Tax-free…or not? Avoid these 4 Roth TSP mistakes

Editor's note: An earlier version of this article incorrectly said Roth TSP distribution may not be subject to income tax and a 10% penalty under certain circumstances.

Tax-free Roth Thrift Savings Plan accounts get a lot of attention, and rightly so. Tax-free growth combined with tax-free withdrawals after decades of compounding can be a powerful tool for retirees. However, there are mistakes that federal employees can make, which will transform their tax-free dollars into taxable dollars, plus a 10% penalty in some scenarios.

Mistake 1. – Thinking the “Rule of 55/50/Any Age” applies to Roth TSP

Federal retirees often separate from service before what many in the private sector consider traditional retirement age. Some federal employees can retire with a full unreduced pension in their 40’s, while many punch out in their 50’s. 

Here’s the catch.

Generally, the IRS imposes a 10% early-withdrawal penalty on distributions from IRAs and employer sponsored plans, like the TSP or a 401(k), if the distribution is taken before reaching age 59 ½. Fortunately, there are multiple ways to legally void this 10% penalty.

One way that Federal Employees Retirement System retirees can get access to their traditional TSP dollars is through what’s commonly known as the “Rule of 55”. This means, if you separate from service in the year you turn 55 or later, the 10% penalty doesn’t apply.

FERS Special Category Employees, who also fall under the definition of Qualified Public Safety Employees, can access traditional TSP funds without a 10% penalty once they separate from service upon reaching age 50, or at any age after completing 25 years of SCE/QPSE service. Unlike the Rule of 55 for regular FERS employees, SCE/QPSE feds must actually be age 50 at the time of separation, if they have not crossed the 25-years of service threshold. This shouldn’t be too hard to remember, since it’s aligned with the OPM voluntary/optional retirement eligibility for SCEs.

Here's a resource from the IRS outlining the 10% penalty exceptions.

Four key things to know about the Rule of 55/50/Any Age:

1. The Rule off 55/50/Any Age does NOT apply to Roth TSP dollars

2. You don’t actually have to be age 55, you just have to turn 55 in the year you separate from service.

3. This exception only applies to employer plans (TSP, 401(k), 403(b), 457(b)), not IRAs. If you rollover your TSP to an IRA, you will not be able to use the Rule of 55 to avoid a 10% penalty on IRA distributions before age 59 ½. There are still other exceptions that may apply, but not this one.

4. The exception only applies to the plan of the employer you are separating from. So, for federal employees separating from service, you can only use the Rule of 55 exception for distributions from your TSP. You cannot use this to get penalty-free access to a 401(k) you still have from a job you had before your federal job.

Mistake 2. – Not understanding “Qualified Distributions”

In order to not pay tax or penalty on your Roth TSP dollars, you must satisfy both prongs of a two-prong test for “Qualified Distributions” from your Roth TSP. TSP outlines this on page 2 of TSPBK 26.

Prong 1: Five years have passed since Jan. 1 of the calendar year in which you made your first Roth TSP contribution.

Prong 2: You are any of the following:

(a) 59 ½ 

(b) Permanently disabled

(c) Deceased

If you do not satisfy both prong 1 and either a, b, or c of prong 2, your Roth TSP distribution is not qualified, and therefore may be subject to income tax and a 10% penalty.

Mistakes 3 and 4 will show exactly what violating prong 1 or prong 2 would look like.

Mistake 3 – Violating the 5-Year Rule, even if over age 59 ½ 

If you withdraw Roth TSP dollars before the 5-year period has passed since Jan. 1 of the calendar year you made your very first Roth TSP contribution, you’ve violated prong 1 in the qualified distribution test.

Here’s an example.

Let’s say you retire in 2025 at age 60, you are not disabled and you’re in the 24% federal tax bracket. You got excited about this whole tax-free Roth idea back in 2022, and made your very first Roth TSP contribution in December 2022. Remember, the “5-year clock” for qualified distributions starts Jan. 1 of the calendar year in which you made your first Roth TSP contribution, so, in this scenario the 5-year clock started Jan. 1 2022, even though you made the contribution in December.

You’ve been maxing out your Roth TSP since 2022, plus the additional catch-up contributions. This has left you with a Roth TSP balance of 140,000. 

Of your $140,000 total Roth TSP balance, $115,000 (82.14%) are your original post-tax contributions and $25,000 (17.86%) is growth.

You’ve heard of the Rule of 55, but realize that doesn’t apply to you since you’re already over age 59 ½. You might be thinking that since you’re over age 59 ½, you can fully access your Roth TSP dollars without having to pay any tax.

At age 60 (year 2025), you withdraw $20,000 from your Roth TSP bucket to build a new shed.

Now, there’s an important fact about TSP withdrawals that you need to know. When you withdraw money from your Roth TSP, the distribution will include a proportionate (“pro rata”) mix of contributions and earnings. Think of it like mixing cream and coffee. When you take a sip, you’re going to get some cream and some coffee. Unlike with a Roth IRA, you cannot withdraw just your Roth TSP contributions.

So, for this $20,000 Roth TSP distribution, you’ll be receiving:

-$16,428 tax free return of Roth TSP contributions. Why? Because 82.14% of the total Roth TSP balance ($115,000 / $140,000) consists of post-tax contributions that you already paid tax on when you made those contributions.

