In this article you’re going to learn what options you have for your TSP at the time you retire and the pros and cons of each of those options. By the end of this article, you will have a clearer understanding of the best options for your TSP when you retire.
Understanding your TSP
The Thrift Savings Plan (TSP) is the government’s version of a 401(k). It allows you to save for retirement, and the contribution limits are identical to those for a 401(k).
Where the TSP differs from a 401(k) is in the limited investment options. TSP’s have five different core investment options plus L or Lifecycle funds which are automatically allocated based on the fund date you choose. The core investment options are essentially low cost index funds covering broad areas of the market, while the L funds are combinations of the underlying core funds and the allocation of each L fund changes as the target date of the fund approaches. Although the TSP investment options are limited, given their low cost and broad market coverage, they are generally good options.
TSP accounts also differ from most 401(k)s and IRAs with regards to your ability to withdraw your money post-employment. More specifically, there are restrictions on the ability to take money from the Thrift Savings Plan on an as-needed basis – although those options are slated to expand in late 2019.
You can’t leave the money in your TSP past age 70 and a half if you are separated from service. You must begin taking distributions.
As part of you retirement plan, you’ll want to determine how much income you’ll need from your TSP account because ongoing ad hoc distributions aren’t allowed. Instead, you’ll have the option of taking the money out as a lump sum, beginning regular monthly payments or purchasing a life annuity. If you choose the first option, if the funds are from pre-tax dollars, a rollover to an IRA will not be a taxable event.
The fact that you can’t withdraw money as you need it from the Thrift Savings Plan makes planning for your cash flow needs a key consideration in retirement.
Option #1 – Leave Your TSP Where it Is (For Now)
The benefits of leaving your money in the TSP are that the fund options are low-cost and straightforward. Once you reach age 70½, if you are separated from service, you’ll need to begin taking withdrawals from your TSP account. In fact, if you fail to take the distribution by April 1st of the year after the year in which you turn 70½ , your account balance can be forfeited to the TSP (though it can be recovered) and the IRS can penalize you.
Your distribution options in that year are the standard TSP distribution options – take a lump sum, begin regular monthly payments or purchase a life annuity. If you chose regular monthly payments but the amount isn’t sufficient to meet the required minimum distribution, the TSP will send a one time distribution to make up the difference.
Things get a bit more complicated if you have multiple retirement accounts. If, for example, you have several IRAs or other pre-tax retirement accounts like 401(k)s, the IRS will allow you to withdraw funds from just one account to satisfy the total required minimum distributions from all accounts. However, this isn’t allowed with the TSP – the plan administrators for the TSP require you to take the minimum distribution based on the TSP balance regardless of the amount you’ve withdrawn from any other pre-tax retirement accounts.
The upshot of this is that when you are cobbling together sources of income in your retirement plan to cover your retirement needs, you need to ensure you include required distributions from the TSP as one of the income sources. You’ll also want to account for the fact that any pre-tax contributions you’re withdrawing will be taxed as income and will likely increase your Federal and State taxes accordingly.
Option #2 – Purchase an Annuity with Your TSP
A second option for your TSP account is to use the proceeds to buy a life annuity. On the plus side, you don’t have to make that decision at retirement, but on the minus side, locking yourself into an annuity without being reasonably certain of your cash needs is a bad idea.
If you are married or have someone else dependent upon your retirement income, you also need to make a decision about survivor benefits.. What happens to your annuity income if you pass away?
If your money is in the TSP and you haven’t chosen to purchase an annuity, the account will pass to your beneficiary. However, if you have annuitized your TSP, what happens to the annuity depends upon the payment option that you take for the annuity.
There are three most common payment options for your annuity:
1.) Single Life – If you choose the single life option, which is typically going to pay you the most each year, then your designated beneficiary gets nothing after you pass away unless you have purchased the cash refund feature. In this scenario, there is no guarantee that the total principal you invested will be paid back
2.) 100% Survivor Option – This option pays less than the single life option, but if you pass away, the income to your beneficiary does not decrease
3.) 50% Survivor Options – The initial payment in the 50% joint option is between that of the single life option and the 100% survivor option. However, if you pass away, your beneficiary’s payment will drop to half the original payment.
There are other payment options as well as two additional features available, but the most popular choices I’ve encountered are Single Life payments and 100% Survivor option . Single life can work well when your spouse has a good income on his or her own and would not have to adjust their lifestyle if the annuity payment ceased.
In those cases, the annuity payment for the couple that I’m working with is “fun money” spent on entirely discretionary items. But in situations where income is lower — particularly in situations in which the deceased spouse earned more than the surviving spouse – the annuity income is critical and the 100% survivor option is usually optimal.
Whether you choose to take monthly distributions out of your TSP or annuitize your TSP, pre-tax dollars that are withdrawn are taxed as income.
Option #3 – Roll Your TSP Into an IRA
The pros of rolling your TSP into an Individual Retirement Account (IRA) include more flexibility in terms of withdrawing your money and a greater breadth of investment options. Fortunately, although the TSP plan options are limited, the options that are available are generally good ones. Lastly, if you are planning on retiring early, the TSP does allow withdrawals with no penalty beginning at age 55 as long as you have separated from service.
If cost is your primary concern but you need greater flexibility in terms of withdrawals, you could roll your TSP funds into an IRA, and replicate your TSP investments using low-cost index funds. The one fund that can’t truly be replicated is the G fund, which provides a return higher than that of cash with no risk to principal. If the G fund isn’t a critical part of your investment strategy, putting together an IRA version of your TSP portfolio should be straightforward.
Mistakes to Avoid with Your TSP
The biggest mistake I’ve seen investors make with their TSP is opting to roll funds to a life annuity without having a clear picture of how the annuity income will fit within the retirement plan. A key consideration that is often overlooked is the fact that expenses will rise over time, but the annuity payments will be level unless the increasing payment option is chosen.
In these cases, the initial annuity payment may appear to be more than sufficient, but if we encounter sustained higher inflation, your future annuity payments may well not be sufficient to meet your ongoing needs.
As an example, if inflation averages 3% per year for the next 15 years, a payment of $30,000 now will be worth just over $19,000 per year in 15 years.
The TSP provides a number of options to retirees, and the option that is best for you depends upon your specific financial situation. As a fee-only financial planner in Atlanta, I have collaborated with a number of federal employees and their families to build retirement plans and make the optimal choices with regards to their TSP accounts.
Please contact me if I can help clarify any questions you have about your TSP or your retirement planning.
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