The Roth 5 Year Rule: Be Careful!
The Traditional TSP is so much easier. Put your money in during your career. Retire. Then get your money out. Simple as that. No early withdrawal penalties if you retire on a regular retirement. No waiting period. If you transfer it to an IRA, still…no waiting period.
The Roth TSP is NOT like that. At all. Let’s discuss how it’s different. And the 5 year waiting period that most don’t fully understand.
(This won’t be a rehashing of the difference between Roth and Traditional. Read this old article for that. Or you can read the TSP Booklet, TSPBK08 “Summary of the Thrift Savings Plan”)
ROTH TSP WITHDRAWALS
When you take a withdrawal from your Roth TSP, part of your money is going to consist of contributions you made previously, and part of your money is going to be earnings that those contributions made. So you are in effect, getting back your money you put in, as well as what that money has made.
In order for the earnings portion to be qualified, meaning completely tax free, you have 2 conditions that you have to meet:
You have to be 59 1/2 years of age.
You have to have had the Roth TSP opened for at least 5 years
Let’s deal with them one at a time. You may say, “Wait Chris, the early withdrawal penalty is waived from TSP if you are under 59 1/2. If you are Regular FERS, you can pull it penalty free after age 55. If you are law enforcement, you can pull it at any age after you retire. Right?”
You’re talking about the Traditional TSP. That’s different. TSP Publication TSPBK26 “Tax Rules about TSP Payments” is specific about Roth TSP. In order for earnings to be qualified, the account must have been opened for 5 years and the individual must be 59 1/2 years of age. This is why when the Roth TSP first came out people were so reluctant to get it. Back then, you could not designate if you wanted withdrawals from one side or the other. The TSP sent the money to you prorated. Meaning, they forced you to take Roth before you were qualified.
If you want to read more about this, check out page 21’s definition of Qualified Earnings “Earnings on Roth contributions that are eligible to be paid out tax-free at withdrawal. Earnings are considered qualified as long as the following two requirements are met: (1) it has been 5 years since January 1 of the calendar year the participant made the first Roth TSP contribution and (2) the participant is at least 59 1/2, permanently disabled, or deceased.”
You can also read more about qualified earnings on pages 2 and 3.
Please note we are talking about EARNINGS. Your contributions are NEVER taxed. And they are never subject to the early withdrawal penalty because you have already paid taxes on them. (Bottom of page 3).
5 YEAR RULE
You cannot open a TSP Roth today, retire next year and withdraw the money tax free, even if you are over 59 1/2. Why? Because there is a rule requiring you to have the Roth TSP for at least 5 years. In other words, your money is locked up for a minimum of 5 years if you want it to be completely tax free. Regardless of your age.
This clock started January 1st of the year you made your first Roth TSP contribution, even if that contribution wasn’t made until say, August of that year.
Example 1:
Jim started contributing to a Roth TSP when he was 52. Jim can withdraw money at 59 1⁄2 with no issues. Jim has satisfied both the age and time requirements.
Example 2:
Meghan started contributing to a Roth TSP at 56. When she turns 59 1⁄2, she has met the age requirement, but not the holding period. She’s had her Roth TSP for 3 1⁄2 years. She has to wait another year and a half before she can withdraw without penalty. In this example, Meghan would be 61 before she can withdraw with no issues.
With me so far? Ok, now let’s make it more complicated.
ROLLOVERS
More and more people it seems are rolling their TSP out into IRA’s after they retire (and understandably so!) Let’s walk through a scenario where an individual wants to roll over their Roth TSP. What happens?
Well, there are several things to note:
The rollover is irrevocable. You can move a Traditional IRA BACK into the Traditional TSP. You CANNOT do that with the Roth TSP. If you move the Roth TSP to a Roth IRA, it is a one-way trip. It cannot go BACK into the Roth TSP. TSP does not accept Roth IRAs as incoming transfers. So note the permanency of this transaction.
