One of the questions that Federal Employees frequently ask us is how they can convert some of their Thrift Savings Plan (TSP) dollars into the ROTH component of the TSP.
As a Federal Employee or member of the armed services, there are so many advantages to actively participating in the TSP. Amongst them is that you can select how you want your contributions treated for federal income tax purposes. There are two choices: Traditional and ROTH.
Traditional vs. ROTH Contributions
Traditional contributions are “pre-tax” contributions and designed for tax-deferred treatment. Meaning, the monies that you contribute in this capacity are not taxed until you withdraw them. Monies in your traditional component of the TSP are subject to Required Minimum Distributions (RMDs). This means that when you reach age 70 1/2 you will have to take a calculated amount of monies out of this investment vehicle. If you don’t, you risk incredibly significant fines for not doing so.
Conversely, you can also make contributions to the ROTH component of your TSP which are after-tax. Meaning, the monies that you put in are taxed today at your current rate so that when you withdraw them later in retirement, you can do so tax-free providing that you satisfy the Internal Revenue Services (IRS) requirements. ROTH investment contributions are not subject to RMDs because you already paid tax on the money you put in.
In the world of private investments, outside of the TSP, a popular strategy was to take monies previously placed in a Traditional Individual Retirement Account and convert them to a ROTH Individual Retirement Account. Through a strategy called a Roth Conversion, investors took the funds from the Traditional IRA and converted them to the ROTH IRA, so that they could pay taxes on the monies at their current rate and take advantage of the “tax-free” status of these accounts earmarked for later in life.
Converting a Traditional IRA to a ROTH IRA
The TSP does not allow for ROTH conversions.
The TSP will allow you to change the tax status of your contributions from Traditional to ROTH which will affect contributions moving forward. However, the TSP does not allow for retroactive changes; you cannot change the monies you already allocated into the traditional tax status (tax-deferred) to the ROTH status (tax-free).
You can change your TSP contributions from tax-deferred to the ROTH by logging into your TSP account online and selecting to do so.
What options do you have if you are younger than 59 1/2? Well, not many when it comes to converting funds from your traditional TSP to a ROTH. However, if you are separated from service or over age 59 1/2 there is a unique planning method you could explore.
Transferring TSP to IRA
If you are separated from service or you have reached age 59 1/2 you can transfer, TRANSFER – NEVER ROLL OVER, some of your TSP funds into an Individual Retirement Account. Caution: Strike the word “Rollover” from your vocabulary and be leery of anyone who uses this term with you. Rollovers are not bad but you have to understand how they work. They are not synonymous with the word “transfer.” When you roll over an account, the agency — in this case, the TSP office — takes your funds and withholds 20%. They send those withholdings to the IRS. Then, the TSP office sends you the 80% balance of what you requested. Within 60 days, you must put 100% of those funds (including the 20% that now sits with the IRS) into a retirement account.
No “Undo” Button
Please remember that under the Tax Cuts and Job Act there is no longer an “undo” button on the ROTH Conversion. Once you convert those funds, there is no going back. You may want to consider waiting until the Fall time period to conduct a ROTH Conversion just so you have time to most accurately anticipate your taxable earnings for that year.
Happy Planning!