Therefore, 82.14% of the withdrawal ($16,428 / $20,000) will consist of contributions.

-$3,572 taxable earnings. Why? Because 17.86% of the total Roth TSP balance ($25,000 / $140,000) consists of earnings that have not yet been taxed, and are only tax-free if you satisfy prong #1 and prong #2.

Therefore, 17.86% of the withdrawal ($3,572 / $20,000) will consist of earnings.

Will you owe tax on the earnings? 

Yes, because you did not satisfy the 5-year rule outlined in prong #1, therefore this is not a qualified Roth TSP distribution. In order to satisfy the 5-year rule in prong #1, you would have had to wait until Jan. 1, 2027, to make qualified distributions since your 5-year clock started Jan. 1, 2022.

Will you owe a 10% penalty on the earnings?

No, because you are over age 59 ½. 

How much tax will you owe on what you thought was $20,000 worth of tax-free Roth money?

$3,572 taxable earnings (x) 24% federal marginal tax bracket = $857.28

*You may also owe state tax.

Total tax paid on a $20,000 withdrawal of “tax-free” Roth money = $857.29

An odd, but important note for the 5-year clock. This testing period survives death. So, if your beneficiary was to withdraw your Roth TSP money they inherited before the 5-year period has passed, they would owe tax on those earnings. They would not owe the 10% penalty, regardless of their age because death is one of the exceptions to the 10% penalty.

Note: A spouse beneficiary could elect to rollover their deceased spouse’s Roth TSP into their own Roth IRA (not an inherited Roth IRA – this difference matters), in which case the 5-year clock of the survivor’s own Roth IRA is what would matter. The 5-year clock is not portable from a Roth employer plan to a Roth IRA. If the surviving spouse had their own Roth IRA funded for at least 5-years, but their deceased spouse’s Roth TSP wasn’t first funded 5-years ago, the earning would not be taxable since the surviving spouse’s own Roth IRA has satisfied the Roth IRA 5-year clock.

Mistake 4 – Withdrawing before Age 59 ½, disabled or deceased

If you withdraw Roth TSP dollars before you’re 59 ½, disabled or deceased, you’ve violated prong 2 in the qualified distribution test.

Here’s an example.

Let’s say you retire in 2025 at age 55, you are not disabled and you’re in the 24% federal tax bracket. You have a $100,000 Roth TSP balance and started contributing to your Roth TSP 10-years ago. A green check mark should be lighting up in your head; prong 1/the 5-year rule has been satisfied for your Roth TSP.

Of your $100,000 total Roth TSP balance, $60,000 (60%) are your original post-tax contributions and $40,000 (40%) is growth.

You’ve heard of the Rule of 55 and you’re retiring in the year you turn 55, so you withdraw $10,000 from your Roth TSP to get that new driveway you’ve been wanting.

Just like before, you have cream and coffee mixed, so part of the $10,000 distribution consists of already taxed contributions and the other part is made up of earnings. 

So, for this $10,000 Roth TSP distribution, you’ll be receiving:

-$6,000 tax-free return of Roth TSP contributions. Why? Because 60% of the total Roth TSP balance ($60,000 / $100,000) consists of post-tax contributions that you already paid tax on when you made those contributions. Therefore, 60% of the withdrawal ($6,000 / $10,000) will consist of contributions.

-$4,000 taxable earnings. Why? Because 40% of the total Roth TSP balance ($40,000 / $100,000) consists of earnings that have not been taxed yet, and are only tax-free if you satisfy prong 1 and prong 2.

Therefore, 40% of the withdrawal ($4,000 / $10,000) will consist of earnings.

Will you owe tax on the earnings?

Yes, because you did not satisfy prong 2. You’re not 59 ½, disabled or deceased, therefore this is not a qualified Roth TSP distribution.

Will you owe a 10% penalty on the earnings?

Yes, because you are under age 59 ½ and in this scenario, no other exception applies.

How much tax and penalty will you owe on what you thought was $10,000 worth of tax-free Roth money?

$4,000 taxable earnings (x) 24% federal marginal tax bracket = $960

$4,000 taxable earnings (x) 10% early-withdrawal penalty = $400

*You may also owe state tax

Total tax paid on a $10,000 withdrawal of “tax-free” Roth money = $1,360

Final Thoughts

The allure of tax-free income in retirement makes Roth TSP accounts incredibly appealing. However, federal employees must be careful not to assume their Roth TSP plays by the same rules as their traditional TSP. Misapplying the Rule of 55 or withdrawing funds before meeting both prongs of the qualified distribution test can lead to unexpected taxes, and even penalties, on what should have been tax-free money. A well-structured Roth strategy can be a powerful tool, but only if you understand the rules that govern it. Don’t let these tripwires turn your Roth TSP into a bonus payment to Uncle Sam.

Tyler Weerden, CFE is a financial planner and the owner of Layered Financial, a Registered Investment Advisory firm located in Arlington, Va. In addition to being a financial planner, Tyler is a full-time federal agent with 16 years of law enforcement experience on the local, state and federal level. He has served in both domestic and overseas Foreign Service assignments.