Question
I very much appreciate your podcast and videos. Thank you for producing them.
I have a question about traditional TSP to Roth IRA transfers/conversions. I know that each conversion creates a new Roth IRA account and a new 5 year clock for penalty free withdrawals. However I am unclear if my contributions to that new IRA are subject to the 5 year rule or only the earnings on those contributions?
Answer
There are actually 2 separate 5 year rules that apply to Roth IRAs. The first 5 year rule says that you have to have a Roth IRA open for at least 5 years before you can take out earnings from the account tax-free.
For example, if you open a Roth IRA and put $100 in, you can always take that $100 out without penalty because it was your contribution. However, if your $100 grows to $150 you’d have to have your Roth IRA open for 5 years to withdraw the $50 of growth tax-free.
The second 5 year rule (and I believe this is the one you are asking about), says that you have to wait at least 5 years after every Roth conversion before the converted money can be taken out without a 10% penalty. And because each Roth conversion has its own clock you can easily have more than 1 of these 5 year clocks running at a time.
The one exception to this rule is if you are already over 59 and ½. If you are then the 10% penalty does not apply and you don’t have to worry about this 5 year rule at all.
But if someone is under 59 and ½ is there a way for them to avoid the 10% early withdrawal penalty on their TSP or IRAs? Yes, there sure is.
Basically if you have a traditional IRA (or traditional TSP) you can convert a portion of it over to a Roth IRA. During that transfer you would have to pay taxes but no 10% penalty would be due. Then if you waited 5 years you would be able to withdraw that converted amount from your Roth IRA without taxes or a penalty even if you are under 59 and ½.
Question
If you take out a TSP loan, where does the interest go? Does it get invested back into your account or does TSP collect it as a finance charge for the agency?
Answer
It goes back into your TSP account so you are basically paying yourself. However, the biggest cost is the fact that that money can’t grow while it is out of your account.
