PODCAST EPISODE 127:
The TSP Early Withdrawal Penalty

If you’re a federal employee leaving federal service, you might have heard that there could be some penalties for accessing funds like the Thrift Savings Plan if you take them too early. Curious that this will apply to you? Well, you’re in the right place to find out.

Hi. Chris Kowalik of ProFeds here and well come to the FedImpact podcast, where we offer candid insights on your federal retirement. So as you know, this show is all about helping you to get super clear on what you want retirement to look like and taking action to make it happen.

For today’s episode, let me kind of fill you in on the backstory here…. We get tons of questions from feds, all over the place, right? Some are eligible to retire, some are not, but they’re leaving federal service and they’re wondering if they’re going to be slapped with a penalty from the IRS when they take money out of the Thrift Savings Plan.

Okay. Nobody wants a penalty, right? And so if we can avoid it, of course we want to do that. Oftentimes we see that once feds understand who is affected by this penalty and perhaps more specifically, what happens to trigger the penalty, they tend to reassess their timing for leaving federal service because they understand the rules more clearly.

When I think about topics for these types of episodes, I’m really drawn to areas where feds tend to make decisions that have really big, unintended consequences. Especially when they’re irrevocable decisions and this topic is no exception.

When it comes to penalties, especially ones levied by the IRS, we should definitely be paying attention and do what we can to avoid them. To give you an idea of kind of the high level overview of what we’re going to be covering today, we’ll talk about what the rule is for this penalty so that everybody has a better understanding of what it is that we’re talking about, what it is that triggers this penalty for feds, a few ways to legally avoid the penalty, and then a few examples and perhaps touching on the bigger impact on the Thrift Savings Plan account if in fact you trigger this penalty.

And of course, any of the resources that I mentioned today, we will put in the show notes so if you happen to be watching from our website, of course, the show notes are going to be right below the player. If you’re listening on a more traditional podcast platform like iTunes, we’ll give you the instructions on how to be able that access those show notes here at the end.

Of course, anybody looking for some training or some one-on-one help for their individual situation, we’ll be sure to let you know how to do that at the end as well, so stay tuned.

Background

So let’s talk about kind of the background of this penalty and what the heck I’m talking about. You’ve worked really hard throughout your career to save money in a tax-deferred account, like the Thrift Savings Plan. And the idea is that you use that money later in life in retirement, but there are rules that the IRS has set for when you can take this money. Don’t forget the IRS gave you a pass on paying taxes when you earned that money. You know you’re going to have to pay them later, right? But when you earned the money, they gave you the pass, but there were some strings attached to that and one of the strings is that you’re only allowed to access that money at 59 1/2 or later.

Now there are some exceptions to this, and we’re going to talk about what that looks like for the Thrift Savings Plan. But I first want you to understand what the IRS rule is. So a person who takes money from a tax-deferred account, prior to the age of 59 1/2, this would be an account like an IRA, they will suffer a 10% early withdrawal penalty from the IRS on that withdrawal. Keep in mind, this penalty is on top of any of the normal tax that you would owe.

So let’s say you take out $20,000, the penalty would be $2,000, right? 10% of what you took out, plus the normal tax based on your tax rate. You might be in the 20%, the 24, the 37% tax bracket, whatever that might be, just know that the penalty is on top of that amount.

The special rule for TSP

Like I mentioned, there are some special rules for the Thrift Savings Plan that I think are worth dive diving into, in more specificity than what you typically hear people talk about. The rule for the TSP is that federal employees either retiring or separating from federal service, in the calendar year in which they turn 55 or older, may access TSP funds without penalty. There are a lot of specifics packed into this sentence, so I want to break each one of them down so that we’re super, super clear on what it is that we’re talking about.

First, when the TSP refers to you retiring or separating, I need you to understand that the TSP does not distinguish between the two. Either you are employed or you’re not. It’s one or the other. If you’re employed, you’re allowed to do certain things on the list and if you are separated or retired, you are allowed to do other things on the list (of all the actions that TSP can do for you). Remember retiring or separating, it doesn’t matter – the TSP views those two things as the same.

