Thrift Savings Plan participants may be able to avoid the Internal Revenue Service’s 10 percent penalty for withdrawing money from their accounts before they’ve reached age 59 ½. That’s good news for those interested in retiring before reaching that not-so-old age.

If you’re considering leaving federal employment while you’re young, you should understand your options for accessing your TSP account without triggering the early withdrawal penalty.

One of the simplest ways to avoid the penalty is to use all or part of your balance to purchase a life annuity, either from the TSP’s provider or from another insurance company you choose. The annuity converts your balance into a stream of income guaranteed to last at least as long as you live and on which you will pay no early withdrawal penalty.

The annuity is irreversible, however, and may produce a stream of income significantly smaller than what could be produced through other withdrawal methods. More important, it may produce a stream of income that fails to keep pace with inflation, and dramatically reduces your spending power over time. This option should only be selected after careful consideration and comparison with the alternatives.

You can also avoid the early withdrawal penalty by creating and managing your own annuity—taking withdrawals designed to distribute your account balance over your lifetime.

The IRS allows three alternative methods to be used in calculating the penalty-free distribution—called substantially equal periodic payments (SEPPs)—that can be taken from an account each year: the life expectancy method, the annuity factor method or the amortization method.

The life expectancy method calculates each year’s distribution by dividing the previous year’s ending balance by your remaining life expectancy, according to published tables. The result is annual distributions that are certain to last your lifetime, but which may vary substantially in size from one year to another.

The annuity factor and amortization methods both rely on complex formulas that produce fixed annual distributions that may or may not last for life. These two methods typically produce similar distribution amounts that are significantly higher than that produced by the life expectancy method.

All of the SEPP exemptions require that the distributions continue undisturbed for five years or until you reach age 59 ½, whichever is longer. You must take exactly the amount produced by an accepted calculation method each year, without adding any money to the account, during the required period. Violating the rules will mean that penalty taxes and interest will be imposed on the entire stream of early distributions taken, a strong incentive to stay within the rules.

There are several additional exemptions to the penalty for distributions taken from your TSP account before you reach age 59 ½. These exemptions apply if the distribution is:

  • Made because the account owner is totally and permanently disabled.
  • Ordered by a domestic relations court.
  • Made because of the death of the account owner.
  • Made during a year in which the account owner has deductible medical expenses exceeding 7.5 percent of adjusted gross income.
  • Made by an account owner who separated from federal service during or after the calendar year in which he reached age 55.

If you qualify for one of these exemptions, you will have unlimited access to your account after you separate from service at any age, without penalty.

The “age 55” exemption is not available for early distributions from an individual retirement arrangement, and this is a key difference between employer-sponsored plans like the TSP and individual retirement accounts. Take this difference into account before deciding to roll over your TSP account to an IRA before reach age 59 ½.

Notice that your years of service, law enforcement officer status, the retirement system you’re under, the type of retirement you’re claiming or whether you’re retiring under Voluntary Early Retirement Authority have no impact on the early withdrawal penalty and when it applies. The exceptions listed are the only ones available, and none of them is unique to federal employment.

The rules governing early withdrawals from retirement plans are strict and complicated. Seek the guidance of a qualified account or financial planner before making any early distribution decisions, since the effects of your choice will last a lifetime.

Written by Mike Miles
For the Federal Times

Publication November 4, 2013