Early TSP Withdrawals, Penalty Free!
12/23/2022 UPDATE: Much of this is largely irrelevant now for Special Category Employees. Under the new law, if an SCE retires under the SCE provisions, they no longer have an early withdrawal penalty, even if they retire in their 40’s. Please see the updated article on this.
(Updated with additional content December 2021)
It seems there is a growing movement to retire early. This is true in both the private sector (mrmoneymustache.com is just one popular example), as well as in the government. This is sometimes named the FIRE concept (Financial Independence Retire Early). Tammy Flanagan, who writes some very good articles at govexec.com, NARFE, and other places, addressed this movement in an article entitled “Can You Retire at 45?”
When FERS employees want to retire early, there are some complications that can arise. This paper deals with penalty-free access to TSP when one retires early. And we’ll define early as prior to the year you turn 50. Because this is rare event, there is not a ton of literature out there to help someone in their research. This paper is meant to fill some of that void. (Early TSP withdrawals are just one complication of early retirement, and the only one addressed in this paper. FEHB, the FERS supplement, and FEGLI may also be affected if you separate from government service before you are actually eligible to retire on an immediate annuity.)
Just to recap, since 1/1/16, FERS LEOs and other special category employees (firefighters, air traffic controllers), are eligible to make penalty free withdrawals from TSP if they retire in the year they turn 50 (H.R. 2146). Understand you do not have to actually be 50 years old, you simply have to turn 50 in the year you retire.
Example: Mike will turn 50 on October 30, 2018. He will complete his 25 years on the job January 31 of 2018. Mike can retire on February 1st and be eligible for penalty-free withdrawals. By the way, the early withdrawal penalty is 10% of the withdrawal amount.
(Non-LEO FERS employees can do the same thing if they retire in the year they turn 55).
If Mike retires at 47, he’s not eligible to make penalty-free withdrawals until he turns 59 1⁄2 years of age, which is why many people stay until they’re 50: to avoid the almost 10-year wait time for accessing their TSP. However, although this is the general rule, there are exceptions and we’ll run through them.
Here’s our scenario: What happens if Mike was hired by the U.S. Marshals at 22 and completes his 25-year requirement at age 47? Does he have to wait until he’s 59 1⁄2 to withdraw TSP money penalty free, as most people may think? Absolutely not. Mike has essentially two separate ways he can access his TSP penalty free at this early age.
1. Buy an annuity. Mike can purchase an annuity with his TSP proceeds, which is not subject to the 10% penalty. This is not a primer on annuities but the gist is this: you purchase an annuity through a life insurance company (currently TSP uses MetLife for annuities), they invest your money, give you a portion back in interest, and agree to pay you for the term of the annuity, either a fixed term or for life. Of course, this isn’t free and you pay for this service. You may also lose some of the freedom and control of your money. This helps explain why less than 1% of TSP participants go this route.
2. IRC 72(t) Withdrawal. This name comes from the Internal Revenue Code Section 72(t). In other words—the tax law. §72(t) covers “Ten Percent Additional Tax on Early Distributions from Qualified Retirement Plans”. Without getting too far into the weeds on this, the IRS basically waves the early withdrawal penalty if a person sets up a series of “substantially equal periodic payments” (SEPP) where the TSP account (or private IRA) pays the owner some of the proceeds over a period of time. The law requires that period of time to be the greater of 5 years or until the individual attains 59 1⁄2 years of age.
Example 1:
Mike retires at 47 and begins his 72(t) payments immediately. He must continue these payments until he reaches 59 1⁄2 years old, at which time, he can stop them.
Example 2:
Mike retires at 47 but doesn’t start his 72(t) payments until he is 57. Since he must continue the payments for the longer of 5 years or 59 1⁄2, the earliest he can stop the payments would be at 62 years of age.
In either example, if Mike stops the payments prior to the required minimum time, he will have to pay the 10% penalty on all payments retroactively from the start.
So, how are the payments calculated?
72(t) did not specify exactly what was meant by “substantially equal periodic payments”. The IRS addressed this initially in IRS Notice 89-25 Q&A #12, and then later refined it in Revenue Ruling 2002-62. The following methods come from these sources and are cited when applicable.
