Leaving the Military: Cash Out Your TSP or Keep It?

You have been faithfully contributing to the Thrift Savings Plan (TSP) since you joined the military. Now, you are counting the days until you get out and have a big chunk of money sitting in your TSP account. What should you do with it?

When you get out of the military and transition to civilian life, you will almost certainly be hit with a ton of unexpected expenses, ranging from the cost of new clothes to medical insurance. It's really tempting to cash out your TSP account to pay for them. But that is almost always the worst thing you can do.

Most experts agree that taking money out of your TSP (or any tax-free or tax-deferred) retirement account before you turn 59½, the normal minimum distribution age, isn't smart.

Why Keep the TSP?

To start with, the TSP is cheap.

When you make any investment, the investment company is going to take some of your money as a service fee; nobody works for free. The TSP currently charges a service fee of 0.04%, which is probably the lowest you will find anywhere in the world. Even index funds, which some investors swear are the best investments, normally have service fees at least twice as high as the TSP. Most employer-sponsored retirement savings plans are at least three to four times more expensive than the TSP is.

Another reason to keep the TSP is the tax advantage. Since the TSP is a tax-deferred or tax-qualified retirement program, you are basically making a deal with the IRS saying you won't use this money until you are close to retiring. For its part, the IRS says it won't tax you on a portion of that money. This is one of the big selling points of any retirement savings plan.

But if you take the money out before you retire, the IRS is going to come looking for its tax money, and they always get it. In this case, they will also get a penalty of 10%.

This penalty will hit you no matter what kind of TSP contributions you have, either traditional or Roth:

  • Normally, if you have a traditional IRA and take the money out after retirement, you pay taxes on the entire amount, including contributions, matching funds and earnings. This isn't a big deal if you are taking a portion out each year. However, if you close out your TSP before the minimum distribution age, you get hit with a lump-sum tax bill for the entire amount, plus the penalty.
  • If you have your money in the Roth version of the TSP, all withdrawals after age 59½ are normally tax-free. But if you close the TSP before that, you have to pay taxes, plus the penalty on the earnings.

That tax can hit hard. The IRS will take 20% for federal taxes, plus another 10% penalty tax. This doesn't even count state taxes, which could hit 5%-10%. So theoretically, if you cash out your IRA, you could get hit with a tax bill of 40% of your total account balance for a traditional plan, or 40% of your earnings for a Roth. Not good.

If you have $100,000 in your TSP and take it all out, you could end up paying $40,000 in taxes!

What Are Your Options?

The most obvious option is to leave your TSP alone. Don't touch it, no matter how tempting it may be. While that isn't always easy, it is the best financial advice.

One nice thing about the TSP is that once you're in, you can stay in, even after you leave the service. You can also contribute money from other qualifying retirement plans and your own IRAs into your TSP account. Conversely, if you get a job that has a good 401(k) plan, you can roll your TSP money into that plan. If you get a government job, you can keep putting money into your TSP.

A 401(k) plan is almost the same thing as the TSP; it's just run by a civilian company. The 401(k) refers to the paragraph of the IRS tax law that authorized the program.

Transferring money from one retirement savings plan to another is almost always tax-free. It usually involves a bit of work filling out forms and talking to finance people who may not be familiar with the TSP, but all the information you need can be found on the TSP website.

Normally, you can only transfer your Roth TSP into a Roth 401(k), or your Roth 401(k) into a Roth TSP. The same goes for traditional TSP and 401(k) plans. There are ways to get around this. To be safe, talk to an accountant. Otherwise, you may end up owing a lot of taxes.

You can also transfer Individual Retirement Accounts (IRAs) and SEP IRAs (for self-employed people) into the TSP and keep the tax advantages.

Once you see the types of retirement plans (if any) offered by employers in the civilian world, you will understand that the TSP is pretty decent, with low expenses and a good range of investment choices. Take advantage of this great plan as long as you can. It's one of those great government benefits civilians wish they had.

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