[Nords note: if you’re reading this then I’m still in Spain visiting my daughter. My e-mail and social media responses will be a day or two behind…]
A reader writes:
First, I just want to say thank you for your service and all the great things you do for the military community.
I served a couple enlistments and I went on two deployments. While overseas I was able to save about $4000 tax exempt in my Thrift Savings Plan. I am no longer in the military and my military TSP has about $42K total. I also have a Roth IRA and I was wondering if it is possible to do a partial rollover of the tax exempt money into my Roth?
I know the TSP has really low expenses that can’t be beat, so I would like to leave the rest in the TSP. I also have a civilian TSP and if I can roll over the tax exempt money I would like to combine my civilian and military TSP at that point.
Thanks again for all you do!”
Minimizing taxes can be an important part of reaching financial independence. Luckily the tax code supports this with a variety of options for rollovers and conversions of the Thrift Savings Plan and IRAs. However your account custodian might limit your actual ability to do the type of rollover you want. If the plan administrator implements all the options of the tax code then you might be able to make the transfers you’re considering, but the administrator is also required to track the funds and keep an auditable record of your transactions. The more options your plan has, the more time and money it takes to meet all the compliance requirements of the tax code.
The Federal Retirement Thrift Investment Board has limited options for TSP rollovers and withdrawals. It’s a great way to minimize the fund expenses, but there’s not much flexibility. If you’re trying to roll over a tax-exempt portion of your TSP, the TSP’s procedures require the custodian of your Roth IRA to certify that it accepts tax-exempt balances. (See page 5 of that PDF.) If the IRA custodian won’t accept tax-exempt balances, then the TSP will pay that amount directly to you. (And it will no longer compound in your IRA.) To make it even more complicated, the TSP only transfers the taxable portion of the rollover first.
If you transfer a traditional TSP balance directly into a Roth IRA, that it’s considered a taxable conversion. All of your deductible contributions to your TSP account, as well as all of its gains, would be considered taxable income in the year that you rolled over the TSP to a Roth IRA.
If you ask the TSP to do as you’re considering, then the TSP would ask your Roth IRA custodian to confirm that they accept tax-exempt balances. If the custodian agrees then the TSP would send all of your balance to them. If your custodian doesn’t accept tax-exempt balances then the TSP would send $38K of your $42K balance to your Roth IRA custodian and the tax-exempt $4000 to you. You (and the IRS) would also get a Form 1099-R from the TSP for an additional $38K of taxable income, and that would be taxed at your income tax bracket.
TL;DR version: the TSP is not set up to do what you want. Your Roth IRA custodian may not be willing to accept a tax-exempt contribution.
Here’s a different option to consider: leave the money in the TSP until you’re ready to convert it to a Roth IRA. (As you’ve pointed out, the TSP’s low expenses can’t be beat.) You could wait on the conversion until either:
- you want to make an early withdrawal of your Roth IRA funds, or
- you’re in a lower tax bracket.
Both of these opportunities will occur when you reach financial independence and stop working. One way to live off your investments would be to withdraw the contributions from your Roth IRA, which can be done tax-free and penalty-free any time for any reason. While you’re in a low tax bracket, you could also roll your TSP into a conventional IRA and then convert a little of that into a Roth IRA every year. If your taxable income is low enough then you’d be able to do it below the 10% income tax bracket, but many people do annual Roth IRA conversions up to the 15% tax bracket. This way you’ll convert all of your TSP and conventional IRA accounts into a Roth IRA before you reach the age of 70.5 years for required minimum distributions. Avoiding RMDs means that you’ll keep your taxable income low for the rest of your life, so your Social Security distributions may also avoid being taxed.
We have that situation coming up in Hale Nords. In 2015 I’m going to roll over all of our traditional TSP balance to a conventional IRA, and then every year after that I’m going to convert a portion of that IRA to a Roth IRA. By the time my spouse starts her Reserve pension in 2022, all of our TSP and conventional IRA accounts will be converted to Roth IRAs. We can withdraw the Roth IRA contributions anytime we want, and (more importantly) we don’t have to hassle with RMDs.
One more point about your military and civilian TSP accounts: the TSP does offer a way to combine them, but there are complications. The biggest drawback is that the civilian TSP account will not accept tax-exempt funds. I’m not familiar with civil-service TSP accounts, but you’ll probably want to leave your funds in that account until you leave the civil service. Then you could roll your civil-service TSP over to a conventional IRA (even the same conventional IRA account holding your military TSP rollover) and gradually convert that to your Roth IRA.
Pretty complicated, eh? It’s a popular topic on MrMoneyMustache.com and Early-Retirement.org. There’s even a way to tap the gains on your TSP and your IRA accounts by a maneuver known as the Roth conversion ladder. But these advanced tactics are not for the faint of heart or the tax-return noobs. If you’re confused or uncertain about anything in this post then consult a fee-only CFP (I can recommend a couple) or a tax CPA to help craft your plan and your timeline.
Early Withdrawals From Your TSP And IRA After The Military
Funding The Gap: “I Need Money From My TSP!”
How Should I Invest During Retirement?
Tax Notice TSP-536: Important Tax Information About Payments From Your TSP Account
Military Saves: Considering A Thrift Savings Plan Rollover? Consider This.