TSP

Internal Revenue Service rule 72(t) deals with substantially equal periodic payments and how they can be used to avoid the 10% early withdrawal penalty in IRAs and employer sponsored defined contribution plans (such as the Thrift Savings Plan).

The 10% early withdrawal penalty will apply to any post separation withdrawals from the TSP that are taken before the year in which you reach the age of 55. For certain special category employees (law enforcement officers, firefighters, CBPOs, air traffic controllers, Supreme Court and Capitol police officers, nuclear materials couriers and DSS special agents in the Department of State), the age is 50 – not 55. It will also apply to anything you withdraw from an IRA before you reach 59 ½ (not the year in which you reach 59 ½, but the actual day you reach 59 ½).

If you take substantially equal periodic payments for whichever is longer, five years or until you reach the age of 59 ½, you are exempt from the early withdrawal penalty. So, a regular employee could separate from federal service under a VERA at the age of 53 and avoid the early withdrawal penalty on TSP withdrawals by following Rule 72(t). In fact, the Thrift Savings Plan has a withdrawal choice that is designed for just such a person; it’s called installment payments following the IRS life expectancy table. By choosing that withdrawal option a person is effectively electing substantially equal periodic payments and will not face the penalty. It makes no difference whether they elect monthly, quarterly or annual installment payments.

BUT – if the above employee were to stray from this withdrawal choice, either by switching to installment payments of a fixed dollar amount, or by taking an additional partial withdrawal (now allowed due to the TSP Modernization Act), that person would end up owing early withdrawal penalties retroactively all the way back to when they began their withdrawals. You’ve got to be careful if you follow 72(t).

If you’re considering taking substantially equal periodic payments from an IRA, coordinate your payments with the IRA custodian.

AND, there’s one more thing that you need to watch out for if you’re taking life expectancy table based payments from the TSP: The infamous “tax trap”. Withdrawals from your traditional TSP are fully taxable at your rate for ordinary income, yet here’s what the TSP says about withholding from life expectancy based payments: “We’re required to withhold for federal taxes from any taxable amount as if you are married with three dependents unless you elect a different option.” You better elect a different option or you will have a nasty surprise at tax time. You might not only owe taxes, but you might owe penalties on top of that.

Read more on TSP withdrawals at ask.FEDweek.com