Planning for retirement is a big deal. It is often compared to climbing a mountain and getting to the top (aka retirement) is a big accomplishment.
But like all hikers and adventurers know, the journey isn’t over once you get to the top of the mountain. You still got to make it down.
Taking money out of your TSP is part of coming down the mountain and there are a number of things that you need to know to do so safely.
Withdrawal Options
The first thing for you to know is that there are only a number of ways that you can withdraw money from your TSP.
Note: These options are significantly better than they used to be since the TSP Modernization Act.
Here are the 3 main ways to withdraw money from your TSP:
You are allowed to use any combination of these 3 withdrawal options and there is no limit to how many withdrawals you can make in retirement. However, the TSP does limit you to one withdrawal every 30 days.
But let’s say that you set up a monthly installment payment to pay you $1,000 per month, you would still be able to take single withdrawals while also receiving installment payments as long as the single withdrawals are at least 30 days apart.
You are able to change the amount, frequency, and withdrawal source (traditional TSP or Roth) at any point for installment payments.
When making a single withdrawal the minimum withdrawal amount is $1,000. There is also a $25 monthly minimum for installment payments.
Should I Take a TSP Annuity?
With the annuity option you would give your TSP balance or at least a portion of it, to an annuity provider (Metlife has the current contract to provide these to federal retirees if desired). They would guarantee you a fixed income for a certain amount of time. You can also have the annuity produce a monthly payment for the rest of your life and the amount of your payment will be set based on your life expectancy.
The major downside of this option is the limited flexibility and reversibility. Once you make this decision, it is very difficult to get access to your money other than what they pay you every month. This option offers security but very limited flexibility.
Not to mention that federal employees tend to already have a large amount of fixed income with a pension and Social Security. And while fixed income is great to have, you will still want sufficient savings and investments to have the flexibility to deal with the uncertainties of life as they come up.
Related: Essential Things to Know Before Taking the TSP Annuity Option
Should I Roll My TSP Into an IRA?
In the past, most people opted to move their money out of the TSP because of the rigidity but with the passing of the TSP Modernization Act, many more people are opting to continue to use the TSP into retirement.
But even now, some find IRAs to be much better for their retirement needs. And while I am not going to dig into the details here, I have written a number of other articles that break down the pros and cons of moving to an IRA in retirement.
Related: TSP Vs. IRA: The Ultimate Guide
TSP Withdrawal Strategies
The majority of people have their retirement savings/investments in three different types of accounts. Traditional (pre-tax), Roth (after-tax), or taxable (non-retirement account/brokerage account).
And when/how you distribute money from each of these accounts will ultimately determine how much you pay in taxes over the course of your retirement.
Here is a basic rundown of how money is taxed when it comes out of these accounts.
Traditional
Your traditional TSP, traditional 401k, and traditional IRA would all fall into this category. These types of accounts are all pre-tax which means that you will have to pay taxes on anything you take out.
These distributions will be taxed as ordinary income which is the worst type of income to have for tax purposes. This means that they will be taxed at your marginal tax rate
Roth
This includes your Roth TSP, Roth 401k, and Roth IRA. Since you already paid taxes when you put money into these accounts, it all comes out tax-free.
For obvious reasons, tax-free income is a great thing to have in retirement.
Taxable
The type of account that is in this category is non-retirement brokerage accounts. Brokerage accounts don’t have the tax advantages of retirement accounts so your investment income can be taxed as you earn it.
For example, in the TSP you don’t pay any taxes unless you take money out of the account. But in a brokerage account, you can be taxed on your earnings as you go even if you don’t remove the money from the account.
Typically, if you hold on to an investment for at least 1 year before you sell, the income will be subject to long-term capital gains taxes rates which will be lower than ordinary income tax rates. But if you sell an investment within a year then it will be taxed at your normal tax rate.
Which Should You Take Out First?
Now that we know how each type of retirement account is taxed, we have to ask ourselves what the best strategy might be to reduce taxes as much as possible across your retirement.
As a general rule, it can often make sense to use traditional money first in retirement. This way you allow your other investments (especially Roth) to continue to grow in a more tax efficient way.
Also, starting at age 72, all traditional investments will be subject to RMDs (required minimum distributions) which means you’ll have to start withdrawing a portion of your account every year which will be subject to taxes. And if your traditional assets have a high balance at age 72 then these forced withdrawals might push you up to a higher tax bracket.
Note: One of the only retirement accounts that is not subject to RMDs is a Roth IRA. This is why many people opt to roll their Roth TSP (if they have one) to a Roth IRA in retirement.
The More Roth the Merrier
One strategy that we often use with our clients is doing mini Roth conversions in retirement.
A Roth conversion is done by moving money from a traditional account to a Roth account. Because you can’t move money from the traditional TSP to the Roth TSP, this strategy will have to be done with a Roth IRA
We do this by looking at how much room they have before they hit the next tax bracket and we convert up to that amount.
For example, Let’s say you are in the 15% tax bracket and are going to have $50,000 of taxable income this year. If you won’t move up to the next tax bracket until you have $60,000 of taxable income that it may make sense to do a Roth conversion of $10,000.
This way you aren’t pushed into a higher tax bracket and you get some money over to a Roth account in which it can grow tax free.
You will be taxed on any money that you convert to a Roth account so you will want to decide every year what the ideal amount is to convert.
Be Aggressive in Roth
If you are pretty familiar with the TSP, I am sure you know that there can be a significant difference between the performance of the G fund and the performance of the C fund.
The C fund is significantly more volatile but has the potential to grow much faster than the G fund.
And in retirement it often makes sense to have some conservative investments and some aggressive investments so that you can provide for your short and long term needs. Because of this, some find it beneficial to put their aggressive investments in their Roth accounts and their more conservative investments in their traditional accounts.
For example, let’s say you decide the ideal allocation for your retirement investments is 50% in conservative investments and 50% in aggressive investments. You could then put the more aggressive investments in your Roth accounts because whatever growth you get in that account will be tax free.
But again, you will want to be careful to not invest any money too aggressively if you are planning on spending it relatively soon.
Note: You will most likely need a Roth IRA to use this strategy because you will need the ability to invest your traditional money and Roth money differently.
