The conversion generated $50,000 of additional taxable income in 2026. There was no 10 percent penalty on the $50,000 conversion performed during 2026.

In 2027, Robert incurs a major expense. Robert decides to withdraw $40,000 from his Roth TSP account. At that point, Robert’s Roth TSP account is worth $200,000 consisting of:

Although Robert satisfied the five-year waiting period for the Roth TSP earnings that began on January 1,2021 and ended December 31, 2025, his distribution is not a qualified distribution because he is younger than 59.5 (he is age 51 in 2027). The taxable portion of Robert’s $40,000 distribution from his Roth TSP is calculated as follows:

$30,000 (accrued earnings)/$200,000 (total value of Roth TSP account) x $40,000 = $6,000.

The remaining $34,000 of Robert’s is not taxable because it represents Roth TSP contributions all of which were made with after-taxed dollars, and Roth TSP in-plan conversion of traditional TSP funds all of which were taxed when converted to Roth TSP funds.

The portion of the $6,000 attributable to contributions:

$120,000/$170,000 x $6,000 = $4,235

The portion of the $6,000 attributable to conversion:

$50,000/$170,000 x $6,000 = $1,765

The $1,765 is taxable. This is because the $50,000 Roth TSP in-plan conversion in 2026 did not satisfy the five-year holding period for an income tax-free withdrawal. Robert’s five-year holding period for the 2026 Roth TSP in-plan conversion will not end until January 1, 2031. The $1,765 taxable portion of Robert’s withdrawal is also subject to a 10 percent penalty because Robert is under age 59.5. Robert therefore has additional taxable income of $1,765 during 2027 and  Robert owes in penalties:

         10 percent of ($6,000 + $1,765) = $776.50 of penalties on his Roth TSP account 2027 Roth withdrawal

Roth TSP in-plan conversions can be performed as a direct distribution within the TSP or as a 60-day (“indirect”) distribution. TSP participants should be aware that if done as a 60-day distribution, the withdrawal is subject to mandatory 20 percent federal income tax withholding. Unlike Roth IRA conversions, voluntary federal income tax withholding on a Roth TSP in-plan direct distribution is not permitted.

Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street - Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.  

These are hypothetical stories and not indicative of any specific situations or client. It is presented only as an example and not intended as investment advice. Investing involved risk and there is no assurance that any investment strategy will be successful.

TSP: The Thrift Savings Plan (TSP) is a retirement savings and investment plan for Federal employees and members of the uniformed services, including the Ready Reserve. The TSP is a defined contribution plan, meaning that the retirement income you receive from your TSP account will depend on how much you (and your agency or service, if you're eligible to receive agency or service contributions) put into your account during your working years and the earnings accumulated over that time. The Federal Retirement Thrift Investment Board (FRTIB) administers the TSP

IRAs: Contributions to a traditional IRA may be tax-deductible depending on the taxpayer’s income, tax-filing status, and other factors. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty

Roth IRA: Like Traditional IRAs, contribution limits apply to Roth IRAs. In addition, with a Roth IRA, your allowable contribution may be reduced or eliminated if your annual income exceeds certain limits. Contributions to a Roth IRA are never tax deductible, but if certain conditions are met, distributions will be completely income tax free. Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted

Roth Conversions: Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.