There are three approved methods for calculating TSP (or private IRA) payments that meet the requirements of §72(t):
1. Life Expectancy Method. Also called the Required Minimum Distribution Method. Payment amounts under this method are determined by dividing the balance of the TSP account by a factor that corresponds with an IRS approved life expectancy table. Because obviously the balance of the account and an individual’s life expectancy change each year, the amounts are not equal over the term of the payments.
Sound confusing? I’ll give an actual, real life example of someone who is retiring soon and will select this option. He will be retiring at 49 but not in the year he turns 50, so he has not reached that milestone allowing penalty free withdrawals under H.R 2146
Real Life Example:
Current TSP balance is $572,639.75. Monthly payments calculated on the life- expectancy method result in the following actual monthly payments:
Age 49 $1,367.71/mo
Age 50 $1,395.32/mo
Age 51 $1,421.68/mo
Age 52 $1,452.93/mo
Age 53 $1,480.17/mo
Age 54 $1,507.82/mo
Age 55 $1,535.86/mo
Age 56 $1,564.29/mo
Age 57 $1,587.40/mo
Age 58 $1,616.51/mo
Age 59 $1,645.98/mo
Projected Balance at 59: $506,765.49
Beginning Balance: $572,639.75
So, let’s unpack this example since there are several things here to note.
--First, these payments are penalty free even though the individual retired at age 49, because he chose one of the approved 72(t) methods.
--Secondly, the total payments exceed $196,000, even though the account balance has only decreased $65,000. Why is this? It is because the balance of the TSP is continuing to earn interest (in this case, the amount was left in the G fund at an approximate 2% return). This interest helps offset the dent in the overall TSP balance due to the payments that you receive.
--Third, and this is a very important point, once this individual reaches age 59 1⁄2, he can stop these payments if he so desires. They may continue if he wants them to, but at 59 1⁄2, he is free to stop them and make penalty-free withdrawals in any way that the TSP allows (and there will probably be much more freedom in the withdrawal options coming, but that is another topic...)
Remember, Mike can stop these payments at 59 1⁄2, because he’s already met the 5- year minimum requirement, as we explained earlier. Understand that this is not a start and stop election; one can’t just turn on these payments and turn them off at will, there is a minimum commitment.
You can see that these payments continue to increase each year. This is because the life expectancy table uses decreasing factors (found in IRS Publication 590-B).
However, once the individual reaches 70 years of age, a separate table is used, resulting in smaller monthly payments. Again though, the individual can stop them and set up monthly payments of any amount once they reach 59 1⁄2. In all likelihood, one would stop the life expectancy payments at 59 1⁄2 and switch to a monthly payment amount of your own choosing.
Lastly, understand that these payments and ONLY these payments are free from the early withdrawal penalty. Mike could not take these monthly payments based on life expectancy and then ALSO take a partial withdrawal from the TSP penalty free.
2. Amortization Method. Also called the Fixed Amortization Method in Rev. Rul. 2002-62. Using this method, the balance is amortized over the life expectancy of the owner at what is referred to as a “reasonable interest rate” (IRS Notice 89-25). 2002-62 further defines this interest rate as “not more than 120% of the federal mid-term rate” (§2.02(c)). This is calculated one time and then fixed, meaning that payments are the same throughout the term. Unlike the Life Expectancy Method, the payment amount does not change. This will generally result in MORE money than the Life Expectancy Method, if that’s what you’re looking for.
3. Annuity Method. Also called the Fixed Annuity Method. Like the Amortization Method, the payments are fixed throughout the life of the term. Unlike the Amortization Method, they are calculated by finding the present value of the annuity by using reasonable mortality tables and a reasonable interest rate (89-25).
This is pretty dry and I’m no CPA—what’s the real difference in all of these?
Fair question. Here are some characteristics to help explain the differences in the 3 methods:
In the Life Expectancy Method, you can have TSP do the math for you when you fill out Form TSP-70 (11/2015) Page 2 when you check the box that says, “Compute my payments based on life expectancy”. Under the other two methods, TSP will not do the math; you will have to.
If you choose the Life Expectancy Method, you are locked in for the duration of the term of payments and cannot switch to one of the other methods. If you choose one of the fixed methods, you may make a one-time switch from the fixed method you originally chose (Amortization or Annuity), to the Life Expectancy Method. Once you switch, you cannot switch back (Rev. Rul. 2002-62 §2.03(b)).