The next thing that I want to break down is where it talks about if you retire “in the calendar year that you turn 55.” If you were to have a birthday in September and you turn 54 at that time, and you want to retire at the end of that year, you will not be in the calendar year in which you turn 55. You turned 54, that calendar year. You would need to wait until the following year to be able to avoid this penalty.

This exception, the special rule for the Thrift Savings Plan, only refers to funds coming to you directly from the TSP. You can’t take money from the TSP and move it to an IRA in the private sector and then take a distribution out of that IRA. If you do that, you’re going to suffer a penalty. So this money has to come to you directly from the TSP. I do think it’s worth mentioning here that if you happen to be a special provisions employee, so that would be our law enforcement officers, firefighters and air traffic controllers, you have a special age and that’s not 55, that’s 50. So of course you’re eligible to retire much earlier in life than the average federal employee is and so they’ve made a special exception for you if you happen to fall within one of those categories. But everything else that we’re going to talk about today is the same.

Who is affected

Now I want to talk about who is affected and who is specifically not affected by these special rules. This exception to the penalty. The people who are not affected at all by a penalty are those regular employees with a regular retirement. By regular employee, I mean someone who is not a special provision employee, a law enforcement officer, firefighter, air traffic controller, and by regular retirement, I mean, those who have reached their minimum retirement age at minimum and have the required years to be able to go.

The people who might be affected by a penalty would be an employee retiring under an early out scenario, a discontinued service retirement. That’s where a job is completely going away. Someone retiring under the deferred retirement rules, meaning they’re way too young to be able to receive that pension right away. And then, like I mentioned before, our special provision employees. So it’s very possible that even though there are some special rules for them, they can still trigger the penalty. You’re going to see how throughout today’s episode.

Determining if you trigger the penalty

So if you do, or don’t meet these special rules and you trigger the penalty, the rules are going to be different for you. And so I want you to be clear on the situation that you’re going to find yourself in to know what applies to you. So, let’s talk about a couple of different scenarios.

The first is if you’re under 59 1/2 and you do not meet these special rules, meaning you triggered the penalty to happen, you are going to be treated the same regardless if you take your money directly from the TSP, or if you move it to an IRA and then take it. Either way, you’re going to get the penalty. You have the flexibility if you choose to, to move the entire account out into the private sector IRA, or leave it all in TSP. Either way, you’re going to get a penalty on any money that you take prior to 59 1/2. Again, that’s only if you don’t meet those special rules that I mentioned.

If it turns out that you’re under 59 1/2, and you do meet those special rules, that basically eliminate the penalty for you, you are going to have penalty-free access to your money that is paid to you directly from the TSP all the way until 59 1/2. Remember, once that money touches an IRA, it loses the special character, this special rule that the IRS has allowed and so we want to make sure that if you have money that’s coming to you penalty-free, it’s coming directly from the Thrift Savings Plan.

Moving TSP money to an IRA

But a question I get an awful lot of is, but I really wanted to move it out to an IRA. Are you telling me my money has to stay in the TSP until I’m 59 1/2? The answer is no. So, here’s how it works. If you have money in the Thrift Savings Plan and you want to move it to an IRA, but you know if you move the whole account, you’re going to get a penalty on any money that you take, prior to 59 1/2, the key here is to leave enough money behind that you’re going to need between the time you separate, all the way to 59 1/2. You can move the rest of the money to an IRA and let it grow and do whatever it’s going to do for you. Just don’t touch it until you get to that 59 1/2 mark.

Now I do have to say that there are ways to legally get money out of an IRA prior to 59 1/2 without a penalty. We’ll cover that in a little bit more detail here in a bit, but for the most part there’s some interesting things that happen in that scenario from an IRA. So I want to stay as much as we can focused on the TSP here.

