The Big Mistake To Avoid When Transferring Your TSP

Most federal employees saving for retirement have heard the terms “IRA transfer” and “rollover,” which refer to how you move your money from the TSP to an IRA.

And while both terms are often used synonymously, they’re not identical and have significant differences that you must be aware of to avoid making a big mistake.

So, to help you correctly move your money from the TSP to an IRA, this week, we’re discussing the important distinctions between transfers and rollovers.

Transfers vs. Rollovers

What Are Transfers?
A transfer sometimes called a “direct rollover,” is when you have all or a portion of your TSP sent directly to an eligible plan. Eligible plans include traditional IRAs, SIMPLE IRAs, and employer-sponsored plans such as 401(k)s, Roth 401(k)s, and 403(b)s.

Transfers are relatively easy because the plan administrators (the Thrift Savings Plan) do all the heavy lifting, sending the funds directly to your IRA, which means you don’t handle any money. This hands-off approach is less work for you and avoids unintentionally causing an early withdrawal penalty or a tax liability (more on this in a bit).

Note: Although transfers and direct rollovers are slightly different (direct rollovers can be executed via check), the terms are used synonymously in this article.

What Are Rollovers?
An indirect rollover, also known as a 60-day rollover or simply a “rollover” (Not a direct rollover), is when you receive a check containing a portion or the entire balance of your TSP, and then deposit the funds into your IRA account. This transaction must be completed within 60 days (not two months) from the date you received the funds. An important distinction to note here is that the check is made payable to you, whereas, with a direct rollover, the check is payable to your IRA custodian.

The Big Difference

When you complete a transfer (direct rollover), the TSP will send the entire amount you requested to the new custodian or send you a check payable to the new custodian. In either case, the TSP is not required to withhold any funds from the transaction, and there are no tax consequences.

An additional benefit of performing a transfer is that you can complete as many as you want throughout the year; the IRS sets no limits.

In contrast, with indirect rollovers, the TSP must withhold 20% of the distribution for estimated taxes; they then send the funds to the IRS.

For instance, if you request a rollover of $400k, you’ll only receive a check for $320k; the other $80k will be sent to Uncle Sam!

The Big Mistake

When you request an indirect rollover, you take a lump-sum distribution from your TSP and are responsible for completing the entire transaction. Meaning, that although you only received 80% of the requested distribution, you’re responsible for depositing 100% of the amount into your new IRA within 60 days.

If you do not deposit 100% of the rollover, you’ll owe taxes on all pretax contributions and earnings and a 10% early withdrawal penalty if under age 59 ½.

Hence, to avoid these stark tax consequences, if you request an indirect rollover, you’ll need to ensure you have enough additional cash on hand to make up for the 20% withheld.

An Example of an Indirect Rollover
Now let’s look at two scenarios of our favorite Fed Bob: He is 49 and decides to rollover his TSP account of $100,000 into his IRA. The Thrift Savings Plan withheld $20,000 (20%) from the distribution, and Bob received a check for $80,000.

a) Now, If Bob only deposits the $80,000 into his IRA and doesn’t come up with the $20,000 withheld, he will be required to report the following: $20,000 as taxable income, $80,000 as a nontaxable rollover, and $20,000 as taxes paid. Since Bob is under age 59 ½, he must also pay the 10% early withdrawal penalty of $2,000.

b) On the other hand, If Bob decides to roll over the entire $100,000, pulling $20,000 from other sources, he will report the following: $100,000 as a nontaxable rollover and $20,000 as taxes paid and assuming he has no additional tax liabilities, he will receive a refund for the $20,000 withheld when he files his tax return.

*Remember that with indirect rollovers, you’ll have the IRS holding on to 20% of your distribution until you receive a refund. Who doesn’t like giving free loans to the government?

Note: You are limited to one Indirect rollover between IRA or Roth IRA accounts a year.

Final Thoughts

While the terms used to move money between financial institutions are often used synonymously, there are significant differences between direct and indirect rollovers.

And knowing the difference between the two transactions can help you avoid early withdrawal penalties, tax consequences, and being forced to give Uncle Sam a free loan.

So, once you decide to move your TSP to an IRA, ensure you know which type of rollover you’re conducting. If you need help moving your TSP, consult a fee-only Certified Financial Planner™.

Lastly, read this article before transferring your TSP to an IRA.

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The SECURE ACT 2.0 passed and impacted many of the articles on this website. While the articles were correct when written, it’s impossible to re-write every article. Please consult a qualified professional (i.e., CFP®, CPA, or attorney) before implementing any strategy.

Author: Jose Armenta, MsBA, CFP®, ChFC®, EA

Hi, I’m Jose Armenta, a Certified Financial Planner practitioner. For over 14 years, I have worked with or among federal employees, from serving in the Marine Corps to my stint as a police dispatcher and now as a financial planner specializing in helping FERS federal employees. In that time, I have spoken to hundreds of federal employees about their benefits and retirement. Helping federal employees maximize their benefits, reduce taxes, and live confidently is a passion of mine. When I am not perfecting financial plans, you’ll find me at the shooting range, playing the drums, or breaching blanket forts with my three little ones.