When you leave your federal job, you might want to consider moving the funds you’ve accumulated in your traditional thrift savings plan (TSP) to another retirement account. Traditional TSPs come with many benefits, although some of their main advantages, including generous contribution allowances and matching employer contributions, disappear once your days as a government worker are behind you.
A Roth IRA is an attractive alternative. These individual retirement accounts (IRAs) offer greater investment choice, aren’t subject to required minimum distributions (RMDs) at any age, and are funded with after-tax dollars, meaning that you can grow your earnings tax free.
If, after doing your own due diligence and perhaps consulting with a financial advisor, you decide to take this path, you should be aware that it isn’t always a straightforward process. There are different ways to move your retirement funds from a traditional TSP to a Roth IRA, and taking the wrong step could prove costly.
- There are two main ways to move money from a traditional thrift savings plan (TSP) account to a Roth individual retirement account (Roth IRA).
- You can instruct the TSP to transfer your funds directly to your new retirement plan.
- Alternatively, you can withdraw the funds and deposit them personally to a Roth IRA by a set deadline.
- Both approaches create immediate tax liabilities, as money in traditional TSPs is taxed at withdrawal.
How to Roll Over TSP Funds Into a Roth IRA
To request a withdrawal, log into your account on the TSP website and click on the “Withdrawals and Changes to Installment Payments” link in the menu. Once there, you’ll be walked through the entire withdrawal process.
Before proceeding, you’ll need to consider carefully how you want to move your money. There are two methods:
- A direct rollover, also known as a transfer
- An indirect rollover, also known as a rollover
If you move money from a traditional TSP to a Roth IRA, you will have to pay taxes on the amount that you transfer.
Direct Rollover (or Transfer)
With a transfer, you instruct the TSP to transfer your funds directly to your new retirement plan. Select this option and someone else will take care of almost everything for you. All you need to do is have a Roth IRA set up and the account details at hand. You’ll also be required at tax time to pay taxes on the transfer amount to the Internal Revenue Service (IRS).
When you do a direct rollover, your employer does not withhold any taxes from the amount transferred. You’ll declare the amount that you transferred on Form 1040. That amount is added to your taxable income for the year. It is then up to you to settle this tax bill.
The TSP will inform the IRS of your withdrawal and mail you a copy of Form 1099-R the following January. This form, which can be downloaded from your online TSP account the first week of February, serves as a record of the transaction.
You can avoid a big tax bill in a single year by doing a traditional TSP-to-traditional (pre-tax) IRA direct rollover first. No taxes are due in this case because there's been no distribution. Then, gradually transfer funds each year from the pre-tax IRA to the after-tax Roth IRA until all have been moved.
Indirect Rollover (or Rollover)
An indirect rollover occurs when money in your traditional TSP is sent by check to you (rather than transferred directly into your new account). You then deposit it into another retirement account yourself. This might sound like a tempting option. However, several caveats will likely give you second thoughts.
The most important things to be aware of are:
- In this case, the TSP withholds 20% of your funds for federal income taxes.
- You then have 60 days to redeposit your traditional TSP funds, including the 20% withheld, to your Roth IRA. If you fail to meet this deadline, then any portion not deposited will be taxed.
- It also will be subject to a 10% early withdrawal penalty if you are younger than age 59½.
If you plan to retire early and need access to your traditional TSP funds, it’s best not to immediately transfer them to a Roth IRA. With a Roth, you’ll pay penalties on withdrawals if fewer than five years have passed since your first contribution and you’re younger than 59½ years old.
Let’s look at an example. On his 59th birthday, Roy takes a $30,000 eligible rollover distribution from his traditional TSP, which he plans to roll over into his Roth IRA. He receives a check for $24,000. $6,000 has been withheld for taxes. He now has 60 days to deposit the full $30,000 into his Roth IRA to avoid paying a penalty.
Before the deadline, Roy acquires an extra $2,000, bringing the total amount that he redeposits into the Roth IRA to $26,000. The problem is that there is still a $4,000 shortfall, and now that the deadline has expired, Roy is going to get taxed on that amount and pay a $400 early withdrawal penalty.
The biggest issues here are having to use additional funds to plug the shortfall of the withheld 20% and being on the clock to make the transfer happen. Sixty days may sound like a long time. However, if you lead a busy life, are not very organized, or something unexpected requires your time, those days will soon pass.
What's the Tax Implication of Converting a TSP to a Roth IRA?
If you move money from a Thrift Savings Plan (a pre-tax retirement account) to a Roth IRA, you will owe taxes on the amount you move. That's because the account from which you're taking money gave you a tax break on your contributions and the account to which you're moving it is an after-tax retirement account (which gives you tax-free withdrawals). At some point, the IRS wants the money that it's due (that's been growing tax free), and that point happens when you change accounts.
Will the TSP Withhold Money for Taxes When I Transfer Funds to a Roth IRA?
Not if you do a direct rollover, also called a transfer. In such a case, it’s your responsibility to inform the IRS when you file your tax return of the amount that you transferred. Anything you transfer is taxable in the year that it is transferred. Of course, that means you’ll need to be disciplined and find a way to put some funds aside to pay those taxes.
Is a Roth TSP the same as a Roth IRA?
No. Both involve contributions with after-tax dollars and are subject to the five-year rule. However, other than those factors, they are vastly different.
The Bottom Line
More and more former federal employees are considering the benefits of switching to a Roth IRA. The logic behind this move is understandable—tax-free withdrawals are attractive. Still, not everyone has the same needs and circumstances, so it’s important to be fully aware of what you are getting yourself into before making the switch.
For those who do make the jump, careful consideration of which rollover technique to use is crucial. In the majority of cases, a simple transfer, also known as a direct rollover, represents the best option.