Rules on Rolling Over TSPs to Roth IRAs

by Wilhelm Schnotz

With thrift saving plans, which are usually known as TSPs, the Internal Revenue Service provides public employers with an investment tool that functions similarly to a 401(k)retirement account private employers offer. TSPs allow tax-deferred contributions up to an annual limit, and, similar to income in 401(k) and traditional IRAs, workers aren’t taxed on the initial investment or the earnings until they receive a distribution, although that tax status changes when rolled over into a Roth IRA.

Roth IRA Rollovers

Contributions to Roth IRA accounts are made on a post-tax basis, so investors are taxed on earnings they place in those accounts in the year they make the contribution. Because funds were already taxed when contributions were made, investors receive qualified distributions untaxed. Investors who roll over pretax funds from a TSP to a Roth owe income taxes on the amount reclassified as post-tax retirement funds at their normal income tax rate, which may be significantly elevated if an investor rolls over a large amount from a TSP in a single year.

Rollover Options

As with any other Roth conversions, investors may perform the rollover in two different methods. If both financial institutions accept trustee-to-trustee transfers – they’re not required by law to do so – the investor may instruct his TSP administrator to transfer the funds to the company that provides the Roth. In other cases, he may need to receive a distribution and reinvest the amount into his Roth on his own. In both cases, the investor receives a 1099-R from the TSP administrator reporting the amount of income; if the transfer wasn’t a trustee-to-trustee rollover, the administrator from the Roth fund will issue a Form 5498 that certifies the funds were received, allowing the investor to avoid the 10 percent early distribution penalty that may be assessed against his distribution.

Uniformed Services TSPs and Combat Pay

Some members of the military invested combat pay into a uniformed services TSP. If contributions were made to the TSP with combat-zone pay, which is tax exempt in all circumstances, those contributions are not taxable when an investor rolls her TSP over to a Roth IRA. The IRS treats earnings on those contributions – and any contributions made from normally taxable sources – as taxable income, and investors should be prepared to pay income taxes on portions of those rollovers.

Tax Strategies

Some investors with large amounts invested in a TSP choose to spread the rollover across several years in order to avoid pushing their annual income into the next higher tax bracket, avoiding additional taxes on the rolled-over funds. Ideally, investors should avoid using rollover distributions to pay income taxes on rolled over funds. This is because you must replace 100 percent of the rolled over amount into your new account otherwise the IRS will treat it as a distribution. If you are younger than age 59 1/2, that would subject you to an additional 10 percent penalty on top of income taxes.

About the Author

Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.