Understanding Tax Implications of TSP Withdrawals

The Thrift Savings Plan (TSP) is a cornerstone of retirement planning for federal employees. While it’s an excellent way to save, understanding the tax implications of TSP withdrawals is essential for making the most of your hard-earned money. Recent legislative changes, such as SECURE Act 2.0 and updates to TSP rules, make it more important than ever to stay informed. Let’s break down everything you need to know about TSP withdrawals, taxes, and strategies to minimize your tax burden in 2025.

1. Traditional TSP vs. Roth TSP: Tax Treatment of Withdrawals

The type of contributions you made determines how your withdrawals are taxed:

• Traditional TSP: Contributions are pre-tax, so withdrawals (including earnings) are fully taxable as ordinary income.
• Roth TSP: Contributions are made after-tax, and qualified withdrawals (both contributions and earnings) are tax-free if:
  • The account has been held for at least 5 years.
  • You are age 59½ or older, disabled, or the withdrawal is made by a beneficiary.

Key Change: As of 2024, Roth TSP accounts are no longer subject to Required Minimum Distributions (RMDs) during the account owner’s lifetime. This change aligns Roth TSP accounts with Roth IRAs and makes them an even more attractive option for long-term tax planning.

Important Note: If you have both Traditional and Roth TSP accounts, withdrawals are prorated between the two. You cannot choose to withdraw from just one type.

2. Required Minimum Distributions (RMDs): What You Need to Know

RMDs ensure that retirement accounts are eventually taxed. However, recent changes have shifted the rules:

• RMD Age: As of 2024, the RMD age is 73. Starting in 2033, this increases to 75 under SECURE Act 2.0.
• Roth TSP Accounts: Roth TSP balances are no longer subject to RMDs during the owner’s lifetime, eliminating a key drawback compared to Roth IRAs.
• Traditional TSP Accounts: RMDs are required once you reach the applicable age, and the amount is fully taxable as ordinary income.

Key Tip: If you’re still employed with the federal government, you can delay RMDs from your TSP until you retire.

3. Early Withdrawals: Penalties and Exceptions

Withdrawing from your TSP before age 59½ typically incurs a 10% early withdrawal penalty, in addition to income taxes. However, there are exceptions:

• Age 55 Rule: If you separate from federal service during or after the year you turn 55, you can withdraw penalty-free.
• Age 50 Exception for Public Safety Employees: Law enforcement officers, firefighters, air traffic controllers, and now other public safety employees who retire with at least 25 years of service can make penalty-free withdrawals, regardless of age.

Key Tip: If you need early access to your funds, consider rolling your TSP into an IRA, which may offer more flexibility with withdrawal rules.

4. Contribution and Catch-Up Limits for 2025

Understanding TSP contribution limits helps you maximize retirement savings:

• Annual Contribution Limit: $23,500 for 2025 (up from $23,000 in 2024).
• Standard Catch-Up Contributions: For participants aged 50 and older, the limit remains $7,500.
• Enhanced Catch-Up Contributions: For participants aged 60 to 63, the catch-up contribution limit increases to $11,250.

New Rule for High-Income Earners: Starting in 2025, participants with wages of $145,000 or more in the prior year must make catch-up contributions to a Roth TSP account, which means these contributions will be made on an after-tax basis.

5. Lump Sum vs. Monthly Payments: Tax Implications

Your withdrawal strategy has a significant impact on your tax liability:

• Lump Sum Withdrawals: Taking a large withdrawal at once can push you into a higher tax bracket, significantly increasing your tax bill.
• Monthly Payments: Spreading withdrawals over time can help manage your tax bracket and reduce your overall tax liability.

Key Tip: Work with a tax professional or financial advisor to develop a withdrawal strategy that minimizes taxes and aligns with your retirement goals.

6. State Taxes on TSP Withdrawals

In addition to federal taxes, TSP withdrawals may be subject to state income taxes. However, state rules vary:

• No State Income Tax: States like Florida, Texas, and Nevada do not tax retirement income.
• State Exemptions: Some states, including New York, exempt federal pensions, such as TSP withdrawals, from state taxes.

Key Tip: Verify the latest tax rules for your specific state, as laws can change.

7. Withholding Taxes on TSP Distributions

The TSP automatically withholds 20% of the taxable portion of withdrawals for federal taxes. While this helps cover your tax liability, it may not be enough if you’re in a higher tax bracket.

• Adjust Withholding: You can request additional withholding or make estimated tax payments to avoid penalties.
• IRS Calculator: Use the IRS withholding calculator to ensure you’re withholding the correct amount.

8. Rollovers: Avoid Immediate Taxation

Rolling over your TSP balance into another retirement account can help defer taxes:

• Direct Rollovers: Funds are transferred directly to the new account, avoiding immediate taxation.
• Indirect Rollovers: If you receive the funds, you have 60 days to redeposit them into a new account. However, the TSP will withhold 20%, and you’ll need to make up that amount to complete the rollover.

9. Tax Planning Strategies for TSP Withdrawals

To maximize your withdrawals and minimize taxes, consider these strategies:

1. Diversify Income Sources: Use a mix of taxable (Traditional TSP) and tax-free (Roth TSP) accounts to manage your tax bracket.
2. Strategic Withdrawals: Delay withdrawals until lower-income years, such as after retiring from federal service.
3. Roth Conversions: Convert Traditional TSP funds to Roth accounts gradually to reduce future tax burdens.
4. Plan for Medicare IRMAA: Be mindful of how taxable income from TSP withdrawals can increase your Medicare premiums.

Understanding the latest tax implications of TSP withdrawals is critical for effective retirement planning. By staying informed and tailoring your withdrawal strategy to your specific circumstances, you can make the most of your TSP and keep more of your savings for the retirement you’ve worked so hard to build.