Withdrawal policies have changed to give account holders much more flexibility, in response to feedback from investors.
Two-fifths of TSP account holders transfer out their money on retirement or separation, most commonly into an IRA. In a 2017 survey, of those near retirement and planning to withdraw their accounts soon after, 85 percent cited the limited withdrawal choices as a main reason. An IRA, in contrast, allows withdrawals in amounts and at the times of an investor’s discretion, subject to the same type of required minimum withdrawal rules for those past age 70 ½.
The TSP is a good deal
The trend of leaving the TSP for other investment vehicles is happening despite the TSP’s low overhead fees in comparison with IRA mutual funds, where annual costs of $10 to $20 or more per $1,000 on investment are not uncommon. In contrast, the TSP’s administrative expenses typically are in the range of 15-30 cents per $1,000 in the account. Such differences amount to receiving a higher rate of return in the TSP on the same type of investment, a difference that is more pronounced the larger the account balance and the longer the period of investment.
The trend also is happening despite the extraordinarily good deal offered by the only-in-the-TSP G fund, which is especially popular with retirees, who are seeking to protect their investments. It yields returns similar to those of mid-term government bonds, around 2-3 percent in recent years, with none of the risk to principal that comes with bond investing in anything but the shortest securities—which pay interest of virtually zero. The G fund by definition cannot lose value.
In September 2019 TSP rules were changed to:
– End the policy limiting account holders to only one partial withdrawal post-separation with the second withdrawal requiring that a choice be made for the remaining account balance.
– Expand the “substantially equal payment” withdrawal option, including the ability to: elect quarterly or annual payments in addition to monthly payments; change the payment amount at any time rather than just once a year; and elect an annuity with the remaining balance after stopping those withdrawals rather than being limited to a lump-sum withdrawal.
– Remove the limit of one age-based in-service withdrawal, allowed without tax penalty after age 59 ½.
Continue reading to understand tax implications of withdrawals, different kinds of withdrawals you can make, annuities, RMDs and more.
Tax Status of Withdrawals
Any withdrawal decision must be made in the context of understanding the tax impact. The TSP, as a retirement savings vehicle, enjoys favorable tax treatment that comes in one of two forms.
In “traditional” balances, investments are made from pretax dollars. The up-front tax break for employees, particularly higher paid ones, can be substantial. Investment earnings are tax deferred until withdrawn. This provides a substantial benefit to investors, allowing the money to compound without reductions for taxes over the years. Generally, retirees are in lower tax brackets when they withdraw the money, adding yet another tax benefit.
In “Roth” balances, investments are made with after-tax money. On withdrawal, Roth investments are tax-free. Their associated earnings also are tax-free if: the withdrawal is made at least five years after the beginning of the year in which the first Roth investment was made; and the participant is at least 59 ½ years old, disabled or deceased. For this purpose, an IRS definition of disability is used, not the federal retirement or Social Security definitions.
As a practical matter, the large majority of federal employee TSP investments are in traditional status. There are several reasons for this. First, up to 2012, that was the only type allowed in the TSP; money already in an account can’t be re-characterized from one to the other. Second, traditional investing is the default while Roth-style investing requires an affirmative choice. Third, agency contributions on behalf of FERS employees are made under the traditional design regardless of how the employee is investing.
However, while TSP investors can choose among those two options while putting the money in, they have no such leeway when taking the money out. All distributions (not just withdrawals but also including loans, death benefit distributions, court-ordered payments, and required minimum distributions) from the TSP will be disbursed pro rata from a participant’s traditional and Roth balances. Those choosing to withdraw their accounts as annuities have to buy separate annuities for each type of balance if they wish to annuitize their entire amount, and have to elect the same annuity options for each, with the same options.
TSP Withdrawal Options Overview
Once you separate from the federal service, you will be offered a series of withdrawal options from which to choose. You can:
• withdraw your money as a lump sum;
• withdraw your money as substantially equal payments based on either a dollar amount or actuarial tables; or
• have the TSP purchase a life annuity for you.
