Investment capital in your TSP account has either been tax or is yet to be taxed. This article explores traditional TSP, in which contributions are made pre-tax i.e considered or calculated before the reduction of taxes.
Describing TSP Taxation:
TSP accounts are treated like all other investment accounts and do not receive any form of favorable tax treatment. TSP accounts are subject to federal income tax and are completely taxable when withdrawn; similar to ordinary income. However, one must always do their due diligence and conduct their research to ascertain what tax rules apply to the withdrawal option chosen as tax rules apply differently depending on whether you’re a federal employee or military personnel. Some withdrawals may also be subject to state taxes.
Early Withdrawal Penalty Tax
Depending on how old you are when you make a particular withdrawal, those making withdrawals before retirement are subject to a 10% early withdrawal. The IRS charges this percentage on the taxable portion of your money and this doesn’t affect the earnings made by your contributions. For detailed information regarding this, one should read the TSP tax notice titled “Important Tax Information About Payments From Your TSP Account” and consult their tax advisor as there may be disparities for Federal and Uniformed employees.
Notice of Taxation:
To help you have a better understanding regarding your tax responsibilities from your TSP account, a notice containing all tax information from your account is updated every year and published online in the TSP website. This particular notice has comprehensive information regarding payments received from your account and will provide a table describing how each type of withdrawal is treated.
Methods of Withholding
TSP provides multifarious withdrawal methods, allowing investors to request additional withholding and devise multiple withdrawal strategies to minimize taxation. While applying for a TSP withdrawal, you are permitted to request additional withholding. For those applying to make a single withdrawal with a 20% default withholding rate, this might not fulfill tax requirements and responsibilities i.e this might not be enough to cover the taxes owed, hence requesting additional withholding is a good idea.
The most popular method is substantially equal monthly installments. If elected, federal income taxes will be withheld, causing greater confusion and indecision. However, if you take a monthly installment plan and do not request to have taxes withheld from distribution – you will be imminently hit by a big tax bill in addition to the estimated tax penalty. The only exception to this withholding rate is that payments who are not expected to last at least 10 years will be withheld at a 20% rate.
Tax Penalty – Estimated:
People working for private agencies do not have to incur the estimated tax penalty, this is because they have a large amount withheld from their payroll to take care of their taxes. On the contrary, federal and uniformed officers do not have this amount deducted from their payroll and will have to do their due diligence. Legally, 90% of a TSP member’s taxation responsibility must be cleared before the end of the tax year unless they wish for the penalty.
If you don’t have enough tax amounts withheld from your TSP account, you will have a 10% penalty equal to the difference between 90% of the tax liability and the withheld amount.
Penalties Based on Age
Two types of penalties are applicable in the following events:
- You withdraw your TSP installments too soon.
- You withdraw your TSP installments too late.
For instance, if you withdraw your TSP amount before your 55th birthday, you will be charged a 10% early withdrawal penalty which could be avoided if you used the money to purchase provisions such as a life annuity.
Exceptions to Tax Penalties:
There is a certain category of employees that are exempt from the early-withdrawal penalty if they retire upon and after turning 50 years old and begin making withdrawals. This category includes but is not limited to Air Traffic Controllers, Custom and Border Protection Officers, Supreme Court and Capitol Police Officers, Firefighters and so on.
These categories will not be charged any early withdrawal penalties either as long as the following conditions apply to them, regardless of their age.
- If you’re disabled/ handicapped
- If the account holder has passed away, and you are simply a beneficiary
- If the withdrawal is ordered by a domestic relations court; related to a divorce or a legal separation.
- If your deductible medical expenses have exceeded 7.5% of your gross income.
If you are in service and require a withdrawal, it is still possible on the precedent of a financial hardship which must be coherent to your financial need. To be eligible, your financial need must result from one of the following conditions:
- Recurring Negative Monthly Cash Flow
- Unpaid and uninsured medical expenses
- Unpaid and uninsured personal casualty loss(es)
- Legal expenses (such as court costs and attorney fees) that haven’t been paid via separation or divorce
In addition to these, there are a few specific nuances to withdraw out of financial hardship including but not limited to,
- You cannot withdraw less than $1,000
- You may only withdraw your contributions
- You are limited to only one financial hardship withdrawal in six months
Despite this, there are some flipside consequences to early withdrawal out of financial hardship, which may subject it to Federal income tax, and in specific cases state income tax. If you are younger than 59.5 you will have to pay a 10% early withdrawal penalty tax and will be unable to make contributions to your TSP account for 6 months. If you’re a FERS or BRS individual, you won’t receive Service/Agency Matching Conditions for this period but will continue to get Service/Agency Automatic Contributions.
If you’re a uniformed TSP account holder, if your employee contributions from basic pay are stopped for 6 months, as will your contributions from incentive pay, special pay and bonuses stop.