The Thrift Savings Plan for Federal employees and armed forces members bears a strong resemblance to a 401(k) or similar private-sector workplace retirement plan. But there is enough difference in how some TSP deferred payroll contributions get treated for you to carefully consider your options before you decide how to treat your TSP assets when you switch jobs or leave the armed forces. In most cases, rolling a workplace retirement plan into a traditional IRA first provides more options – including Roth conversions – but in some circumstances a direct rollover from your TSP to a Roth IRA might be advantageous.
The Thrift Savings Plan offers limited investment options, but those options carry remarkably low expenses. As long as you have more than $200 in your TSP account, you are not obligated to move it elsewhere. But if you want the widest array of investment choices – though almost certainly with higher fees – rolling your TSP into an IRA, either traditional or Roth, is the only option without paying a 10 percent early withdrawal penalty.
If you deferred combat pay or other earnings into your TSP while you served in a tax-free zone, those contributions are never subject to federal taxes, even when you withdraw them. Check the tax-exempt balance on your TSP statement. If a high proportion of your assets are tax-exempt, consider a direct rollover into a Roth IRA.
Immediate Tax Consequences
The nonexempt portion of your account will be taxed as ordinary income in your rollover year, but you won't pay an early-withdrawal penalty by sending the assets to a Roth. Plus, if a large percentage of your rollover year's earned income consists of combat or other tax-exempt pay, you likely will be in a lower tax bracket than in succeeding years. That will decrease the tax bill you will be assessed on your nonexempt rollover assets.
Long-term Tax Consequences
Once you complete the Roth rollover, the rules for Roth IRAs allow you to withdraw your rollover contributions tax-free at any time, for any reason, if the money you contributed to the TSP was tax-free to begin with. On the other hand, if you pay taxes to roll tax-deferred TSP contributions into a Roth, you'll have to wait at least five years to take them out. After that, they, too, can be removed tax free and penalty free at any time. Roth investments grow tax free, but earnings must pass a couple of tests to qualify for tax-free withdrawals.
Qualified Earnings Distributions
In general, earnings cannot be taken as a tax-free distribution until Jan. 1 of the fifth year after you open at least one Roth IRA account -- whether it is your rollover account or some other Roth. After you meet the five-year test, only certain types of earnings distributions qualify as tax-free: those after you reach 59 1/2; payments made to a beneficiary after your death; disability distributions; or qualified first-time homebuyer distributions.
The IRS doesn't allow you to cull out the tax-exempt portion of your TSP and roll it over tax-free into a Roth, leaving behind the nonexempt part. If you decide on a partial rollover, the converted amount must be in proportion to the TSP's tax-exempt and nonexempt assets.
Gradual Roth Conversion
You can roll over your entire TSP account into a traditional IRA with no immediate tax liability or penalty, then convert the money over several years into a Roth IRA. Such a move gives you immediate investment flexibility and provides the opportunity to cut the tax liability on the Roth transfer into smaller portions. However, conversions from a traditional IRA to a Roth must remain in proportion to the TSP's tax-exempt and nonexempt assets, and any account earnings within the traditional IRA will be added to the nonexempt portion of the account.
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- Penalties for Roth IRA Early Withdrawal
- Tax Differences in a Roth 401(k) Vs. a Roth IRA
- How do I Calculate & Convert an IRA to a Roth IRA?
- How Long Do You Have to Hold a Roth IRA?
- Traditional Roth IRA Conversions & Non-Deductible IRA Contributions
- Are Distributions From a Roth IRA Taxable?