Further, you can combine these choices.
Note: These options are the same whether or not you begin an immediate federal annuity on separation.
With the lump sum option, you can have the TSP transfer all or part of your investments into your IRA or other eligible retirement plan. Such transfers also are allowed under the substantially equal amount payment option. In both cases, required minimum distributions may apply, however.
If you have both traditional and Roth balances, transfers of lump sums or portions of substantially equal payments must be processed separately so that the tax status remains the same. And as noted above, if you have both types of balance and elect to purchase an annuity, you must have separate annuities for each, with the same options.
You can leave your money in the TSP where it will continue to earn interest and defer a decision about what to do until a later date, within the minimum distribution requirements. Although you may no longer make investments into your TSP account after separating from federal service for retirement (or other reasons) you may continue to change the way your money is allocated among the investment funds.
A one-time partial withdrawal is allowed—except for those who took an “age-based” withdrawal after age 59 ½ while still employed—with any second withdrawal having to cover the remaining amount in the account. However, a law passed in 2017, due to take effect as soon as sometime in 2018, would change that policy. It would allow multiple partial withdrawals, both age-based before separation and post separation withdrawals. The TSP does have the authority to limit the number allowed.
The lump sum withdrawal option is the most straightforward. You can withdraw up to your entire TSP account balance in a single payment. That payment can be sent directly to you, or it can be transferred into an IRA or other qualified retirement plan—for example a 401(k) plan that you have from a former or new employer—subject to minimum distribution requirements. You also may have part of the payment paid directly to you and part transferred.
To make a lump sum withdrawal, use Form TSP-70, Request for Full Withdrawal, or TSP-77, Request for Partial Withdrawal When Separated. These forms also include procedures for transferring all or part of your money to an IRA or other qualified plan, if you wish.
The advantage of receiving money directly—as opposed to having it transferred into an IRA or other retirement savings account—is that you can put it to some specified use that you may have in mind. This could include retiring debts such as paying off the remaining mortgage on a home or clearing up college education or other loans. Or it could include major new purchases such as a vacation property, a recreational vehicle or an addition to your home. Or, you might want money for a once in a lifetime vacation.
For your traditional balance, the major disadvantage of a direct distribution is taxation. For a Roth balance, if you have one, the money you invested would come out tax-free, as would its associated earnings if the qualifying conditions are met, as described above.
A transfer allows you to continue managing your money while it remains in tax-favored status, probably in an account with much wider investment and withdrawal options than the TSP offers. The TSP, with its limited choice of funds and all of them passive index funds, can be frustrating for those who wish to more actively manage their money.
However, as described above, the TSP charges lower administrative costs than other investment vehicles. The TSP’s options also are relatively easy to understand and are not subject to the performance of a money manager—who may out-perform the market but may under-perform it too.
Substantially Equal Payments
The substantially equal payments option falls between the lump sum and annuity options in terms of flexibility, and it has some features of both. For example, like the lump sum, but unlike the annuity, this option allows payments to be transferred into an IRA or other qualified retirement plan (within minimum distribution requirements). But like the annuity, and unlike the lump sum, this option provides a string of payments that come automatically and don’t present the opportunity—or challenge—of managing a large sum of money all at once.
The options are:
– A set amount. In this option, you decide the dollar amount you want to receive as an periodic payment. The TSP will continue paying that amount until the money runs out. Changes in law enacted in 2017 and due to take effect as soon as sometime in 2018 allow for quarterly or annual payments in addition to monthly payments. That law also will allow account holders to change the amount at any time, rather than only once per year.
– Payments based on life expectancy. The initial amount is based on your account balance and age when you begin receiving payments. At the end of each year, the TSP will recalculate the amount of monthly payments based on how much money is left and your age. You have a one-time opportunity to change to a dollar amount payment.
To make a series of substantially equal payments withdrawal, use Form TSP-70, Request for Full Withdrawal, or TSP-77, Request for Partial Withdrawal When Separated.
