AVOIDING PITFALLS WITH ROTH TSP: Steer clear of these 4 potential missteps in a tax-exempt investment plan
The Thrift Savings Plan (TSP) is a popular retirement savings option for federal employees. However, understanding the rules surrounding TSP distributions is crucial to avoid penalties and ensure tax efficiency.
Firstly, let's discuss the "Qualified Distributions" test, which Roth TSP account holders must satisfy to avoid income tax and penalty on their distributions. This test consists of two prongs. Prong 1 requires that a five-year period has passed since January 1 of the calendar year in which the first Roth TSP contribution was made. Prong 2 has several conditions, including being 59 ½, being permanently disabled, deceased, or meeting specific other conditions.
It's important to note that the Rule of 55 exception only applies to employer plans, not IRAs. This means that if you rollover your TSP to an IRA, you will not be able to use the Rule of 55 to avoid a 10% penalty on IRA distributions before age 59 ½.
The Rule of 55 also has some exceptions for certain federal employees. For instance, FERS Special Category Employees who are Qualified Public Safety Employees can access traditional TSP funds without a 10% penalty once they separate from service upon reaching age 50, or at any age after completing 25 years of SCE/QPSE service. SCE/QPSE feds must be age 50 at the time of separation if they have not crossed the 25-years of service threshold. Federal law enforcement officers can also access traditional TSP funds without a 10% early withdrawal penalty if separated from service before age 50.
It's also worth mentioning that Roth TSP dollars are subject to the 5-Year Rule, and violating this rule, even if over age 59 ½, may result in a distribution being subject to income tax and a 10% penalty.
The IRS imposes a 10% early-withdrawal penalty on distributions from IRAs and employer-sponsored plans like the TSP or 401(k) if the distribution is taken before age 59 ½. The exception only applies to the plan of the employer you are separating from.
Lastly, it's essential to remember that tax-free growth and tax-free withdrawals in Roth TSP accounts can be a powerful tool for retirees. However, if you do not satisfy both prong 1 and either a, b, or c of prong 2, your Roth TSP distribution may be subject to income tax and a 10% penalty.
For more information on the 10% penalty exceptions, the IRS has a resource outlining these details. It's always a good idea to consult with a financial advisor or the IRS directly to ensure you fully understand the rules surrounding your TSP distributions.