The 5 year clock starts over if you transfer the Roth TSP to a Roth IRA. What?! See, the Roth IRA has its own 5 year rule too. And it doesn’t count any of the time the money was in the Roth TSP. So the Roth IRA 5 year clock starts Jan 1st of the year the rollover was performed.
HOWEVER….(and this is a big however so make a note). The IRS is only concerned with when the FIRST Roth IRA was funded. If you already have a Roth IRA that has been opened for 10 years, then the rollover is fine. Because you have already had one Roth IRA for at least 5 years, and that’s what the IRS cares about—when the first Roth IRA was funded.
Confused? Of course you are. That’s how the government prefers it. Otherwise they would write things plainly.
Let’s do a few examples.
Example 1:
Andy retires from the government at 58. He began contributing to his Roth TSP at age 52 (satisfied the 5-year period). He transfers his Roth TSP to a Roth IRA that he opened just for this purpose. He did not have a Roth IRA prior. Andy cannot withdraw earnings from his Roth IRA at 59 1⁄2 without issues. He must wait 5 years, or until he is 63 (58 + 5) in this example. Even though he met the holding period in his Roth TSP, that holding period restarts when he transfers the money to a Roth IRA.
Example 2:
Jill retires at 58. She transfers her Roth TSP to a Roth IRA that she opened many years ago (over 5). Jill will have no issues withdrawing at 59 1⁄2 because the Roth IRA has contributions in it older than 5 years. In other words, the waiting period has already been satisfied.
Example 3:
Mary retires at 58. She transfers her Roth TSP to a new Roth IRA that she opened up for this transfer. However, she had a separate Roth IRA that she contributed to many years ago that has just been sitting. Like Jill, Mary will have no issues withdrawing at 59 1⁄2 from either Roth IRA. This is a little quirk in the tax code, but the IRS doesn’t require each and every Roth IRA be held for 5 years, only that the oldest one owned by the taxpayer is held for at least 5 years.
Example 4:
Bubba retires from federal law enforcement at 46. He had the Roth TSP his entire career. He cannot withdraw that money completely tax free for another 13.5 years. He is free to withdraw the Traditional TSP without any early withdrawal penalty, but his Roth TSP earnings will be taxed. If Bubba rolls his Roth TSP into a Roth IRA at retirement, then at 59 1/2, his 5 year rule would have long been satisfied since he rolled it over at age 46 (13 years). If Bubba waited until 59 1/2 and then rolled his Roth TSP over into a Roth IRA, then he would have to wait until 64 years of age to withdraw it completely tax free (assuming he had no previous Roth IRAs).
TAKEAWAY?
What do we do with this information? First of all, let’s just all agree up front, it is best to have some professional guidance if you’re going to be doing rollovers. There are tax issues at stake, time restrictions, and also irrevocable decisions (aka, mistakes you can’t undo).
I’m constantly staggered by people who are moving 6 and even 7 figure accounts and doing it on their own to save literally a few thousand or even a few hundred dollars, by not speaking with a financial advisor. Please don’t do this. If you’re fortunate enough to have accumulated hundreds of thousands of dollars in retirement savings, please take care of that! Manage it wisely. And part of that wise management will include some solid guidance. Please find a professional that can assist you to make sure it’s all done correctly!!!
By the way, just so we are all clear, this article is NOT a substitute for sitting down with a CPA or a CFP and having them analyze your situation.
Secondly, it might be a very good idea to set up and fund a Roth IRA right now if you have a Roth TSP. Get the 5 year clock started. If you want to do a rollover in the future, the clock will have already begun ticking on the Roth IRA.
SUMMARY
Roth TSP earnings can be taxed if pulled out prior to 59 1/2 (Regular FERS or SCE)
Roth TSP contributions are never taxed
Roth TSP has a 59 1/2 PLUS a 5 year rule before earnings are completely tax free
Roth IRAs also have 5 year rules and the Roth TSP time doesn’t carry over to the Roth IRA time
Roth TSP can be rolled over into a Roth IRA, but it can never be rolled back into the Roth TSP.
PLEASE CONSULT A FINANCIAL PROFESSIONAL TO ADVISE YOU THROUGH THIS