If you were to carve out the money that you think you would need between the time you separate and 59 1/2, and leave that amount in the TSP and you move the remainder of your account out into the IRA, you really can get the best of both worlds, right? You can get the very best of what the TSP has to offer, which in this case is avoiding a penalty on money that you’re going to take from it. In the private sector because of the flexibilities and control allowed out in private IRAs, you get all of that, too. The key is you just don’t want to start receiving that money until you’re 59 1/2 or older.

Let me share with you a good financial professional who understands how these accounts work, specifically with these special rules with the TSP, will caution you from moving your attire account to an IRA. Why would they? If you need the money prior to 59 1/2, or at least part of it, it would seem to reason that we would leave that money back in the TSP and take it as we need it, meanwhile, allowing the other portion to grow and do its thing out in an IRA.

Other ways to avoid the penalty

Within the TSP, there are other ways to avoid the penalty as well. Things like if you’re a disability retiree, this has to be a total and permanent disability, you will not be penalized. And if you choose to take your TSP in very specific withdrawal methods, you will not be penalized. So for instance, if you were to take the Thrift Savings Plan annuity… I would not recommend this annuity for a lot of reasons. That’s for another episode, but that’s one of the ways to avoid the penalty, know that this is a lifetime decision and one that’s irrevocable. So, a lot I don’t love about that particular form of an annuity.

Another way to avoid this penalty (if you’re taking money directly from the TSP) is if you have deductible medical expenses that exceed 10% of your adjusted gross income, or most commonly, if you choose to have your money paid to you as what we call substantially equal payments. That can come directly from the TSP or that’s again how to be able to get money out of an IRA as well. Some different rules that we associate with IRA “substantially equal payments,” but this whole concept of being able to get those payments out, not in a monthly form that you designate, like I want a thousand dollars a month, but allow the entire account to be calculated as if it was paying you out over your lifetime, that in and of itself would avoid the penalty. Now, what I don’t love is that if you change your mind, then you can be subject to all of the back penalty that you otherwise would have received.

Let’s say you’re 55 when you leave federal service and you’re a regular employee. If you decide to do these substantially equal payments and have the TSP calculate the monthly amount that you’re going to receive, not annuitize it, but simply calculate the monthly payments and at 58, you go in and need to change your mind because you’re not getting enough income out of your TSP, they’re going to look backwards from 55 to 58 and assess the penalty as if you hadn’t done any of that properly during that time.

I’m going to link in the show notes to the TSP publication that talks specifically about the early withdrawal penalty. We always tend to get some ancillary questions about other ways to avoid this penalty and so we want to link right to the document that will show you from the TSP.

I want to talk more about just the average feds that’s retiring out there that don’t maybe have all these other special exceptions, like being a special provision employee or anything like that. When we think about having penalties, based on the timing of when we separate or retire from federal service, it stands to reason that if there’s a way to avoid it by simply changing your retirement date or the day you separate from service, that you should consider that.

Two examples

I’ll give you an easy example. If you’re given an early out offer by your agency and you’re really considering taking it. Maybe you’re unhappy at work, you want to go explore another opportunity, whatever that might be, and all things considered, it looks like a pretty great offer. Maybe there’s some cash in it with the voluntary separation incentive payment. It frees you up to be able to go do something else that you want to do. All of that sounds great, but if by virtue of how old you are, you don’t qualify for this special exception and you know that if you take that early out, you are going to be penalized for all of the money you take from the Thrift Savings Plan, all the way to 59 1/2, that great offer might not seem as great now.

If you’re a special provision employee, let’s talk about this a little bit. We deal with this actually quite a bit because you guys are allowed to retire so young compared to the average fed. Let’s say that one of the requirements for you to be able to retire is if you have 25 years of say law enforcement service, you’re able to go out at any age. So let’s say you’re 49 and you hit your 25 year mark, you’re technically eligible to retire at that point. But if you’re not within the calendar year in which you turn 50, you have now triggered that penalty to happen, not just for a couple of months, but all the way until you are 59 1/2. And so, although you might be eligible say towards the end of the year, and you’re 49, but you’ve got your 25 years, that’s all great, but you might very well choose to wait until the following January to retire because that is the calendar year in which you’re going to turn 50 and avoid this penalty.

