The Federal Thrift Savings Plan (TSP) is the “401K” for military and other federally employed physicians. It is a great retirement plan, with minimal expenses (2-3 basis points total), and 5 great index funds, plus a bunch of Lifecycle funds similar to Vanguard’s Target Retirement funds. Their G Fund is a unique investment that provides intermediate term treasury yields while taking money market risks. The TSP even recently implemented a Roth option.
Tax Exempt TSP Money
When deployed to a war zone as a military doctor, you are given the option to contribute money to the TSP above and beyond the $17,500 annual limit. This money is (mostly) earned tax-free because you’re in a war zone. When it comes out of the TSP in retirement, it also comes out tax-free, but the earnings from it do not. It turns out that this acts like a non-deductible IRA, which is really inferior to a taxable account unless you’re going to hold on to it for many decades. But there is a way to get that tax-exempt money OUT of the TSP, and into a Roth IRA. All of the research I have done on this indicates it to be completely legal, but you’re not going to get any help from the TSP, the IRS, or a Roth IRA provider like Vanguard on this. Here are the required steps.
Separating Tax-Exempt TSP Money
First, make sure it actually makes sense to contribute tax-exempt money into the TSP. If you have better uses for the money, such as regular traditional or Roth TSP contributions, contributions to Roth IRAs, contributions to your spouse’s 401K, high interest debt, or even the Savings Deposit Program (SDP) you probably are better off using the money for that rather than sticking it into the TSP.
Second, get deployed. You ideally want to max out your TSP contributions for the year PRIOR to deploying or AFTER returning, so that the tax-exempt money is going in to the TSP in addition to the regular contributions. January to January deployments make this hard. Go to finance and make sure they’re doing the right thing with your money. It’ll likely require multiple trips if you’re like most of us.
Third, get out of the military. You can’t pull TSP money out until after you separate from the military.
Fourth, transfer almost all your TSP money out to a traditional IRA. If some of it is Roth, then I suppose that portion would go to a Roth IRA. The Roth TSP wasn’t available when I did this. I left $200 in the TSP. Keep in mind you can only do a partial TSP withdrawal like this ONCE.
Fifth, transfer an amount equal to your tax-deferred money (your total minus your tax-exempt money) BACK into the TSP. The TSP DOES NOT permit the transfer of “post-tax money” (such as those tax-exempt deployment contributions) so the only money that goes into the TSP is the tax-deferred money, leaving you a traditional IRA with the basis equal to the value.
Sixth, You then convert this IRA to a Roth. There should be no tax bill for this.
When all is said and done, you’ve essentially taken the tax-exempt TSP money out of the TSP and put it into a Roth IRA, while leaving the rest of the money inside a great retirement plan. Now instead of earnings on that money being fully taxable, it is now completely tax-free forever. My tax-exempt contributions were about $25K. Over the next 40 years at 8%, that might save me as much as $171K in taxes.
Beware The Step Transaction Doctrine
You should be aware there is some risk that the IRS could consider this illegal due to the step transaction doctrine. This is the same issue some people have with the backdoor Roth IRA. Basically, if a series of steps, although all legal by themselves, are simply a means of performing an illegal action, then they’re all illegal. Frankly, I don’t think anyone at the IRS cares about stuff like this (they’re too busy chasing down Tea Party groups and partying), and even if they did, I could afford it. I’m also not sure how they’d figure out I did all this from what gets reported on my taxes from the whole process. It looks very clean on your tax forms. I haven’t heard of the IRS having any kind of a problem with this, but I confess I’m the only person I know who has ever done it. Certainly many people have used similar methods to isolate the basis in their 401Ks.
Issues with the Roth TSP
Now that the TSP has a Roth option, most military docs should be using it. Not only does it allow you to shelter more money ($17,500 after-tax is more than $17,500 pre-tax), but the marginal tax rate for military docs is often comically low, especially in a year with a deployment. I believe the tax-exempt money is always considered to be put into the tax-deferred portion of the TSP, so even if all your other contributions were Roth, you’d still have fully taxable earnings in the tax-deferred portion. It would still be worthwhile isolating your basis using this method. The TSP is still considering allowing in-service conversions, but hasn’t reached a decision yet.