Under both designs, if you have both traditional and Roth balances, the distributions will be drawn proportionately from both.
Investment gains or losses while the payments are being made will affect them. Gains will increase the number of payments if you selected a fixed dollar amount and will increase the payments you otherwise would receive if you chose a withdrawal based on a fixed number of payments or life expectancy. Similarly, losses will reduce the number of payments you receive if you chose a fixed dollar amount and will reduce the size of the payments if you chose a life expectancy-based payout.
Once you have begun receiving payments you also may change:
– to a final single payment (note: under to the change in law referenced above, the purchase of an annuity, or a combination of an annuity and a lump-sum payment, will be allowed);
– the proportion transferred to an IRA or other eligible retirement plan; or
– the IRA or plan to which your payments are sent.
Use form TSP-73, Changes in Monthly Payment Amount.
The substantially equal payment option provides the advantage of remaining in the TSP with its low investment costs and easily understandable range of investment options.
If you’re planning to be more active for a number of years after retirement but expect to slow down afterward, you might consider setting up a dollar amount withdrawal schedule to provide needed funds for those more active years. Or, your early retirement years might be a period in which you are retired but not yet receiving part of your total annuity benefit—for example, if you retire under FERS years before you start drawing Social Security benefits. Similarly, you might use these payments to provide income after a spouse retires but before he or she begins drawing benefits, in order to pull your total household income up to a desired level.
The TSP offers three basic types of annuities:
– a single life annuity;
– a joint life annuity with your spouse; or
– a joint life annuity with someone other than your spouse.
The TSP will take whatever money you designate and turn it over to a private annuity provider—currently MetLife. The provider will set up your account and begin issuing monthly payments, which begin arriving about a month after the annuity is purchased. All administrative matters, including income tax withholding information, reporting to the IRS and so on will be handled by the company.
To purchase an annuity, submit Form TSP-70, Request for Full Withdrawal, or TSP-77, Request for Partial Withdrawal When Separated.
Note: If you have both a traditional balance and a Roth balance in your account, you must purchase two separate annuities, one for each type of balance, and they must have the same features. Roth balances withdrawn as an annuity are federal tax-free so long as the qualifying conditions are met. TSP annuity payments based on a traditional balance are taxed as ordinary income in the years that you receive them. However, they are not subject to IRS early withdrawal penalties, even if you are under age 55 (age 50 for law enforcement officers, firefighters and air traffic controllers) when they begin.
If you elect a single life annuity, the payments will be made as long as you live.
If you elect a joint life annuity, the monthly payments will continue to you or to your joint annuitant after either one of you dies. The monthly payments can be in the same amount or reduced by half, depending on whether you choose to provide 100 percent or 50 percent survivor protection.
Choosing the 100 percent option reduces the amount of your annuity. There is no reduction for choosing the 50 percent survivor option as long as both spouses are the same age (there are adjustments for age differences). The reason for this is that if a 50 percent survivor benefit is elected in a TSP annuity, the payments are reduced to 50 percent when either spouse dies, not just when the primary beneficiary dies.
For someone other than your current spouse to be eligible for a joint life annuity, that person must have an “insurable interest” in you. That means the person is financially dependent on you and could reasonably expect to derive financial benefit from your continued life. Persons in certain relationships with you are presumed eligible; for others, proof of the financial connection must be provided.
There are two other annuity features, each of which also results in a reduction to the basic TSP annuity. Under the cash refund feature, if you (and your joint annuitant, if one is selected) die before the full amount in your account balance used to buy your annuity has been expended, the remainder will be paid to your beneficiary in a lump sum. Under the 10-year certain feature, if you die before receiving annuity payments for a 10-year period, those payments will continue to your beneficiary for however many months are left. This feature can be combined with a single (but not a joint) life annuity and with either level or increasing payments.
The options you choose can reduce but not increase your payments. The highest payments are under the single life option with level payments and no other features. That is the basic TSP annuity. Adding any options from that point, including inflation protection, survivor benefits or the cash refund or 10-year certain features, incurs a cost.
