By George Ray
During my benefits training sessions, we focus on the various options for taking distributions from your Thrift Savings Plan (TSP) when you retire. Usually, someone asks about getting access to their money before retiring and mentions that they’ve heard there is a penalty. Someone else in the class will tell us that they’ve been told of a mysterious rule called 72(t) that is supposed to provide exceptions to the penalty. Let’s take the mystery out of the rule by discussing the nine ways to avoid an early retirement penalty.
Your Thrift Savings Plan (TSP) has been designed to help you save money for retirement by having funds taken directly from your paycheck and contributed into your account. Your contributions are salary deferrals, and because you’ve asked your agency to defer (or delay) giving you a portion of your salary presently the Internal Revenue Service (IRS) says that you don’t have ‘constructive receipt’ of that pay. As a result, you don’t have to pay any taxes on your current contributions to the TSP, and the funds are considered tax-deferred. Since you also don’t currently have access to the interest or growth on your money in your account, taxes on that interest or growth are also deferred. (The scenario is a bit different if you decide to use the Roth TSP, however.)
You probably know that you must generally wait until you retire to withdraw your TSP savings. After all, this money is for your retirement and we generally think of retiring in our 60’s or later. Today, however, there are many who would like to retire earlier except that they’re concerned that they won’t be able to access the money in their TSP without being subject to the dreaded 10% early withdrawal penalty that we’re all told about.
The Internal Revenue Service (IRS) Code includes a rule that is designed to provide a strong incentive to keep your retirement money in a retirement plan (like your TSP) so that it will be there when you retire. You can withdraw your money whenever you want (it is your money, after all, at least the vested portion is), but generally if you take retirement funds out before you’ve reached age 59½ you’ll pay the 10% penalty tax, in addition to paying taxes at your current tax rate on any previously untaxed portion that you receive. This creates a strong incentive for most people to keep their money in the plan until they have satisfied this age requirement.
But Congress recognized that there may be times when you need to access your funds and shouldn’t be penalized. Internal Revenue Code Section 72(t) eliminates the penalty for those exceptions. This means that if you satisfy one of the exceptions, you won’t be accessed the 10% penalty tax. When filing your tax return, you’ll simply need to provide the IRS with documentation and an explanation of how you’ve satisfied an exception found in Section 72(t) to avoid the penalty. So, here are the nine exceptions found in the mysterious IRC Section 72(t) that apply to your Thrift Savings Plan:
- Receive the funds on or after you turn age 59½. The first one is easy. If you don’t want to pay an early withdrawal penalty, then just follow the rule and wait until after you’ve turned 59½ to withdraw your money from the TSP.
- Receive the funds after you separate from service (or retire) during or after the year that you reach age 55. Most employees are not aware that if they leave Federal service at age 55 or later, their funds in the TSP can be withdrawn without a penalty. A gentleman in one of my sessions who berated me with questions on this got so excited when I finally convinced him of it that he announced to everyone in the class that he was now going to retire. They all clapped for him, although I’m not sure if they were happy for him or just glad to get rid of him.
In June 2015, Congress amended this exception (IRC Section 72(t)(10)(B)(ii)) for public safety employees for distributions taken after December 31, 2015. This amendment allows Federal law enforcement officers, customs and border protection officers, Federal firefighters and air traffic controllers to take distributions at age 50 without penalty. Employees in these professions may retire at age 50 with 20 years of service or at any age with 25 years of service. Most also have mandatory retirement ages that are below age 59½. The rule update was applauded as it just wasn’t fair to make public safety officers wait many years before being able to access their TSP funds without a penalty.
- Receive payments as an annuity. If your distributions are made as part of a series of ‘substantially equal periodic payments’ taken over your life expectancy or the life expectancies of you and your designated beneficiary, there is no 72(t) penalty. Turning your balance (or some portion of it) into an annuity will satisfy this exception.
If these distributions are from a qualified plan (like your TSP), you must separate from service before the payments begin. If your payments are later modified (other than because of death or disability) within 5 years of the date of the first payment, or, if later, age 59½, the exception to the 10% penalty tax does not apply. In that case, your tax for the modification year is increased by the amount that would have been imposed (but for the exception), plus interest for the deferral period. In other words, change the payments or stop them within the first five years and you’ll not only owe taxes on all the distribution, but also the penalty, and even interest on the taxes that you didn’t pay timely, to begin with. Ouch.
- Receive monthly payments based on your life expectancy. You don’t have to turn your distributions into an annuity ‘officially’. You could simply take monthly payments based upon your life expectancy (or you and your spouse’s life expectancies) like the annuity exception mentioned above. The payments will be calculated by the folks at the TSP using life expectancy tables and must be taken for a minimum of five years without stopping or changing the amount. If you stop or change the payments within that time, you’ll owe the penalty on the distribution, plus taxes on the distribution. You’ll also owe interest calculated back to the year the distributions began. After you’ve reached age 59½ and satisfied the five-year rule, you could then stop or change the payments without being subject to the penalty. If you turn your distribution over to an insurance company and receive an annuity, they may not permit you to make changes to the payments later.
- Payments ordered by a domestic relations court. Funds that are required to be distributed from your account by a domestic relations court for alimony or child support are not subject to the penalty tax and are considered an exception. Since these funds will not likely be used for your retirement, Congress deemed it appropriate not to assess you an early withdrawal penalty.
- Payments distributed because of your death. If you die prior to age 59½, payments distributed to your estate or your beneficiary will not be accessed the penalty tax (to your estate or to your beneficiary) even though you were under the age of 59½ at the time of your death. This is another logical exception to the rule. You aren’t really benefiting by getting access to the funds early (since you’re no longer around), so no penalty should be accessed.
- Payments made from a beneficiary participant account. If for example, your spouse passed away and made you the beneficiary of his or her TSP, you will receive notification that a beneficiary participant account has been opened in your name. You may withdraw funds from this account (a partial withdrawal, full withdrawal, or a use a combination of distribution options including monthly payments and/or an annuity) without being subject to the 10% penalty tax. Once again, this isn’t the way the money was supposed to be distributed, and Congress didn’t want to penalize the beneficiary for getting access to the funds before his or her age 59½.
- Receive a payment in a year that you have deductible medical expenses that exceed 10% of your adjusted gross income. If you have large medical bills that warrant you taking a distribution from your retirement plan to prevent dire financial consequences, you will not be penalized for this early withdrawal.
- Received as a result of a total and permanent disability. If you can provide documentation that you incurred an injury which has left you totally and permanently disabled, you can access the funds inside your TSP account at any age without being subject to the early withdrawal penalty.
There you have it. It wasn’t really that mysterious after all, and these exceptions make sense. If you need to get your money out of your TSP account before age 59½, or if it must be distributed for some reason, it may come out without a penalty. Simply satisfy one of the exceptions that are available under IRC Rule Section 72(t). Remember, if you can’t satisfy one of the exceptions, you could still get your money out, but it’s going to cost you.