Those separating from the military with tax-exempt money in the TSP should consider isolating the basis to convert that tax-exempt money to Roth money.
What do you think? Have you isolated basis before? Do you have tax-exempt TSP money? Comment below!
This article was very helpful as I separated $55k of CZTE contributions out of my larger TSP bucket after retiring from military. It’s definitely a niche area (financially savvy and high saving military members), so not too much info around.
I ended up transferring my traditional TSP balance to Schwab and then sent the non-CZTE portion back to TSP. It took about a week to transfer each direction. Once I’d isolated the CZTE portion I easily converted that to my Vanguard Roth account…though I felt a bit nervous clicking that button due to the tax implications if I screwed up.
I left a little over $200 in my traditional TSP the entire time, but that probably wasn’t necessary since I never moved my significant Roth TSP balance. Oh well, a little bit of my TSP is still trapped CZTE…
Bear in mind that Vanguard won’t track your CZTE balance, so you’ll have to rely on the letter you get from TSP to know how much to not transfer back to TSP. You also have to be careful in filing your taxes the next year as the 1099R from Vanguard didn’t reflect it was a post-tax contribution. I had to play around with TurboTax and look up some mega-Roth conversion articles to ensure I wasn’t paying tax on that $55k conversion.
Sounds like exactly what I did more than a decade ago.
I’m very grateful for being reminded about this article! I retired about a year ago and have 65k in CZTE contributions; I really need to move that money ASAP. This transaction is not for the faint of heart though, I’m a bit terrified to do it! Has anyone done this recently with all the changes TSP is making to their website? It’s possible that it’s easier to do now than it was previously.
In checking with the TSP website as of Mar 2022, they are going to suspend all transactions from mid May 2022 to the beginning of June 2022 while they modernize the website. They have stated they are going to attempt to make all transactions digital and do everything (or at least most transactions) online, along with a host of other features by expanding the website capabilities (you probably got their email about the modernization). I’m going to hold off on doing the CZTE transfer since I don’t want to get caught in the middle of the change, and so I’ll be one of the first to attempt it in the new system, what could go wrong? LOL! At least one can hope that with the modernization will come the capability to transfer out just the CZTE portion. I will try and remember to follow-up with how my transfer goes.
A month of down time? Leave it to the feds. That’s nuts.
Resurrecting the dead indeed! Still reading all these thoughts to try to get spouse’s CZTE TSP money into Roth from traditional TSP,
Working on doing this after that CZTE has over 14 years eventually taxable earnings. Finally listened to idea of Roth converting our all traditional TSP money, which since we have no Roth TSP (like Jim not offered when we contributed) means taking it out of the TSP. Thanks Jim, and Jim Lange. (I also think tax rates will go up so despite deciding we WON’T have an RMD supersaver problem, Roth conversions up to 24% bracket before age 75 make sense. Also he, though not I, would jump 8% or more in current tax rates to single filer if widowed.)
I will post another response about 2023 process if we proceed.
TSP: One must add an outside account 7 calendar days before they will send anything there. So we have passed now 21 days adding traditional IRA, oh then Roth IRA account (thought he could cleanly convert from it at Vanguard but don’t want to press our luck), and now finally checking account since don’t see a way to send two separate amounts to the two IRA accounts. Spouse says close it all to streamline our finances so we’ll do that next week to avoid getting a check in the mail he’d then need to roll over to his Roth IRA. Now we just need to keep records of why the CZTE money owes no taxes when he contributes it to the Roth IRA from the checking account.
So add your IRA and your checking etc. account details all in one fell swoop, y’all.
I am not closing my TSP account as of now; will have time since no CZTE money which ought to be in a Roth there anyway.