How Federal Employee Retirement Benefits Are Taxed by the IRS

This is the sixth in a series of FEDZONE columns discussing how federal retirement benefits are taxed by the IRS. This column discusses the federal income tax consequences of transferring or rolling over a traditional TSP and a Roth TSP distribution.

UPCOMING TAXES WEBINAR

Edward A. Zurndorfer

Transferring or Rolling Over a Traditional TSP Distribution

It is important to first define what a traditional TSP “transfer” is and what a TSP “rollover” is. A TSP transfer of a TSP participant’s traditional TSP account occurs when payments are made directly (“trustee to trustee”) from the TSP to a traditional IRA or to a Roth IRA, or to an eligible employer-sponsored qualified retirement plan (such as a 401(k)-retirement plan, a 403(b)-retirement plan or a 457-retirement plan). A TSP rollover occurs when payments are made directly to TSP participant. The TSP participant then has 60 days to deposit the TSP funds into a traditional or to an eligible employer-sponsored qualified retirement plan.

Before a TSP participant decides to transfer or rollover his or her traditional TSP account, he or she should find out whether the traditional IRA or the qualified retirement plan accepts transfers or rollovers, the minimum amount the IRA or qualified retirement plan will accept, and whether tax-exempt contributions will be accepted. TSP tax-exempt contributions include contributions made to the traditional TSP via payroll deduction by a Uniformed Services member while serving in a combat zone. While serving in a combat zone, the Uniformed Service member’s compensation is tax-exempt.

It is also important for the TSP participant to keep in mind that the qualified retirement plan he or she chooses to transfer or rollover traditional TSP funds into may be subject to different tax treatment and plan rules (such as spousal consent rules) from those that govern the TSP. Also, the rules of the IRA or eligible employer-sponsored retirement that receives the rollover will determine the TSP participant’s investment options, fees and rights to payment.

Tax Consequences of Transfers and Rollovers of a Traditional TSP Account

The following rules apply if a TSP participant requests that the TSP transfer part or all of his or her traditional TSP account that is eligible for a rollover (called an “eligible rollover distribution”):

The direct transfer of traditional TSP funds to a traditional IRA or to an eligible employer-sponsored retirement plan will not be taxed in the current year; therefore, the TSP will not withhold any federal income tax from the amount of the direct transfer. The traditional TSP participant will not be taxed on the transferred funds until it is withdrawn from the traditional IRA or the employer-sponsored retirement plan.
Any part of a TSP participant’s traditional TSP account transferred to a Roth IRA will be taxed in the current year. No federal income tax will be withheld by the TSP at the time of the transfer. Before requesting a TSP transfer of a traditional TSP to a Roth IRA, a TSP participant is highly encouraged to speak with a tax professional in order to determine how much in federal (and in most states) and state income taxes have to be paid as a result of the transfer, and how to pay the taxes due (for example, through estimated tax payments or extra tax withholding from another source).

With respect to rollovers, a TSP participant may rollover only “eligible” TSP rollover funds from his or her traditional TSP account. An example of “non-eligible” TSP funds includes a retired (over the age of 72) TSP participant’s annual required minimum distribution. The following rules apply if the TSP makes a payment from a TSP participant’s traditional account directly to the participant and the TSP participant decides to make a rollover to a traditional IRA, Roth IRA, or to an eligible employer-sponsored qualified retirement plan himself or herself:

• Since the TSP is making the payment directly to the TSP participant, the TSP is required to withhold 20 percent of the payment in federal income taxes. This means that in order to rollover the entire payment, the TSP participant must use other funds to make up for the 20 percent in federal income taxes withheld. The following example illustrates:

Example 1. Theresa requests a $100,000 traditional TSP withdrawal to rollover to a traditional IRA. The TSP will withhold $20,000 in federal income taxes and remit to the IRS. Theresa will therefore receive from the TSP a net check of $100,000 less $20,000, or $80,000. If Theresa wants to rollover the entire $100,000 to a traditional IRA, she will need to find $20,000 from another source (such as a savings account) and send it to the traditional IRA along with the $80,000 payment she received. She must do so within 60 days of her receiving the $80,000 payment from the TSP.

If a TSP participant does not rollover the entire amount of the withdrawal, the portion not rolled over will be taxed, and will also be subject to the 10 percent early withdrawal penalty if the TSP participant is under age 59.5.
If a TSP participant rolls over the entire payment from his or her traditional TSP into a Roth IRA, the full amount rolled over will be taxed in the current year. The following example illustrates:

Example 2. Richard requests a $100,000 payment from his traditional TSP that he intends to rollover into a Roth IRA. The TSP will withhold 20 percent or $20,000 of the withdrawal because the $100,000 payment is made directly to Richard. However, if Richard rolls over any part or all of the net $80,000 payment to a Roth IRA, he will owe federal (and state) income tax on the entire $100,000. Note the $100,000 will likely push Richard into a higher federal and perhaps state marginal tax bracket.

Transferring or Rolling Over a Roth TSP Distribution

A TSP participant who owns a Roth TSP account is permitted to transfer or to rollover an eligible rollover distribution from the Roth TSP to a Roth IRA or a Roth account maintained by an eligible-sponsored retirement plan (including a Roth 401(k), a Roth 403(b) or a Roth 457 retirement plan) that will accept transfers and rollovers. Roth TSP participants should be aware that the amount rolled over will become subject to the tax rules that apply to the Roth IRA or to the Roth account administered by the eligible employer plan. These tax rules are not identical to the rules governing a TSP Roth balance. Differences may include the following:

When a Roth TSP balance is transferred or rolled over into a Roth IRA, the starting date for satisfying the five-year rule for qualified distribution dates does not carry over. Instead, the five-year is counted from the January 1^st of the first year the Roth TSP participant contributed to any Roth IRA.
A Roth IRA owner does not have to take a distribution from a Roth IRA during his or her lifetime. However, a TSP participant who has both a Roth TSP and a traditional TSP balance is subject to required minimum distributions (RMDs) that is determined based on the combined balance of both accounts. RMDs start when a retired federal employee becomes age 72 (70.5 if born before July 1, 1949).
Distributions from a Roth IRA can only be rolled over or transferred to another Roth IRA.
Distributions from Roth IRAs are paid first from contributions and then paid from earnings.

TSP Transfers from Roth TSP Accounts

If a Roth TSP participant requests the TSP to transfer part or all of an eligible rollover distribution from the Roth TSP account, the transfer of the Roth TSP balance will not be taxed in the current year, and no federal income taxes will be withheld from the Roth TSP distribution. Subsequent distributions from an either a Roth IRA or a Roth eligible employer-sponsored Roth retirement plan may be taxed and subject to the 10 percent early withdrawal penalty.

TSP Rollovers from Roth TSP Accounts

If the TSP pays an eligible rollover distribution from a Roth TSP account to the Roth TSP participant, and the Roth TSP participant decides to do a rollover to a Roth IRA or to an eligible Roth employer-sponsored retirement plan, the following rules apply:

If the payment to the Roth TSP participant from the TSP is not a qualified Roth distribution, then the TSP is required to withhold 20 percent of the earnings portion of the distribution for federal income taxes. This means that in order to rollover the entire payment to a Roth IRA or to a Roth employer-sponsored retirement plan, the Roth TSP participant must use other funds to make up for whatever amount the TSP withheld for federal income taxes.
The taxable portion of a nonqualified Roth TSP distribution is treated the same as a distribution of a traditional TSP distribution. This means that whatever portion is not rolled over is taxed, federal and state. A 10 percent early withdrawal penalty will be imposed if the Roth TSP participant is under age 59.5.

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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.