TSP Participants Living in New Jersey and Pennsylvania Should Be Aware on How Their Traditional TSP Withdrawals Are State-Taxed
Edward A. Zurndorfer -
Most federal employees are familiar with the tax benefits associated with the traditional Thrift Savings Plan (TSP). Employee contributions made via payroll deduction from an employee’s gross salary result in current year federal income tax savings. Employees have a choice of five TSP core funds (three stock funds - the C, S, and I fund; two bond funds – the F and G funds; 10 life cycle funds; and the TSP “mutual fund window”. Contributions and earnings – interest, dividends, and capital gains – grow tax-deferred over time and are federally taxed only when traditional TSP funds are withdrawn. The following example illustrates:
Example 1. Ann, age 40, is a federal employee whose SF 50 salary during 2023 is $110,000. Ann is contributing the maximum possible ($22,500) to the traditional TSP during 2023. Ann’s gross salary and taxable salary during 2023 are summarized as follows:
- Gross annual salary: $110,000
- Less: Traditional TSP contributions: ($22,500)
- Taxable annual salary: $87,500
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Note the following: (1) The taxable annual salary will appear on Ann’s 2023 W-2 statement (Box 1) as “taxable wages”; and (2) Ann’s “Social Security wages” (Box 3 of her W-2 statement) will be $110,000 as will be Ann’s 2023 “Medicare wages” (Box 5 of her 2023 W-2 statement).
The $22,500 that Ann contributes to her traditional TSP during 2023 will accrue earnings in the various invested TSP funds or life cycle funds. In the future, when Ann withdraws the $22,500 and accrued earnings, she will pay the full amount of federal income tax on the amount withdrawn.
What about the state income tax consequences? If Ann lives in a state that has no state income taxes (Florida, Tennessee, New Hampshire, South Dakota, Texas, Wyoming, Washington and Alaska) then she does not have to be concerned about any state income tax consequences when she contributes to her traditional TSP nor when she withdraws from her traditional TSP. But this assumes that Ann is a resident of a state that has no state income tax when she both contributes to the traditional TSP and when she withdraws from her traditional TSP.
If Ann is a resident of a state with a state/local income tax, then the state income tax treatment of Ann’s traditional TSP contributions and withdrawals are identical to the federal income tax treatment of contributions and withdrawals. That is, contributions are state income tax deductible and fully taxable (together with accrued earnings) when withdrawn. The following example illustrates:
Example 2. Peter, age 58, is a federal employee who lives in New York state. Peter has 35 years of federal service. During 2023 Peter intends to contribute the maximum $30,000 he can to his traditional TSP account. His SF 50 salary is $150,000 during 2023. His federal and New York taxable salary during 2023 are:
- Gross Salary: $150,000
- Less: Traditional TSP Contributions: ($30,000)
- Taxable Salary (Federal and New York): $120,000
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.
The following table summarizes selected IRS penalties the IRS imposes on individuals:
|Total Contributions (2001 - 2021)||$120,500|
|Agency Matching Contributions||$80,500|
|Agency Automatic (1%) Contributions||$10,000|
|Total Value of Account (12.31.2021)||$450,000|
To determine how much of the $428,571 distribution is taxable for New Jersey income tax purposes, one must use the IRS General Rule (as explained in IRS Publication 939):
|1. Contributions made to the Traditional TSP||$120,500|
|2. Total value of TSP account on day of withdrawal||$450,000|
|3. Percentage excludable (divide line 1 by line 2)
for state income tax purposes
|4. Amount withdrawn in a lump sum||$428,571|
|5. Amount of line 4 excludable from NJ state income tax (multiply line 4 by line 3)||$114,762|
|6. Amount of line 4 subject to NJ state income (line 4 less line 5)||$313,809|
By using the General Rule to determine how much of the $428,571 traditional TSP withdrawal is taxable for New Jersey income tax purposes, Alexander saved 8 percent of $114,762 or $9,181, in New Jersey income taxes. Had Alexander not contacted the TSP for the information, he would have owed 8 percent of $428,571 or $34,386 in New Jersey income taxes.
Those federal employees who are contributing to the traditional TSP while residents of New Jersey or Pennsylvania and who intend to retire in those states should take note:
- While contributing to the traditional TSP a New Jersey or Pennsylvania resident’s contributions are made with after-taxed salary for state income tax purposes.
- While withdrawing funds from a traditional TSP account, those traditional TSP participants who contributed to the TSP residents of New Jersey or Pennsylvania will not have to pay New Jersey or Pennsylvania income tax on the traditional TSP withdrawals if they are a New Jersey or Pennsylvania resident at the time of withdrawals.
- New Jersey or Pennsylvania TSP participants who retire in those states must request from the TSP a printout of how much they contributed to the traditional TSP as a New Jersey or Pennsylvania resident. They or their accountants will need this information in order to use the General Rule in calculating how much of their withdrawal is taxable for New Jersey or Pennsylvania state income tax purposes.
Edward A. Zurndorfer is a Certified Financial Planner, 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 the employees of Serving Those Who Serve 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.
The investment profiles are hypothetical, and are presented only as examples and are not intended as investment advice. Please consult with your financial advisor if you have questions about these examples and how they relate to your own financial situation.