Generally, the Amortization or Annuity method results in a larger payment than the Life Expectancy Method. Something to consider if you are looking to maximize your income from the TSP.
The Life Expectancy Method results in different amounts each year, while the two fixed methods result in equal payments for the duration of the term.
None of the methods are unique to the TSP only. While the TSP will calculate the Life Expectancy Method for you, you are not required to remain in the TSP in order to use that method. Section 72(t) applies to private IRAs as well; one could rollover all (or a portion) of their TSP balance to an IRA and set up the payments using one of the above methods for that IRA.
I would strongly recommend you consult with a financial planner if you are considering any of the early withdrawal methods. Be prepared to speak with more than one if you are uncomfortable with the level of expertise they have in this area. There is a lot of confusion regarding 72(t) withdrawals, so it is probably best to find a financial planner who has experience with them. Feel free to bring this paper with you. What you will want to ask them is if they have experience setting up a “SEPP plan in compliance with 72(t) withdrawal rules”.
Having just walked someone through this using the Amortization Method, I can assure you, this is NOT a DIY deal. You REALLY need to speak to a CPA or a CFP that is well versed in these things. The downside can be brutal—make a mistake and you can end up paying 10% penalty retroactively all the way back to when you started the distributions! Which could be years!
Chris—it sounds like there are so many bad reasons for doing it, why would anyone even consider it??? Primarily, I can think of 2:
They need the money. They actually HAVE to have the money to live on. So instead of working or finding the income some other way, they’d rather use their TSP balance, or
Tax purposes. For those that are concerned about RMD’s later in life, a strategy might be to start reducing the TSP as soon as possible. And maybe the SEPP plan is the way to go. These individuals aren’t so much looking to spend this money, as they are looking to get it out from behind the tax-deferred account subject to RMD’s, and into a taxable brokerage account. Or maybe even into a Roth IRA. Let’s look at an example:
John retires from the FBI at 48. He’s getting his pension, and he has no debt, so he doesn’t need to touch that TSP at all. Let’s say he has $800k in there. He could conceivably wait until age 72 and start withdrawing the money. By then the account could be $3.3 million at 6% annual return. That’s a pretty healthy chunk of money he’ll have to pull out for RMD’s (over $120k the first year.) Maybe he’s not so keen on that.
By using the rules under Section 72t, John can set up current withdrawals of approximately $28,000 using the current interest rate allowable under the Amortization Method. Sure, John pays tax on this $28,000, but if he’s not working and all he has is his pension, he may be at a fairly low tax bracket (maybe even 12%?) Once the taxes come off the top, John could reinvest the remaining into a Schwab or Vanguard account, and let that grow in the taxable account. His withdrawals from that account down the road would be taxed on capital gains only. Hopefully at a more favorable rate than the ordinary income rate on a large RMD. And never any RMD’s. That’s the strategy anyway. And maybe John works enough to be able to contribute some of those TSP SEPP to a Roth and in effect, basically be doing a small-scale Roth conversion.
Those are a couple of options. As with everything else in this article, PLEASE have a competent financial professional run some numbers and come up with a plan that makes sense for your situation if you want to go down this road. You’ll definitely want to have a solid plan, since there’s no changing this thing for quite some time.
SUMMARY
If early retirement is in your future, congratulations. Very few achieve what you have accomplished.
There are withdrawal options available to you if you want your money while avoiding the early withdrawal penalty.
Of course, there is no requirement to begin early TSP withdrawals at all. One can simply leave their entire TSP balance in their account until the required minimum distribution (RMD) rules hit at 72. Remember that this TSP balance may need to get you through 30 or 40 years of retirement, so think carefully before you start withdrawing early.
Please understand that ALL payments from a traditional TSP account are subject to taxes, regardless of age or whether the early withdrawal penalty applies. This is true for any withdrawal method. Remember, you funded that traditional TSP with pre-tax money and rest assured Uncle Sam hasn’t forgotten that fact. (Roth TSP withdrawals are not subject to tax, assuming withdrawal requirements are met).
Please speak to a financial planner if you are considering any of these options.
As always, I am available to answer any questions you may have.
If you’ve gotten this far, I congratulate on sticking with it! I realize some of this is very dry material.