Another variable is what’s called the “interest rate index”—an interest rate that the annuity provider uses in determining how much each dollar of money invested in the annuity will be paid out monthly. This is set at the annuity purchase and does not change. In recent years it has reflected the generally low level of interest rates in general.
The primary advantage of purchasing an annuity is that it provides a steady stream of income to you while you no longer are working. In effect, it turns the defined contribution of the TSP savings vehicle into a defined benefit. That benefit is the monthly income you will be provided for the rest of your life—and for the rest of the life of a survivor, if you choose to buy a survivor annuity. Over the years, those monthly payments could amount to much more than you turn over to the annuity provider when you purchase the benefit.
Also, an annuity relieves you of the responsibility after retirement of managing that portion of your overall savings. If in retirement you’d rather not deal with investment decisions as actively as you do while still employed, this can be a good trade.
However, while protecting you from losses, buying an annuity also means removing from you the opportunity for especially good performance with your money. Also, it is possible to “lose” by purchasing an annuity. If you purchase a single life annuity and die after receiving even only one payment, you—or more precisely, your heirs—would be out of luck. The annuity provider keeps the difference between what you paid for the annuity and what it paid you, unless you chose the cash refund or 10-year certain features. The same could apply even if you choose a joint annuity, if both you and your designated survivor die soon after payments start.
Required Minimum Distributions
The minimum distribution rule is designed to insure that a person who has been saving in a tax-advantaged plan (such as the TSP, an IRA or other similar tax-advantaged arrangement) is compelled to start taking distributions from the plan beginning at age 70 1/2.
Note: Required minimum distributions are drawn proportionately from traditional and Roth balances, for those who have both.
Failure to take a required distribution will result in a 50 percent penalty on the amount that should have been withdrawn. (Note: If you remain employed after reaching age 70 1/2, the minimum distribution rules do not apply to funds in the TSP, but do apply to funds held in other tax-advantaged plans such as an IRA.)
The first minimum distribution must be taken by not later than April 1 of the year following the year the participant reaches age 70 1/2. A minimum distribution must be taken for all subsequent years by not later than December 31. If a person waits until April 1 of the year after reaching age 70 1/2 to take a minimum distribution, the participant will be required to take two minimum distributions in the same year, the distribution for the year in which he or she attained age 70 1/2 and the minimum distribution for the following year.
The amount of a minimum distribution is determined by dividing the aggregate balance in all of the taxpayer’s tax-advantaged plans (all IRAs and the TSP) by the taxpayer’s life expectancy (or the joint life expectancy of the taxpayer and his or her beneficiary). All qualified plans are combined for purposes of applying the minimum distribution rules.
A Word about the Investment ‘Window’
Apart from limited withdrawal options, TSP participants long have expressed dissatisfaction with the limited range of investments. The TSP offers just five basic funds, all tracking broad market indexes, and five lifecycle funds, which mix the basic funds in differing ratios depending on the planned holding period. That’s the tiniest fraction of what’s available on the open market.
The most recent investor survey found only 77 percent of account holders were satisfied, and among those planning to move the money out of the TSP soon after retirement, 84 percent cited the lack of investment options as a reason.
Congress – as long ago as 2009 – enacted a law allowing the TSP to create an investment “window” through which participants could direct at least part of their accounts.
The TSP sat on that idea for years, out of a view that investors would have a hard time making up for the added costs of outside investing, and that by chasing returns they would raise their risk of losses.
Finally, concerns about the post-separation exodus overcame that view. During 2015, the TSP committed to contracting with a mutual fund provider to provide such a service. This essentially will mirror what would be available by transferring the money to an IRA provider, since in both cases investors would have the full range of funds available through a financial firm.
Some features already are clear—for example, that the TSP will allow investments in any of the funds the provider offers and will not screen out any based on its own criteria—but others were to be determined—such as the fees for using the service.
But soon after making that commitment, the TSP had to turn much of its attention to broadened participation rules for military service members that had to be launched as of January 2018.