Federal Employees News Digest
Traditional TSP Participants Should Understand the Tax Consequences When Transferring Funds to a Roth IRA
- By Edward A. Zurndorfer
- Nov 11, 2019
One of the expanded Thrift Savings Plan (TSP) withdrawal options that took effect on Sept. 15, 2019 allows traditional TSP participants to make multiple transfers of their traditional TSP accounts to a “rollover” Roth IRA. Note that a “rollover” Roth IRA is distinguished from a “contributory” Roth IRA in which an individual directly contributes using after-taxed dollars.
Under the expanded TSP withdrawal options, a traditional TSP participant age 59.5 or older who is still in federal service may make up to four transfers of his or her traditional TSP account to a “rollover” Roth IRA. A retired traditional TSP participant may perform up to 12 transfers per calendar year of their traditional TSP account to a “rollover” Roth IRA. Traditional TSP participants who are interested in performing such transfers should understand the tax consequences and possible penalties when performing these transfers, which this column discusses.
Transferring Traditional TSP to a Roth IRA
When an employee contributes to the traditional TSP, the contributions are deducted from an employee’s gross salary. An employee who is covered by the Federal Employees Retirement System (FERS) receives an automatic one percent of gross pay TSP contribution and a maximum matching TSP contribution of four percent from his or her agency. The employee’s contributions, the FERS employee’s agency, automatic and matching contributions and all accrued earnings on these contributions are tax-deferred. A traditional TSP participant pays federal and state income taxes on his or her account if any of the traditional TSP account is transferred to a Roth IRA.
A Roth IRA can be established in one of four ways, namely: When a federal employee or annuitant: (1) Contributes to a Roth IRA; (2) transfers funds from the Roth TSP to a Roth IRA; (3) transfers funds from the traditional TSP to a Roth IRA; or (4) converts a traditional IRA to a Roth IRA. In the case of (1) and (2), contributions and the amounts transferred are made with funds that were previously taxed. In the case of (3) and (4), the amounts transferred or the amounts converted are pre-taxed dollars.
Possible Penalties and Tax Consequences When Transferring Traditional TSP Funds to a Roth IRA
Penalty-free distributions from “rollover” Roth IRAs funded with traditional TSP transfers. When a traditional TSP participant younger than age 59.5 transfers part of his or her traditional TSP account to a Roth IRA, the traditional TSP participant must wait five years before he or she can take a penalty-free (no 10 percent penalty) distribution of the Roth IRA funds. Note that the potential penalty applies to the traditional TSP contributions and not to the TSP accrued earnings. The five year clock restarts for each separate transfer of traditional TSP to a Roth IRA.
Roth IRA distributions from transferred traditional TSP funds are always tax-free when the traditional TSP funds were transferred to the Roth IRA. This is because the income taxes were paid when the traditional TSP funds were transferred to the Roth IRA. But the Roth IRA distribution could still be subject to the 10 percent early withdrawal penalty. This is an anomaly in the Internal Revenue Code because normally an IRA owner can have a 10 percent penalty imposed on a taxable distribution.
However, when converted Roth funds are withdrawn before they are held for five years, the withdrawn funds will be subject to the penalty, even though the actual distribution will be tax-free. The following example illustrates:
Donald was age 60 in 2019. Upon retiring from federal service on Oct. 31, 2019, he transferred a part of his traditional TSP account to a Roth IRA. Donald paid full taxes on the full value of the transfer. The IRS recognized the transfer as happening on the first day of the year; therefore, Donald’s holding period began on Jan. 1, 2019. As a result, Donald must wait five years until Jan. 1, 2024 to take a penalty-free distribution from the Roth IRA. If Donald withdraws any of the Roth IRA before Jan. 1, 2024, the distribution will be tax-free but subject to the 10 percent early distribution penalty, even though the actual distribution will be tax-free.
2. Tax-free distributions of Roth IRA earnings. In order to make tax-free withdrawals of Roth IRA earnings, there must have passed at least five years since Jan. 1 of the year that the traditional TSP funds were transferred to the Roth IRA. Each transfer has a separate five year holding period. The following example illustrates:
Sandy retired from federal service in 2014 at age 56. Immediately upon retiring from federal service, she transferred a part of her traditional TSP to a Roth IRA. She must wait until the five year holding period ending on Jan. 1, 2019 and until she is at least age 59.5 for the distribution of her earnings to be tax-free. In 2019, when Sandy is age 61, she could withdraw the entire Roth IRA account penalty-free and any earnings would not be taxable because Sandy would have met the five year holding period.
Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant 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, located at 833 Bromley Street Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652.