Among the changes that will come to the TSP with the implementation of the Thrift Savings Plan Modernization Act on September 15th is that participants will have the ability to specify from which of their balances (Roth or traditional) they want their withdrawal to come. This does not, however, eliminate what has come to be known as the “Roth tax trap”, it only gives participants the means with which to avoid it.
Let’s start out by explaining exactly what the Roth tax trap is. Generally, in withdrawals from Roth arrangements (including the Roth TSP) money withdrawn is tax free. Because you have contributed out of already taxed dollars, you will never have to pay tax on the portion of your Roth withdrawals that are attributable to your contributions. And, if your Roth withdrawals are qualified, you will not have to pay tax on the earnings either. The Roth tax trap strikes when your withdrawals are not qualified. With a non-qualified withdrawal, you will have to pay federal income tax on the portion of your Roth withdrawal that is due to earnings.
There are two tests that must be met for a withdrawal from your Roth TSP to be considered qualified. First, you must have had the Roth balance in your TSP for at least five years. You will meet the five-year requirement on January 1 of the year that is five years from the year that you opened your Roth balance. So, if you began participating in the Roth TSP when it was first available back in 2012, you would have met the five-year requirement on January 1, 2017. Second, you must be at least 59 ½ years of age.
It’s the second part of the test that catches many folks in the Roth tax trap. Many federal employees are eligible to retire before they reach 59 ½, and some are required to retire at a younger age (e.g., Law Enforcement Officer, Firefighter, etc.).
Current TSP rules require that all withdrawals from TSP accounts that have both a Roth and traditional balance be proportional between the two balances. So, someone under the age of 59 ½ with an account that has both traditional and Roth balances will end up paying federal income tax on the portion of their Roth withdrawal that is attributable to earnings. Of course, they will be liable for federal income tax on the entire traditional portion of their withdrawal.
Beginning on September 15, 2019, the proportionality requirement does not change unless the participant requests that their withdrawal be taken from one balance or the other. Absent a request from the participant, the withdrawal will still be taken proportionally. The change does not eliminate the tax trap, it simply allows those who are aware of it to avoid it by requesting that their withdrawal come solely from their traditional balance. Those with Roth balances who plan on taking distributions from the TSP need to be aware of this; what they don’t know can hurt them.