Tuesday October 21, 2014
Federal Employee Benefits: Roth TSP vs Roth IRA
Roth TSP’s are not Roth IRA’s. They are similar in many regards, but under certain circumstances investors can be caught seriously off guard if they don’t realize that while the Roth TSP may look like a Roth IRA, there are some subtle rule differences. For those in the private sector, substitute Roth 401(k) for Roth TSP – the same rules apply.
The main difference with the pre-tax TSP and Roth TSP plans is the taxation of contributions and withdrawals. Dollars deposited into the pre-tax TSP are just that – before-tax contributions. After-tax dollars are contributed to the Roth TSP. However with the Roth TSP, assuming it’s a qualified distribution (i.e. the five year and post-age 59½ rules are met), all future withdrawals are income-tax free. Having a source of income in retirement that is tax free can be very appealing, particularly for those in a high tax bracket as they look to diversify their retirement income sources.
Another nuance with a Roth TSP is that lifetime Required Minimum Distributions (RMDs) do apply to Roth TSP plans, but they do not apply to Roth IRAs (unless they are inherited). When the owner reaches age 70½, they must take an RMD from the Roth TSP plan each year. Roth TSP plans behave like pre-tax TSP when it comes to taking RMDs; you must satisfy the RMD from each qualified plan.
Having to begin spending down a Roth TSP at age 70 ½, or at a time when the money is not needed, can curtail one’s future cash flow, tax and estate planning. RMDs can be avoided from Roth TSP plans by simply rolling the Roth TSP plan to a Roth IRA before the investor reaches their required beginning date.
But – if you roll over your Roth TSP plan to a Roth IRA, the five-year rule starts all over again. The clock starts ticking from Day 1 that the rollover funds hit the Roth IRA for purposes of meeting the five-year rule. Your time in the Roth TSP plan does not count here. However, if you had contributed to any Roth IRA in a prior year, the five -year period for determining qualified distributions from a Roth IRA takes into account the date you first contributed to any Roth IRA.
So if you are contributing to the Roth TSP (or a Roth 401(k)) the take-away planning item here is to open a Roth IRA at least 5 years prior to your anticipated retirement date. You can usually do this at a Bank or your Credit Union with $500 or less. This lets you avoid the 5-year rule on qualified distributions because the Roth TSP balance that is transferred to the Roth IRA is grandfathered in to the date the Roth IRA was opened.
*What is the Five Year Rule for Roth IRA’s? An investor can withdraw his or her contributions to a Roth IRA at any time without tax or penalty. But, that is not the same case for any earnings or interest that you have earned on your Roth IRA investment. In order to withdraw your earnings from a Roth IRA tax and penalty free, not only must you be over 59 ½ years-old but your initial contributions must also have been made to your Roth IRA five years before the date when you start withdrawing funds. If you did not start contributing in your Roth IRA five years before your withdrawal, your earnings would not be considered a qualified distribution from your Roth IRA because of its violation of the five year rule.
*What Happens If You Violate The Five Year Rule? There are many exceptions that allow you to withdraw earnings from your Roth IRA tax free before you reach the age of 59 ½ such as a first time home purchase, transferred to your estate after death, in the event of a severe disability, and other reasons. But, none of those exemptions save you from having to abide by the five year rule for Roth IRA withdrawals. A withdrawal that is made before the five year time frame is complete will trigger a 10% penalty for an early withdrawal much like it would had you withdrawn the money prior to turning 59½ years-old as well as the requirement to pay taxes on the earnings. This can seriously erode 40% or more of your investment depending on which tax bracket you are in at the time of withdrawal. In some cases, a large enough withdrawal can even put you into a higher tax bracket further penalizing you. The five year rule for Roth IRA withdrawals is not something to be taken lightly as it can have serious repercussions on your earnings if you are penalized.
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