How TSP Withdrawals and Rollovers Are Taxed

Ed goes in-depth on how TSP withdrawals and rollovers are subject to taxation.

Edward A. Zurndorfer-

If TSP account owners have made traditional (non- Roth) contributions to their TSP account, they have not yet paid taxes on those contributions and the accrued earnings. They will owe taxes on those contributions (except contributions made from tax-exempt pay made by a Uniformed Services member while serving in a combat zone) and earnings when they receive a payment (distribution) from their account. They may continue deferring payment of taxes by directly transferring or directly rolling over the payment to a traditional IRA or to an eligible employer plan.

If TSP account owners have made Roth contributions to their TSP account, they have already paid taxes on those contributions. They will not owe taxes on those contributions when they receive a payment (distribution) from the account. The tax treatment of earnings depends on whether the payment is a “qualified distribution,” which means that the participant’s entire payment is distributed tax-free.

The earnings in a Roth balance become “qualified”, and are therefore paid tax-free, when the following two conditions have been met, namely: (1) Five years have passed since Jan. 1 of the calendar year in which the account owner made his or her first Roth contribution (this is referred to as the “five-year rule”); and (2) The account owner is at least 59.5 or disabled.

All of the monies distributed from a traditional TSP account are taxable in the year that the monies are paid to the account owner. Withdrawals made from the TSP are taxed as ordinary income. This is because neither the contributions nor the earnings have been included previously in the account owner’s taxable income.

Uniformed Services TSP Accounts

A uniformed services TSP account owner who has made contributions that are from combat zone pay does not include those contributions as taxable income when they are withdrawn. However, any earnings on those contributions are subject to tax when they are distributed. The TSP will send a statement to the TSP account owner stating the total of the distributed amount and of the taxable amount of the distribution.

TSP Annuity

A TSP account owner who has left or retired from federal service can purchase a TSP annuity. If the account owner has a traditional (non-Roth) balance in the TSP account, the taxes on those contributions (and the earnings) are deferred until the money is paid to the account owner from the TSP annuity. The TSP annuity payments (composed of traditional (non-Roth) contributions and accrued earnings) will be taxed as ordinary income in the years when the owner receives them. If the owner has a Roth balance in the TSP account, those contributions were made with after-tax dollars. The TSP annuity payments composed of Roth contributions will not be taxed. Whether the Roth earnings portion of any annuity payment is taxed depends on whether that particular payment meets the IRS rules for qualified Roth distributions.

Note: TSP annuity payments are not subject to the IRS early withdrawal penalty, even if the TSP annuity owner is under age 55.

Cash Withdrawals

Cash withdrawals from a traditional TSP account, a single payment or a series of monthly withdrawals, are taxed as ordinary income in the year they are paid out. Individuals who receive a single lump-sum payment may be able to use the 10-year lump-sum option to figure the tax due on the withdrawal. To qualify for the 10-year option, the plan participant must have been born before Jan. 2, 1936.

If a TSP account owner receives a single payment, the TSP generally must withhold 20 percent for federal income tax. This federal withholding will also occur if the TSP account owner chooses to receive the account balance in monthly payments over a period of less than 10 years. Any money paid to TSP account owners younger than age 59.5 may be subject to an additional 10 percent tax on early distributions. This additional tax does not apply in the following situations:

The TSP account owner separates from government service during or after the calendar year he or she reaches age 55 or older.
The TSP account owner chooses to receive his or her account balance in monthly payments based on life expectancy.
The TSP account owner retires as a result of a total and permanent disability.

Withdrawal rules for Federal Law Enforcement Officers, Air Traffic Controllers, and Firefighters

The Defending Public Safety Employees’ Retirement Act (P.L. 114-26) amended the Internal Revenue Code to allow specified federal law enforcement officers, customs and border protection officers, federal firefighters, and air traffic controllers who separate from service in or after the year they turn age 50 to make a withdrawal from the TSP without incurring a 10 percent early withdrawal penalty. The law applies to TSP withdrawals paid after Dec. 31, 2015.

The TSP will rely on employing agencies and services to inform participants if a separating (or already separated) employee was a public safety employee as defined by the law.

Rollover Rules

A rollover is a tax-free withdrawal of cash or other assets from one qualified retirement plan or traditional IRA that is reinvested into another qualified retirement plan or traditional IRA. Any amount rolled over is not included in the account owner’s income. The amount rolled over is taxed later when it is withdrawn from the new account.

Effective Jan. 1, 2010, eligible TSP account owners (those who have retired from federal service or who are still federal employees at least age 59.5) are allowed to take some or all of their traditional TSP account and transfer it to a Roth IRA. There are no restrictions for performing a TSP rollover to a Roth IRA. Those eligible TSP account owners who request such rollovers must keep in mind that: (1) All such transfers are fully taxable in the year of transfer; and (2) the TSP account owner must have owned an existing Roth IRA to which the TSP funds will be rolled over.

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Any amount rolled over from the TSP to a Roth IRA is subject to the same rules as for converting a traditional IRA into a Roth IRA. For more information, see Can You Move Amounts Into A Roth IRA? in IRS Publication 590-A (Contributions to Individual Retirement Arrangements) (download here)

If an eligible rollover distribution is paid to the TSP account owner, then the TSP must withhold 20 percent for federal income taxes even if the TSP account owner plans to roll over the distribution to another qualified retirement plan or traditional IRA. The full amount is treated as a distribution even though only 80 percent is received by the TSP account owner. The owner must include in income any part of the distribution, including the part withheld for taxes that is not rolled over to another qualified retirement plan or to a traditional IRA. Withholding from an eligible rollover distribution paid directly to an account owner is not required if the distributions for the tax year total less than $200.

A TSP account owner who leaves government service before the calendar year in which he or she reaches age 55, and who is younger than age 59.5 at the time a TSP distribution is paid, may have to pay an additional 10 percent on any part of the distribution, including any tax withheld that is not rolled over. More information on taxes on early distributions is found in IRS Publication 575 (Pension and Annuity Income).

A TSP participant who wants to roll over more of an eligible rollover distribution than the amount that was received after federal income taxes were withheld can add funds from another source, such as savings or borrowing amounts. Here is an example that illustrates this point.

Example. Phillip leaves federal service at age 52. On March 1, 2022, he receives a check from an eligible rollover distribution of $50,000 from his TSP account. Because the check is made out to Phillip, the TSP withholds $10,000 so that he actually receives $40,000. If Phillip wants to roll over the entire $50,000 to postpone including the amount in his income, then he will have to get $10,000 from another source and add it to the $40,000 actually received. If Phillip rolls over only $40,000, he must include in his income the $10,000 not rolled over. Also, he may be subject to the 10 percent additional tax on the $10,000.

A surviving spouse of a deceased federal employee may be able to rollover—tax-free—all or part of the TSP distribution received. The rollover rules apply to the surviving spouse as if he or she were the employee. A distribution paid to a beneficiary other than the employee’s surviving spouse must be made to an eligible rollover distribution.

The TSP should provide a written explanation of the eligible rollover options to employees who leave or retire from federal service. This written explanation must be provided no earlier than 90 days and no later than 30 days before the distribution is made.

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.