How Federal Employee Retirements Benefits Are Taxed by the IRS – Part V

This column discusses the federal income tax consequences of making withdrawals from a TSP participant’s traditional TSP account and/or from a TSP participant’s Roth TSP account.

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Edward A. Zurndorfer

This is the fifth in a series of FEDZONE columns discussing how federal retirement benefits are taxed by the IRS. This column discusses the federal income tax consequences of making withdrawals from a TSP participant’s traditional TSP account and/or from a TSP participant’s Roth TSP account.

Withdrawals/Payments from a Traditional TSP Account

Any withdrawal (distribution) or payment from a TSP participant’s traditional TSP account is considered taxable income and 100 percent taxable by the IRS. This is because within the entire traditional TSP account, a TSP participant has deferred paying taxes on the entire monies within the TSP account. The money being withdrawn consists of the participant’s contributions made via payroll deduction from the participant’s gross salary), accrued earnings, and for FERS-covered employees, agency automatic (one precent of gross pay) and matching contributions. None of these three components of a traditional TSP account has previously been taxed.

The TSP is required by IRS rules to withhold a portion of a TSP participant’s requested withdrawal for federal income tax purposes. With certain types of withdrawals, a TSP participant may require an increase or decrease in the percentage withheld, or a waiver of federal income tax withholding altogether. The following chart entitled “Federal Income Tax Treatment for TSP Withdrawals” presents the federal income tax withholding rates and the withholding options that apply to the various types of TSP withdrawals.

Federal Income Tax Treatment for TSP Withdrawals

Additional 10 percent Early Withdrawal Penalty Tax

TSP participants who request a traditional TSP withdrawal before they reach age 59.5 may have to pay an early withdrawal penalty tax equal to 10 percent of any taxable portion of the withdrawal not directed transferred to a traditional IRA or to a qualified retirement plan. The additional 10 percent tax does not apply to:

• Payments made to a TSP participant who separates from federal service during or after the year a TSP participant reached age 55, or age 50 if the TSP participant is a public safety employee
• Up to $5,000 of any payment received within one year following a birth or qualified adoption in accordance with section 72(t)(2)(H) of the Internal Revenue Code
• Annuity payments made via the purchase of a TSP annuity
• Automatic enrollment refunds
• Payments resulting from total and permanent disability of the TSP participant
• Payments resulting from death (payments made to the named beneficiary of a deceased TSP participant)
• Payments made from a beneficiary TSP participant account
• Payments made in a year a TSP participant has deductible medical expenses that exceed 7.5 percent of the participant’s adjusted gross income
• Payments ordered by a domestic relations order; or
• Substantially equal payments over the TSP participant’s life expectancy.

Withdrawals/Payments from a Roth TSP Account

Those TSP participants who have contributed to the Roth TSP (the Roth TSP became available to federal employees starting in May 20212) have two pools of money within their Roth TSP account balances, made up of contributions and earnings. A Roth TSP participant has already paid federal and state income tax on the contributions made to their TSP account. This means that withdrawals of Roth TSP contributions will not be taxed when they are withdrawn. The same is true of the portion of the Roth TSP withdrawals that come from the earnings pool but only If the distribution is qualified.

For a Roth TSP distribution to be qualified, both of the following conditions must be met:

• Five years have passed since January 1^st of the first year a TSP participant made his or her first Roth TSP contribution via payroll deduction; and
• The TSP participant is age 59.5 or older, permanently disabled, or has died. In case of death, the TSP beneficiary does not have to wait an additional five years for a withdrawal to be considered qualified.

If either requirement has not been met at the time of the Roth TSP participant’s withdrawal, then the distribution is not qualified. The earnings of the Roth TSP withdrawal will be taxed as income. In addition, If the Roth TSP participant is under age 59.5 at the time of the Roth TSP withdrawal, he or she may be subject to a 10 percent early withdrawal penalty on the earnings portion of the Roth TSP withdrawal. The following example illustrates:

Paul made his first Roth TSP contribution on July 15, 2018. He made subsequent Roth TSP contributions until he retired from federal service on December 31,2021 at the age of 60. Paul’s five-year Roth TSP “clock” was January 1,2018. This is because Paul made his first Roth TSP contribution on July 15, 2018. Paul’s five-year Roth TSP clock therefore ends on January 1,2023. At that time, Paul will over age 59.5 and therefore can penalty- and tax-free withdrawals from his Roth TSP account.

TSP participants who have questions or seek tax advice and guidance concerning withdrawals from their traditional TSP and their Roth TSP accounts are encouraged to talk to a qualified tax professional.

PART VI >

Federal Retirement Benefits