David Fulton is a Colorado Springs, CO fee-only financial planner providing Hourly and On-Going Financial Planning and Investment Management. While he works with a broad range of clients, David specializes in working with Active and Retired Military, Federal Employees, and Families with Special Needs Children.
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One of the most frequent questions asked by those leaving government service is what to do with their Thrift Savings Plan (TSP). The decision will be whether to retain your contributions inside the TSP or to roll those contributions over to an Individual Retirement Account (IRA) or subsequent workplace retirement account such as a 401(k). There are many good reasons to keep your TSP. For many people, keeping your TSP in place is often the right answer. We previously discussed 6 of those reasons. Before reading further, you should start there.
But this begs the question, given that the TSP is likely the simplest and most cost-effective solution, why would someone want to transfer over into what is likely a more expensive IRA? Well, there happen to be 6 good reasons…
Reason #1: Required Minimum Distributions (RMD)
While the TSP is a tax-advantaged plan with your contributions being left to compound over time, however, the IRS is still eager to get a share. The Internal Revenue Code requires that you begin receiving annual distributions from your beneficiary participant account according to its required minimum distribution rules. These rules require you to receive a certain portion of your account each year based on your life expectancy. This ensures that you do not keep accruing savings indefinitely and in turn, your savings become ordinary income and taxed on the way out. It is important to note that while the Roth IRA and Roth TSP are similar in that they are funded with after-tax income, and growth and distributions are tax-free, their RMD rules are not the same.
The RMD rules apply to your TSP account. Both the Roth TSP and Traditional TSP must start taking RMDs at 72 years of age. Failure to do so will incur a steep 50% penalty on whatever amount you were supposed to take that year. This is problematic for those who may not need to spend down their savings so aggressively. If you do not anticipate needing to take distributions from your retirement accounts, taking an RMD may be a deal-breaker and you would be better served by rolling your account to a Roth IRA and avoiding RMDs altogether.
Reason #2: Targeted Distributions
While the TSP will meet most of your retirement needs, one area that critics are right to point out is the inability of a TSP investor to target their distributions down to the individual fund level. In an IRA you can specify which funds to liquidate during your spend down years, however, you can do no such thing with the TSP.
This is especially troublesome during a down market when you would likely wish to take your distributions from your appreciated holdings such as bonds and cash positions and conserve your depressed stocks until the market rebounds, thereby preventing you from selling high and buying low.
With the TSP you are forced to take distributions across all the funds equally. So, if the C-Fund has dropped in value, you would likely not want to sell shares from your C-Fund to fund your distribution and would choose to take those distributions from the F or G Fund instead. The pro-rata distribution makes managing your withdrawals less efficient and can have an impact on the size of your portfolio over time.
In this case, a prudent investor would be best served by using a whole of portfolio approach by maintaining a greater portion of bonds and cash in their IRA, where they can control the distribution, and a larger amount of stock positions in their TSP, thereby getting the best of both worlds.
Reason #3 Consolidation and Efficiency
In many cases, when those who depart government service may only have saved in their TSP, and their situation is relatively straightforward. However, many ex-military and former government employees choose to serve in follow on careers, where they will have access to additional workplace retirement plans or choose to take advantage of their retirement accounts. What was once a simple financial situation can quickly become more complex. Those who have multiple retirement accounts, taxable accounts, and other savings, are often at risk of inadvertently creating a dissonant investing strategy.
A good reason to roll your TSP into your IRA is that you can better create a simplified and efficient portfolio. While a good financial advisor should be able to work with the TSP and build around its limitations, often do-it-yourselfers become frustrated with trying to coordinate so many different accounts. Advantages of consolidation include simplified statements, straightforward total returns for the portfolio, and ease of estate planning administration.
Reason #4 Beneficiary Transfers
Beneficiary designations are an important component of proper estate planning. Beneficiary designations allow investment accounts to go straight to the designated individual without having to go through probate with the rest of the owner’s estate. The TSP has unique beneficiary rules that may not be appropriate for everyone.
When a spouse is determined to be a beneficiary for a TSP account, the process is uncomplicated. Upon the death of the account owner, the TSP will establish a beneficiary participant account in the spouse’s name as long as the spouse inherited more than $200. The spouse can then choose to leave money in TSP or roll it over. This is a good thing because the money in a beneficiary participant account is not subject to Federal income tax withholding until it is withdrawn.
However, if you are not married or you choose for someone else to be the beneficiary such as your children, or a trust, then the non-spouse beneficiary must take all money out of TSP immediately. This creates a potentially dangerous tax situation for the beneficiary and could end up costing thousands of unnecessary dollars in taxes.
Death benefit payments made from your beneficiary participant account must be paid directly to your beneficiary in a lump sum, who are then subject to all the taxes in the year it was received. The problem with your beneficiaries being forced to take a lump sum is that the amount is added as ordinary income and will be subject to their marginal tax bracket, which will likely drive them into a higher bracket in the process. If they were able to distribute this account more strategically they could save a bunch on taxes.
A non-spouse beneficiary can avoid withholding and tax liability by requesting that the TSP transfer all or part of the payment directly into an “inherited” IRA. Unfortunately, the Secure Act significantly reduced the benefit of an Inherited IRA. However, Inherited IRAs may still provide tax benefits though their required distributions can only be spread across the ten years stipulated by the Secure Act.
Reason #5: Qualified Charitable Distributions (QCD)
For those who are charitably inclined, Qualified Charitable Distributions (QCD) can be a powerful way to give to charity while avoiding paying taxes on your retirement savings withdrawals. Using QCDs to directly transfer a portion of the portfolio to charity is only available through an IRA and not the TSP. The amount transferred is excluded from income and most importantly, the transfer can count towards the RMD of that IRA owner. This means that if a Federal or Military retiree with a TSP account who wants to use a QCD to avoid an RMD while acting charitably, then the account holder would have to first transfer his or her TSP account to an IRA.
Reason #6 Financial Advice
Lastly, as a TSP participant, you are on your own to formulate your investment strategy. Participants are often left to make critical investment decisions on their own and maybe unaware of gaps in their financial plan because they do not have a professional financial advisor proactively searching their plan for weaknesses that should be addressed. If you are a do-it-yourselfer you may enjoy this part of the process. Others maybe not so much.
Even DIYers often find value in bouncing their ideas off someone who spends every day looking at portfolios. With the TSP you get limited advice. For those who value the work a financial advisor can bring to the table are stuck looking externally for support and may find it necessary to roll over their TSP to work with an outside advisor.
Much of the financial service industry may not provide advice for clients unless they are willing to give up control of their investments and meet a minimum amount of investable assets. Fortunately, there is a growing field of fee-only financial advisors who can provide the requisite knowledge and experience and are willing to charge an hourly or flat ongoing fee, thereby divorcing investment advice from the investments themselves. For a TSP participant who wants to keep their TSP…this is the right kind of professional relationship to seek.