The 20% Tax Trap Between a TSP Withdrawal and IRA Rollover
Most federal employees are aware that upon leaving federal service they are able to conduct a TSP IRA Rollover without being taxed on the rollover. This tax deferral works just fine if your TSP withdrawal application seeks to have all or part of the account balance moved straight to the IRA or another employer plan.
However, if the TSP pays an eligible rollover distribution directly to you, you then have only 60 days to deposit the funds into the IRA or qualified plan. Failing to do so can result in it being taxed as income (unless it’s from your Roth TSP balance, but we’ll leave that alone for now) or worse, if you are not yet 59 ½ then the withdrawal could also be penalized an additional 10%.
The point here is that the TSP is required to withhold 20% of the distribution for federal income taxes. So, you only get 80% of the amount you have chosen to move from your TSP account to your checking account, then subsequently to your new IRA. So, in this instance, you would have to pay taxes on the 20% which has not been moved from the TSP to the IRA or plan. You may additionally also need to pay the 10% early withdrawal penalty on the amount not moved into the IRA or plan.
How to Avoid Being Taxed on the Tax Withholding of a TSP IRA Rollover
It seems silly that you could be forced to pay federal income tax, an early withdrawal penalty, and possibly state and local income taxes on an amount which the government has already taken from your account as a tax. You can write to your Congressional representatives and ask them to fix this, however unlikely.
In the meantime, there is an easy fix. If you want to avoid being taxed and penalized on the tax withholding, you will have to make up the missing 20% out-of-pocket yourself to complete the tax-free TSP/IRA rollover. Do this and it becomes a tax-exempt rollover, and you will not have to pay taxes or the early withdrawal penalty until you get a distribution from the IRA or plan.
An easier solution – if you are going to make a TSP to IRA rollover, simply make sure your TSP rollover request is filled out correctly and make sure you are receiving solid TSP withdrawal advice. If you do both things you should be able to avoid any of the issues mentioned in this article.