Maximize your TSP by minimizing your tax

You’ve saved for years, maybe decades, building up your Thrift Savings Plan account to help ensure a comfortable retirement. The day comes when you must make that first required minimum distribution, fondly known as the RMD. Or perhaps you want to take some funds out earlier. Or take more than the RMD.

Whatever you decide, the reality will soon set in: TSP withdrawals often come with tax implications – meaning you might owe. Don’t forget, you paid into a traditional TSP account with pre-tax dollars. That meant the tax was merely deferred, not forgiven.

Therefore, however you decide to use your TSP savings, your strategy must include a tax planning component.

Keep in mind there’s a distinction between early withdrawals and retirement withdrawals. Early withdrawals because you need the money before the age of 59½, also called non-qualified withdrawals, incur a 10% penalty in addition to the taxes due. That’s tax law, not anything the TSP board imposes.

You can avoid the penalty, but not the taxes, if you make non-qualified withdrawals for instances like medical costs, or you get a disabling or terminal illness.

Roth TSP accounts, made with after-tax contributions, have a couple of wrinkles. Qualified withdrawals from a Roth TSP — those taken after age 59½ and after the account has been open at least five years — are tax-free. But subsequent earnings on the original principal do get taxed and penalized if you make non-qualified withdrawals. The five-year penalty rule also applies to funds you transferred from a traditional TSP.

As for qualified withdrawals, those made once you reach the statutory minimum age of 59½, those are taxed at your current tax rate. If your income, and hence your tax bracket, are lower than when you made the contributions, then you’ve legitimately avoided some federal tax. That’s in part the original idea behind traditional individual retirement accounts and their variants like the TSP.

How much you need

Like many federal retirees, you might find you can meet your lifestyle needs between Social Security, your Federal Employee Retirement System Annuity and whatever other income you might earn. That might in turn mean you need only take your RMD and no more, thereby keeping taxes somewhat at bay. Better yet, if you retire in your late 60s, you let your TSP keep growing by delaying your first RMD until you legally have to. Current law pegs that at 73 years old if you were born January 1, 1951 – December 31, 1959.

Depending on your circumstances, you could choose the option of withdrawing all of your traditional TSP and roll it over to a Roth. You would, of course, pay taxes on the entire amount, potentially placing you in a significantly higher tax bracket for that year. Only consider this step after consulting with a qualified tax expert. Serving Those Who Serve has such experts available.

Some retirees roll their TSP over to a regular IRA. Note that it’s a one-way street. Your TSP reverts to zero and you can no longer move money into it. You gain more fine-grained control over your investments, but the same tax rules apply. There is no tax otherwise on a direct rollover.

Another option: Purchase of an annuity with your TSP funds or a portion of them. The Federal Retirement Thrift Investment Board offers MetLife annuities starting at $3,500 withdrawn from your TSP.

You don’t immediately pay taxes on TSP money rolled over to an annuity. So in that sense, it continues the tax deferral. But you do pay taxes – again, at your current income rate – on the fixed payments you receive from the annuity.

Fixed annuities offer a certain guaranteed growth rate, roughly on par with inflation, plus the certainty of regular payments. Variable annuities offer higher growth potential but also higher risk. Either way, annuities come with costs of their own. Here again, a careful analysis aided by a tax professional is in order.

STWS staff have found over the years that TSP annuities are inappropriate for most federal retirees precisely because they also have both a defined benefit pension and Social Security.

Still another option is to set up automatic withdrawals. You can do this right at the TSP website. The TSP machinery is capable of calculating your installments using IRS life expectancy tables. It will recalculate them every January 1^st so you don’t run afoul of RMD rules. Otherwise, you can specify fixed dollar amounts for your automatic withdrawals. Either way, withdrawals incur taxes. You might want to go the yearly calibration route if the RMD amount is sufficient for how you live.

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