The Purpose of a Thrift Savings Plan & The Rule of 55
This is the second blog in our 3-part series: What FERS Retirees Should Know Before Starting Social Security Retirement Benefits & TSP Withdrawals
The Thrift Savings Plan (TSP) is a defined contribution plan, which simply means that the employee is permitted to define how he or she will deposit money into the plan. These contributions are generally made pre-tax. In private industries, this type of arrangement is called a 401(k), and in a nonprofit organization, a 403(b).
The purpose of these funds is to be a source of retirement income after retirement. To ensure these funds remain in the account until retirement, policymakers designed a 10% early withdrawal penalty if the funds are disbursed before the age of 59 ½.
Because of life situations, not everyone can wait until 59 ½ to use the funds in their retirement accounts. Fortunately, the TSP and other 401(k) vehicles offer an IRS-approved option: the rule of 55.
What Is the Rule of 55?
The rule of 55 is an IRS guideline that permits the withdrawal of TSP accounts without the 10% early withdrawal penalty if you leave the Federal service during or after the year you turn the age of 55.
This means if you retire or are terminated in the year you turn 55 or older you can access the TSP funds without the extra 10% tax/penalty. This does not allow for someone who retired at age 53 to begin withdrawals penalty-free at 55. You must separate from service on the year you turn 55 or older to use the penalty waiver.
Should You Use the Rule of 55?
Using the rule of 55 may be part of an early retirement strategy. Combining this with the Social Security Supplement may be a way to cover expenses until you find another job or begin other sources of income later.
However, you should be careful not to deplete these funds early if they are needed to provide income in your later years.
Roth Thrift Savings Plan
The TSP began offering a Roth option in 2012. This feature combines the after-tax (no up-front tax deduction) option to the existing benefits of the TSP. Since April 2012, you could choose between two tax treatments for your TSP contribution, or you may even elect to do both!
- Less Tax Now
Traditional (Pre-tax): You defer the taxes on your contributions and earnings until you withdraw them, in effect, deducting the contributions from current taxation now.
- Less Tax Later
Roth (After-Tax): You pay taxes on your contributions now, as you make them, then all earnings and deposits are tax-free on withdrawal. Thus, contributing to the Roth TSP will result in lower take-home pay, because you are paying the taxes now in exchange for tax-free distributions once you retire.
You might ask, “Why would I want to give up my tax deduction now?” The answer is that your Roth savings may grow tax-free along with eventual withdrawals from the TSP. To put it differently, the Roth TSP can be a source of tax-free income to you in retirement. There are a couple of rules regarding withdrawals from the Roth TSP that you need to know:
- You will not pay tax on the earnings if you take distributions after the age of 59½.
- Distributions must not be made for at least five years after your first Roth contribution. If you break either of these two rules, you will lose the tax advantages and pay a 10% penalty
With a Thrift Savings Plan, as well as retirement planning in general, there is no “one-size-fits-all” solution. Variables to be considered include current and anticipated cash needs, other sources of retirement income, whether you plan to work after you begin benefits, and what the advantage of delaying the start of Social Security would be.
When you work with any of the advisors at Medallion Financial Group, you will get help charting a course through the complex world of wealth management and tax planning. We work together to build a dedicated, long-term, and disciplined approach that is tailored to your unique needs and objectives.
About the Authors
John and Laura Stohlman have been working with clients to help them achieve retirement success since 1987. Both John and Laura have the following designations: Certified Financial Planner (CFP®) and Chartered Federal Employee Benefits Consultant (ChFEBC®).
For over 30 years, federal employee retirement planning has been a key focus of Medallion Financial Group. We recognize that FERS retirement benefits have extra layers of complexity, such as the Thrift Savings Plan (TSP), 401K, Pension plan, FEGLI and more. It’s easy to get lost in a sea of bad advice when so few people understand the basics. We help with the basics and beyond to enable our clients to get the education and advice they need to retire with confidence.
Our focus is twofold: first and foremost, we are fiduciary advisors. We stand against any violation of laws, values, and ethics. Second, we treat our clients as part of our family, not only those who call Maryland and Georgia home, but clients across the US who have benefited from our reputation of personal service, integrity, and expertise.
We strive to exceed client’s expectations – because we have high expectations of ourselves.