Tax Today, Freedom Tomorrow: Understanding the TSP’s New In-Plan Roth Conversion Proposal

In-plan Roth TSP conversions are one step closer to reality after a new proposed rule was issued by the FRTIB.

The Federal Retirement Thrift Investment Board (FRTIB) has issued a significant proposal that would enhance the flexibility of federal employees and retirees in managing their Thrift Savings Plan (TSP) accounts. The proposal, published in the Federal Register, would enable investors in the TSP to convert existing traditional (pre-tax) TSP balances into a Roth account (after-tax) balances within the plan—a feature that has long been available in many private-sector 401(k) plans but not in the TSP.

There are significant advantages to a Roth account. There are also significant tax implications TSP investors have to consider.

This article provides a brief overview of the potential tax implications and advantages of a Roth plan. 

Please note that the TSP includes millions of participants. The different personal and financial situations of these many people are vast. For some TSP investors, a Roth plan offers numerous advantages and a greater chance to accumulate wealth for their retirement years. For others, a Roth plan would not be a good idea.

Check with your financial advisor and a tax expert before making a decision on whether a Roth conversion makes sense for you under your unique circumstances. One article cannot purport to offer universal advice on the personal financial implications for everyone with a situation that is this complex.

FedSmith has published several articles on using a Roth for TSP investments. Check out some of these articles.

Key Provisions of TSP In-Plan Roth Conversions

Here are the key provisions of this proposed rule published by the FRTIB.

TSP participants and beneficiaries would have the option to convert all or part of their traditional TSP funds to a Roth balance. The converted amount would be considered taxable income in the year of the conversion, but would continue to accrue tax-free within the plan.

The rule incorporates several essential conditions to ensure administrative simplicity and mitigate frequent small transactions:

• Minimum Balance Requirement: Participants must maintain a minimum balance of $500 in their account to be eligible for conversion.
• Minimum Conversion Amount: Each conversion must be at least $500.
• Remaining Balance Rule: Participants must retain at least $500 in each of their tax-deferred employee contribution, tax-exempt contribution, agency automatic (1%) contribution, and agency matching contribution balances.
• Limits on Number of Conversions: The plan’s recordkeeper may establish a cap on the number of conversions that can be made within a calendar year.
• Restrictions on Mutual Fund Window Assets: Balances invested through the Mutual Fund Window must be transferred back into core TSP funds before they can be converted.
• Administrative Holds: Participants subject to administrative restrictions (under § 1690.15) may be temporarily ineligible to request conversions. This is a regulation under FRTIB rules that governs administrative holds (also known as account freezes) on Thrift Savings Plan (TSP) accounts.

These measures aim to strike a balance between investor flexibility and operational efficiency for the TSP.

Tax Implications and Precautions

While the new flexibility would be beneficial, participants should be aware of the tax consequences before converting.

When traditional TSP funds are converted to Roth funds, the converted amount is treated as ordinary income for federal tax purposes in that year. For instance, converting $50,000 could increase that amount to your taxable income, potentially placing you in a higher tax bracket. State income taxes may also apply.

The TSP is not expected to automatically withhold taxes on these conversions. This means participants must set aside funds outside of the TSP to cover the additional tax liability or make estimated tax payments.

Despite the initial tax cost, Roth conversions can provide long-term advantages; future withdrawals of earnings and contributions from a Roth TSP are tax-free in retirement, provided IRS conditions are met. This can be advantageous for participants who anticipate being in a higher tax bracket in retirement or those seeking to reduce future required minimum distributions (RMDs) from their traditional accounts.

However, participants in higher income brackets today or those without liquid savings to cover conversion taxes should think long and hard before making a decision. Even partial conversions can have cascading effects on Social Security taxation, Medicare premiums, and tax credits associated with income levels.

Below are illustrative examples of the tax implications associated with transitioning to a Roth plan within the TSP. Please note that these are approximate figures. Your tax situation may deviate from the information presented here. Any prudent, intelligent investor will engage in a comprehensive discussion with a tax professional to ascertain the specific tax implications tailored to your individual circumstances, considering factors such as your state of residence, local taxes, and other relevant distinctions.

Estimated Federal Tax Due on a Roth In-Plan Conversion

Here is a rough guide on potential tax payments for some TSP investors who are considering converting to a Roth. These figures are subject to change and may not be accurate for all investors, depending on their individual personal and financial circumstances. This provides information for guidance on whether your specific situation may be beneficial for converting to a Roth. The tax rate is also graduated as your income moves up. Your tax adviser can provide specifics.

Do not allow potential tax payments to automatically determine whether a Roth plan is suitable for you. There are significant tax considerations, and there are also potential gains for some TSP investors.

The TSP has also announced that it is developing a calculator as part of bringing in-plan Roth conversions to the TSP to let plan participants estimate the effects of converting traditional money to Roth money within their TSP accounts.

Potential Benefits of a Roth Plan

There are several potential benefits to a Roth conversion for many TSP investors. Tax implications for some investors will greatly reduce these benefits, though, and both taxes and potential benefits need to be considered.

Tax-Free Growth and Withdrawals

Once money is converted into a Roth account:

• All future earnings grow tax-free.
• Once converted, qualified withdrawals (after age 59½ and 5 years after the first Roth contribution/conversion) are tax-free.
• This makes Roth balances particularly valuable if you anticipate investment growth or higher tax rates in retirement.

Pay Taxes Now, Avoid Higher Taxes Later

• Traditional TSP balances are taxed upon withdrawal; Roth balances are not.
• If you anticipate being in a higher tax bracket in retirement — either due to higher income, inflation, or tax law changes — paying taxes now can lock in today’s rates.
• This is often referred to as “tax diversification,” reducing your future exposure to uncertain tax increases.

No Required Minimum Distributions (RMDs)

• The Roth TSP balance isn’t subject to IRS required minimum distributions (RMDs), which means you can keep your Roth contributions and earnings in your TSP account as long as you want.
• This allows your money to remain invested and continue compounding tax-free for as long as desired — even for heirs.

Greater Retirement Planning Flexibility

• Having both Roth and traditional balances provides you with control over when and how you are taxed in retirement.
• Roth accounts offer a strategic approach to managing your tax bracket throughout the year. You can draw from Roth accounts during high-income years and traditional accounts during low-income years, providing flexibility in your financial planning.

• Additionally, Roth accounts provide estate and inheritance benefits. Heirs who inherit Roth accounts can take distributions tax-free, subject to specific rules. This makes Roth funds more tax-efficient assets to leave to beneficiaries compared to traditional pre-tax funds.

• Roth conversions are particularly advantageous during years of temporarily lower income, such as early retirement or career transitions. These conversions allow you to move money into a Roth account at a lower tax cost. Spreading conversions across multiple years can also help avoid significant one-time tax spikes.

• As noted above, consider the immediate tax implications of Roth conversions. The amount converted now is taxable, and it is generally recommended to pay this tax with non-retirement funds to avoid reducing your investable balance and potentially triggering penalties.

Roth conversions can eliminate future tax liability, provide flexibility in retirement income planning, reduce required distributions, and improve after-tax wealth for you and your heirs. A Roth conversion is most effective when you can afford the upfront tax, expect to be in an equal or higher tax bracket later, and have time for the Roth money to grow tax-free.