Beware of the Income Tax Consequences When Transferring a Traditional TSP Account to a Roth IRA.
Edward A. Zurndorfer -
Federal employees who are 59.5 and over and federal retirees are eligible to make withdrawals from their Thrift Savings Plan (TSP) accounts, including from both the traditional TSP and the Roth TSP accounts. The TSP has made available a booklet entitled “Tax Rules about TSP Payments” (can be downloaded by TSP participants at www.tsp.gov). TSP participants are encouraged to review the booklet. Due to the complexity of some of the information presented in the booklet, TSP participants may have to consult with a qualified tax advisor.
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One withdrawal option for TSP participants is a rollover., including a traditional TSP rollover and a Roth TSP rollover. This column discusses the actual case of a traditional TSP participant who during 2022 transferred a portion of her traditional TSP account to a Roth IRA. The participant was informed incorrectly by the TSP that the entire transfer was a taxable direct rollover. As a result of the incorrect information, the individual filed for an extension on her 2022 federal and state income tax returns until the TSP corrects the situation.
This column explains what constitutes a rollover – in particular, a direct rollover – and why the transfer of a TSP participant’s traditional TSP to a Roth IRA does not constitute a rollover according to IRS rules.
How the TSP Explains a TSP “Rollover” Distribution
In its publication “Tax Rules About TSP Payments,” the TSP explains that not all types of distributions and withdrawals are eligible to be rolled over. On page 17 in the publication, the TSP has a table entitled “Tax Treatment for TSP Payments” that lists which types of TSP distributions and withdrawals are eligible to be rolled over. One example of an eligible distribution/withdrawal is a total or partial distribution by a separated TSP participant (for example, a CSRS or FERS retiree with a TSP account). The TSP states that the type of retirement plan or account that the TSP participant can rollover his or her TSP account to depends on whether the funds are rolled from the traditional TSP or from the Roth TSP.
Retirement account owners, including TSP participants, are encouraged to request a direct rollover of their retirement accounts. A direct rollover allows a retirement account owner to transfer funds from one qualified retirement account (for example, the TSP) into another retirement account (for example, an IRA). The original fund custodian will draft a check or a wire transfer on behalf of the TSP participant of the funds, made out to the new account custodian and not to the TSP participant).
The purpose of a direct rollover is to maintain the tax-deferred status of the retirement assets without creating a taxable event or incurring penalties. To avoid penalties and taxes, the rollover must be completed within 60 days of withdrawing funds from the original account.
The following table summarizes the tax consequences of a direct rollover of traditional TSP and Roth TSP accounts.
|Type of TSP Account||Type of Account Directly Rolled Over To:||Federal Income Tax Withholding Rate|
|Traditional||Qualified traditional retirement account (401(k), 403(b), 457 retirement plans)||0%|
|Roth||Qualified Roth retirement account (Roth 401(k), 403(b), 457 retirement plans)||0%|
How the TSP and the IRS Differ on What Constitutes a Traditional TSP Direct Rollover
The TSP and the IRS differ as to what constitutes a traditional TSP direct rollover:
TSP: Eligible rollover distribution may be rolled over to a traditional IRA, an employer (qualified) retirement plan, or to a Roth IRA.
IRS: Direct rollover of a distribution to a qualified retirement plan or to a traditional IRA.
Note that the IRS does not include the rollover of a traditional retirement plan (such as the traditional TSP) to a Roth IRA as a valid rollover. This is the case even though there is no federal income withholding, as is the case of a direct rollover of the traditional TSP to a traditional IRA.
When a TSP participant elects to transfer a portion of his or her traditional TSP to a Roth IRA, the transaction is fully taxable and considered a taxable distribution and not a rollover. As such, the IRS document used to report a distribution from a traditional TSP account (IRS Form 1099-R) is coded differently depending on whether there is a normal distribution or a direct rollover.
Box 7 of IRS Form 1099-R is used to identify the type of distribution the TSP participant received. Code “G” in Box 7 means a “direct rollover”. Code “7” means a “normal distribution” (taxable).
The following example illustrates (actual case, but the identity of the person and actual TSP distribution numbers has been changed to protect privacy):
Suzanne is a 72-year-old CSRS annuitant who is in the process of transferring her traditional TSP to a Roth IRA, held at the XYZ brokerage firm. She has been performing the traditional TSP transfers to Roth IRAs for the past five years. During 2022, Suzanne became age 72 and therefore required to take her first TSP required minimum distribution (RMD). The TSP calculated that her first TSP RMD based on: (1) Suzanne’s traditional TSP and Roth TSP account balances as of 12/31/2021, and (2) Suzanne’s life expectancy (Uniform Lifetime Table for age 72) of 27.4 years. Suzanne also requested separately during 2022 that the TSP transfer $50,000 of her traditional TSP account to a Roth IRA at the XYZ brokerage firm. The following is a portion of the two 2022 1099-R’s that Suzanne received from the TSP:
Table 1. 1099-R showing a $8,600 distribution to satisfy Suzanne’s 2022 TSP RMD:
|1. Gross Distribution $8,600.00||2022|
|2a. Taxable Distribution $8,600.00||Form 1099-R|
|7. Distribution Code: 7||4. Federal income tax withheld: $860|
|Recipient Name: Suzanne|
Table 2. 1099-R showing a $50,000 transfer of Suanne’s traditional TSP to a Roth IRA:
|1. Gross Distribution $50,000.00||2022|
|2a. Taxable Distribution $50,000.00||Form 1099-R|
|7. Distribution Code: G||4. Federal income tax withheld: $0|
|Recipient Name: Suzanne|
When Suzanne prepared her 2022 federal income tax return in March 2023, she included the 1099-R information that she received from the TSP on her Form 1040 lines 5a and 5b (Pension and Annuities), as shown here. Line 5a shows the “gross distribution” and line 5b shows the “taxable distribution”. The following appeared on Suzanne’s 2022 Form 1040, lines 5a and 5b:
Note the following: Suzanne’s taxable distribution is not the same as the gross distribution. According to what appears in box 5b, the only taxable portion of Suzanne’s two distributions from her traditional TSP was the $8,600 distribution (her 2022 TSP RMD). Her $50,000 traditional TSP transfer to a Roth IRA – coded as a “G” (rollover) in Box 7 of Table 2 - is shown as not taxable when in fact it is taxable. Had the TSP used a code 7 in Box 7 of Table 2, then the taxable amount on line 5b would have been $58,600, which is what it should be.
The TSP needs to correct this coding error in Box 7 of Form 1099-R. In the meantime, Suzanne has filed for an extension for her 2022 federal and state income tax returns. She is doing this in order to be able to pay the federal and state income taxes due on the transfer of the $50,000 in her traditional TSP account to a Roth IRA.
TSP participants who are considering transfers of their traditional TSP accounts to Roth IRAs – this includes retirees and employees aged 59.5 and older – are advised of this problem. They are advised to hold off performing such transfers until the TSP corrects the problem.
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.