This is a question that I received the other day from someone who has a lot on his plate. He’s getting his financial life in order and was trying to figure out whether a Thrift Savings Plan (TSP) rollover was the right thing. While everyone has different perspectives and situations, there is one constant: Any financial decision you make should be consistent with a financial plan that reflects your values and goals.
This article will discuss the pros and cons of rolling your TSP account into an IRA. However, any decision you make should be consistent with the long-term plan or strategy you have in place. (For more, see: 9 Tax Issues for Transitioning Service Members.)
The Pros of a TSP Rollover
There are several arguments for doing a TSP rollover. Some of those benefits are listed in more detail below.
Account aggregation: As people depart the military, they may find themselves trying to get their financial house in order. Part of that process includes account consolidation. If you’ve already been contributing to an IRA and you’re departing the military, it might be convenient to transfer your TSP account into that IRA.
Investment choices: Although you could argue that a TSP has plenty of diversification for any investor, there are several situations in which a TSP is not the right savings vehicle. Two specific examples come to mind:
- First, there are people who want to have a self-directed IRA to manage real estate or a closely-held business. Due to the tax treatment of leveraged investments inside retirement accounts, both of these ventures would receive maximum benefit from a consolidation of retirement assets. Since a TSP doesn’t allow for self-directed investments, an IRA is the only other logical investment vehicle.
- Second, there are people who might benefit from purchasing a qualified longevity annuity contract (QLAC). QLACs are for people who are approaching the age for required minimum distributions (RMDs) but do not need the income. The benefit of a QLAC is that it allows the account owner to defer RMDs until a later date. While this article won’t discuss specifics, a QLAC can be an effective tax-planning tool and a long-term care planning tool. While you can purchase a QLAC in an IRA, you cannot do so from TSP.
The Cons of a TSP Rollover
There are also some drawbacks to rolling a TSP account into an IRA. Let’s look into those as well.
Costs: There’s just no getting around this. Although Vanguard is the lowest-cost IRA provider, it still costs more than a TSP. How much more? Let’s look at this hypothetical chart of 20-year returns. This chart used the following numbers:
- Stock market returns. Literally, numbers I pulled out of my head. You can do this yourself with any set of numbers. The focus should be on the comparison between TSP, Vanguard and the industry average.
- TSP: The TSP’s expense ratios equal 2.9 basis points or .029%.
- Vanguard: Vanguard cites that their average exchange-traded fund (ETF) fees are 12 basis points or .12%.
- Industry average: 53 basis points or .53%, also according to Vanguard.
The chart indicates three things:
- Not even a TSP is an exact proxy for market returns. You can see that the 2.9 basis point annual fees take their toll over time.
- However, a TSP is closer to the pure stock market return than Vanguard.
- Both a TSP and Vanguard are pretty close to the pure market return. However, many people who aren’t conscious of their fees might see their returns eroded in the long term.
Retirement Account Aggregation
Huh? Wasn’t this a positive to moving your money into an IRA? However, you can just as easily consolidate your IRA and other retirement plans under a TSP. This is a great idea for families who have multiple IRAs or 401(k) plans, but who see a TSP as a cornerstone of their financial future. You can find more information on rolling accounts into TSPs on the TSP website.
Tax Planning for Thrift Savings Plans
This is a tough one, so try to follow me here. For those who have significant amounts of combat-zone deferrals, you’re probably aware that the eventual distribution from those deferrals are tax exempt, even though the earnings on those contributions are not. This information is easily produced by a TSP and you can look on your account statements to know exactly where you stand.
When you transfer this account to an IRA, most likely your IRA custodian will have no idea how to segregate your tax-free and taxable contributions. Combat zone contributions are the only type of contributions that are tax-free. And a TSP is the only retirement plan that accounts for combat zone contributions. Other plans are primarily focused on pre-tax and after-tax contributions, not tax-free. (For more, see: The Best Life Insurance for Military Families.)
What this means is that when you shift your TSP to an IRA account, your IRA custodian will likely treat your account in the following manner:
- Traditional accounts will be considered pre-tax
- Roth accounts will be considered after-tax
Your eventual distributions will have required withholdings by the IRA custodian. This means that your tax-free distribution may have tax withholdings, even though they’re tax-free. You can eventually claw back the withheld money when you file your tax return.
However, the burden of proof is on you to clearly identify that the transferred money originally came from contributions that you made when you were in a combat zone. This means you’ll have to maintain records that clearly indicate:
- Your deployments and total contributions during those deployments
- That your deployments qualified for tax-free contributions according to IRS Publication 3 (Armed Forces Tax Guide)
- That your rollover and distributions were consistent with IRS Notice 2014-54 (Guidance on After-Tax Amounts to Rollovers)
If you’re not familiar with IRS Notice 2014-54, it’s a doozy. In essence, it means that when you withdraw from a retirement account plan (such as a 401(k) or TSP), and you have both pre-tax and after-tax (or tax-free) contributions, then you must make your withdrawals in proportional amounts. (For related reading, see: 5 Debt Plan Considerations for Military Families.)
For example, let’s say you have $100,000 in a TSP ($80,000 in traditional and $20,000 in Roth). When withdrawing from this account (or rolling over), you must withdraw equally from each account. If you’re rolling over the entire balance, there’s no problem. However, let’s say you’re only drawing out $20,000. You cannot just cherry pick $20,000 in Roth just to avoid paying taxes.
The IRS mandates that your $20,000 must be in equal proportions from each account. In this case, you would take 80% from the traditional and 20% from the Roth account or $16,000 and $4,000, respectively. (The TSP accounts for this and will distribute proceeds from your accounts in this manner).
Tired yet? Just wait until you try to manage this on your own, without any assistance from a TSP (who is no longer managing your account). You might spend a lot of money to hire an accountant, enrolled agent, or fee-only financial planner to help you wade through this correctly or even more time and frustration (and possibly money if done incorrectly) doing it on your own. This might be a situation where you decide to leave your money in TSP.
Note: We haven’t yet gotten to the point where there are a lot of TSP account holders who are managing distributions of combat zone contributions. However, when we do, it will be quickly apparent that this will be a big deal for those people who rolled their TSP over into IRA accounts. Perhaps the bigger IRA custodians will incorporate procedures to amend this gap. However, since TSP rollovers account for such a small portion of the overall IRA rollover market ($443 billion for TSPs versus $4.8 trillion for 401(k)s), I wouldn’t hold my breath.
The Bottom Line
Whether or not you decide to do a TSP rollover into an IRA depends completely upon your circumstances. It’s important that you not make this decision too quickly. The last thing that you want to do is jump from the frying pan into the fire. Instead, the decision to roll your TSP into an IRA should be part of a methodical, long-term financial plan that is consistent with your values and financial goals, and should consider all the pros and cons. (For more from this author, see: 5 Considerations About Military Life Insurance.)