As you transition into retirement, it becomes crucial to grasp the extent to which federal income taxes are withheld from your TSP distributions. Failing to do so might result in an unforeseen tax liability and potentially trigger a 10% IRS penalty. Compounding the urgency to get it right is the fluctuating amount of taxes withheld, contingent upon your chosen method of withdrawing funds.
A Lump Sum Withdrawal from Your Traditional TSP
Opting for a lump sum withdrawal offers flexibility, as the payment can either be disbursed directly to you or rolled over to an IRA or another qualified retirement plan. If you opt for a direct payment, the IRS mandates a 20% withholding for federal income taxes.
However, the adequacy of this 20% withholding hinges on your tax bracket in the withdrawal year. It’s imperative to gauge your marginal tax bracket accurately and request supplementary withholding if deemed necessary. Conversely, if you decide to transfer your tax-deferred balance to a traditional IRA or another qualified retirement plan, federal taxes on that amount are deferred until subsequent withdrawals.
“Note that if your anticipated monthly TSP disbursements are projected to fall short of a decade (less than 120 payments), federal taxes will be withheld at the 20% rate.”
Monthly Installment Payments from Your Traditional TSP
For federal retirees, opting for equal monthly TSP payments is a prevalent choice. Regardless of the elected amount, the TSP automatically withholds taxes from these payments as if you were married and claiming three dependents.
Given that most federal retirees are unlikely to have three dependents, you have the option to augment the withholding amount by completing the relevant section of your TSP withdrawal form. Remember, if your monthly TSP payments aren’t anticipated to span at least ten years (less than 120 payments), federal taxes will be withheld at the 20% rate.
Other Tax Obligations on Retirement Income
Considering that your monthly annuity and Social Security are also subject to income taxes, it’s imperative to complete withholding forms for these benefits as well. State income tax on retirement income varies depending on your state of residence. Although the TSP doesn’t withhold state or local income tax, it does report all TSP distributions to your state of residence if it imposes a state income tax.
Without proficient tax planning, retirement could bring about an unexpected “tax bomb.” Connect with an FRC® trained advisor who can facilitate communication with a tax expert well-versed in TSP intricacies.