And the same would hold true for a regular employee who is edging up on 55. The same concept holds true. But it’s very common for special provision employees like law enforcement officers to trigger this penalty because of the flexibility that they have at those much earlier ages to be able to retire.

Pay attention to the penalty and avoid it if you can

So here’s the bottom line. Nobody likes penalties, I would argue, especially the ones from the IRS! So anything we can do to avoid those penalties is really worth considering. Those penalties can spiral your account and here’s what I mean. You take the money, you suffer a big penalty and you’re like, oh gosh, I wasn’t expecting that penalty. Now I need more money because I have a bigger penalty and now you get a bigger penalty because you keep taking more money, right? It’s a spiraling of your account that could be really, really dangerous. And so we want to be careful that we don’t put you in a downward spiral of your Thrift Savings Plan account because before you know it, it will be gone.

And here’s the deal. If I’m really talking bottom line with all of you guys today, most employees that we find are not truly prepared for taxes in retirement. So when we talk about penalties on top of that, that early withdrawal penalty assessed by the IRS is salt on a wound and it will not feel good and it will take a bite out of your TSP and your overall budget way more than you’re planning for. Make sure that you know if you are retiring under the age of 59 1/2, can you qualify for this special exception? If you can, it is worth making sure that you do, meaning that you’ve waited long enough to be able to avoid that penalty.

I want to share that with you again, what the special rule is. Federal employees retiring or separating from federal service in the calendar year that you turn age 55 (or 50 if you’re a special provision employee) or older, you can access the TSP funds without penalty. So as long as you meet that rule, you are good to go. If you’re super close to meeting that rule, I would encourage you to figure out what it’s going to take to get there and strongly consider it.

Taking action on your retirement

I hope today’s episode was helpful for you. Of course, this is a super narrow topic on the early withdrawal penalty for TSP, but when it comes to money and your future, it’s really kind of a small part of what you need to know to confidently step into retirement. Our job is to help you to take action, and we want to make sure that we give you a path to do that.

You likely know we teach workshops throughout the country, and it is our very mission to help feds bring together all of those crazy parts of their situation, to see more clearly what retirement looks like and all of those decisions that they need to make today to make that happen. So if you haven’t been to one of our workshops yet, or maybe you just need a refresher, or you want to access the show notes from today. That includes, of course, the replay, the full transcript, any of the resources that we mentioned today, here’s how to do it. So pull out your phone and text the word, “PODCAST” to 224-444-6144. We’ll make sure that you get access to both the show notes and all of the workshops that we have open. So you can find one for your area. Again, to get that, text the word, “PODCAST” to 224-444-6144, and we’ll send that right away.

Wrap-up

To wrap up, if you are not retiring in the calendar year that you turn 55 or older, and you are a regular employee, you may trigger this penalty, this 10% early withdrawal penalty. If you’re a special provision employee, law enforcement, firefighter, air traffic controller, that age is 50. If you meet the special rules to be exempt from the penalty and you want to move money to an IRA, just be sure to leave enough behind to cover any of those expenses or big purchases that you have been thinking about between the time you separate and 59 1/2. Of course, if you do trigger the penalty, this will apply to all money that you take from the TSP, all the way until 59 1/2. So very, very important that you realize this is a long term penalty. It’s not forever, but it is all the way until you get to 59 1/2. If you know you’re going to be penalized, please consider adjusting your retirement or separation date to avoid it.

That’s it for today. I hope that our talk about the TSP early withdrawal penalty has been helpful to you as you think through all of the different aspects of planning to retire. Please stay tuned to the Fed Impact podcast to get straight answers and candid insights on your federal retirement. And of course, if you haven’t already, please subscribe today so you’re sure not to miss an episode.