Roth Thrift Savings Plan Explained: Part One

We've cleared up the Supplement, so let's turn our sights onto the Roth TSP, which can also be a confusing topic. Don't worry, we won't try to tackle everything in this one article. We'll just cover how contributions are made, and withdrawal regulations, including the unique 5-year waiting period. In Part Two, we'll look at transfers and RMD's (required minimum distributions.)

First of all, as a FERS employee, you have the option within your TSP to contribute with "before tax" dollars in the Traditional side of TSP, or "after tax" dollars in the Roth side of your TSP. (Or a combination of the two). To contribute $100 to a Roth, you have to actually make somewhere around $120 or $130 first. Uncle Sam takes his $20 or $30 bucks, and leaves you with $100 that can now go to your Roth. Another way of looking at it is that it costs you more money than your actual contribution. You get zero tax benefit up front for a Roth contribution. The perceived benefit in this arrangement is that when you take the money out down the road, you don’t have to pay taxes on it then.

In contrast, if you contribute to a Traditional TSP, you get the tax benefit right now. It is “before-tax”money. Meaning, Uncle Sam doesn't get his fiscally irresponsible hands on the money before you get a chance to contribute. This has the effect of lowering your taxable income for the year. If you contribute $100 to the Traditional, you receive a tax break of $20-$30, meaning your $100 contribution really only cost you $70-80. The perceived downside to this is that you have to pay taxes on the money when it comes out.

If you retire from the government in the year you turn 55 (or 50 for you SCEs), you can begin withdrawals from your Traditional TSP penalty-free. This is ONLY for the Traditional TSP. The Roth TSP still requires that you reach 59 1⁄2 before you can begin to withdraw money penalty-free. This is one of the most common misunderstandings I’ve encountered. The early withdrawal exceptions are not for the Roth TSP, only the Traditional TSP. By the way, the penalty for early withdrawals from either account is 10%. For the Roth accounts, the penalty would only apply to the earnings—you’ve already paid taxes on the contributions themselves.

What Happens When You Transfer TSP Money to IRAs?

A popular option is to transfer money from the TSP to a private IRA in retirement. People do this for any number of reasons: more investment choices, they found a “great” financial advisor who will manage their money, or they just hate paying the low fees of the TSP and want to pay a lot more for the exact same product. (Just seeing if you’re paying attention--that last one is not an actual reason. Although I’ve come across more than one fed that has done it.) Both Traditional and Roth TSPs allow for this transfer option into an IRA. But because one contains pre-tax money and one contains after-tax money, they can’t go into the same type of IRA. The Traditional TSP goes into a traditional IRA and the Roth TSP goes into a Roth IRA.

Regardless of which account you transfer them to, all IRAs have a 59 1⁄2 age withdrawal limit, both traditional and Roth. Withdraw from a private IRA of either kind before 59 1⁄2 and you have to pay the 10% penalty. The ability to withdraw at 55 or 50 penalty-free only applies if you are withdrawing from the TSP. Once the money is transferred out of the TSP, the money no longer benefits from the TSP rules. The money is now under IRA rules.

5-Year Waiting Period

In addition to the 59 1⁄2 limit, the Roth accounts (both TSP and IRA) have an additional restriction: a 5-year waiting period. The 5-year waiting period works like this: in order to withdraw your money without paying taxes, you have to be at least 59 1⁄2 years old, AND have first contributed to your Roth at least 5 years ago. Please understand this point because it will be very important in just a second.

Example 1:

Jim started contributing to a Roth TSP when he was 52. Jim can withdraw money at 59 1⁄2 with no issues. Jim has satisfied both the age and time requirements.

Example 2:

Meghan started contributing to a Roth TSP at 56. When she turns 59 1⁄2, she has met the age requirement, but not the holding period. She’s had her Roth TSP for 3 1⁄2 years. She has to wait another year and a half before she can withdraw without penalty. In this example, Meghan would be 61 before she can withdraw with no issues.

Again, this 5-year holding period does not apply to the Traditional TSP or IRA. But it does apply to the Roth TSP and Roth IRA. Additionally, there are slight differences between the Roth TSP and the Roth IRA holding periods. Here’s where it starts to get sticky:

Remember how I said you could transfer your Roth TSP to a Roth IRA? And remember how I said that they each have a 5-year waiting period? Well, unfortunately for those of you doing this, the holding period DOES NOT CARRY OVER from Roth TSP to Roth IRA. I can’t stress that enough. Roth TSPs are under Roth 401(k) rules and the tax code states that Roth IRAs have to be open for 5 years before withdrawals on earnings are made. The IRS has made no provision for an exception for rollovers into a Roth IRA. So, whether you are just contributing money each month to a Roth IRA, or you fund it by transferring in your Roth TSP, withdrawals on earnings can’t be made without penalty for 5 years. Confusing? Examples seem to help so let's try a few:

Example 1:

Andy retires from the government at 58. He began contributing to his Roth TSP at age 52 (over the 5-year period). He transfers his Roth TSP to a Roth IRA that he opened just for this purpose. He did not have a Roth IRA prior. Andy cannot withdraw earnings from his Roth IRA at 59 1⁄2 without issues. He must wait 5 years, or until he is 63 in this example. Even though he met the holding period in his Roth TSP, that holding period restarts when he transfers the money to a Roth IRA.

Example 2:

Jill retires at 58. She transfers her Roth TSP to a Roth IRA that she opened many years ago (over 5). Jill will have no issues withdrawing at 59 1⁄2 because the Roth IRA has contributions in it older than 5 years. In other words, the waiting period has already been satisfied.

Example 3:

Mary retires at 58. She transfers her Roth TSP to a new Roth IRA that she opened up for this transfer. However, she had a separate Roth IRA that she contributed to many years ago that has just been sitting. Like Jill, Mary will have no issues withdrawing at 59 1⁄2 from either Roth IRA. This is a little quirk in the tax code, but the IRS doesn’t require each and every Roth IRA be held for 5 years, only that the oldest one owned by the taxpayer is held for at least 5 years.

That's probably enough for one article.

In Part Two, we'll cover the unique aspect of how transfers only work one way, as well as the in's and out's of the dreaded Required Minimum Distributions. None of this should be considered official financial advice. If you want some of that, contact me or your other favorite CPA to discuss your options.

Stay tuned....