The Thrift Savings Plan (TSP) will begin to allow In-Plan Roth Conversions in January 2026 military members, federal civilian employees, separated/retired participants and spousal beneficiary participants will be eligible to convert tax-deferred TSP funds into Roth TSP funds within their TSP accounts. I wrote about this news a year ago when it was first announced.
It is worth revisiting the topic now that it is upon us as a refresher but also because the TSP has added extra details on how exactly thein-plan Roth conversions will work within their system.
Why Roth Assets Are Important
As a reminder, Roth assets are important during retirement because they allow us to pull money out of our retirement accounts without affecting our tax rate during that year of retirement. This gives us a lot of flexibility in controlling our tax rate during retirement and allows us to make irregular big ticket purchases without spiking our income taxes during our golden years.
How In-Plan Roth Conversions Can Reduce Lifetime Taxes & Other Expenses
Roth conversion in general, but also in-plan Roth conversions, can lower our lifetime tax expenses when properly executed. Many people experience low income years before they choose to retire during which their marginal tax rate is well below what it will be after they begin receiving social security income (SSI) and required minimum distributions (RMD's). Since SSI and RMD's are taxed as ordinary income and are somewhat predictable we can make a decent prediction about what someone's tax rate during retirement might be and determine if it might make sense for that person to convert some of their retirement assets from tax-deferred into tax-free Roth accounts. For some people, moving assets from tax-deferred accounts to Roth accounts may also make a material difference in determining the amount of extra Income Related Monthly Adjusted Amount (IRMAA) payments they on Medicare premiums. Avoiding or reducing IRMAA premiums can make mean hundreds or thousands of dollars of savings every year during retirement.
What You Need To Know About How The TSP In-Plan Roth Conversions Work
Income Taxes
The first thing you need to understand before making an in-plan Roth conversion with the TSP is that it will likely trigger higher income taxes. Whenever a person moves money from a tax-deferred account to a Roth account they ending their tax deferral and therefore they will be on the hook for recognizing that amount of money that was converted as income in the year in which it was converted. The catch with the TSP in-plan conversion is that they will not allow you to have the tax withheld directly from the account. You must pay for the tax expense from some other source of funds.
Tax-Exempt Contributions vs. Tax-Exempt Earnings
Another important factor to consider is what portion of your TSP tax-deferred account values were contributed with tax-exempt status versus earnings on those contributions. If you are like me, then you spent some portion of your time in service deployed to a combat zone with tax-exempt status. This is known as a Combat Zone Tax Exemption (CZTE). When you contributed to your TSP while deployed to a CZTE area those funds were given a special nontaxable status. Even though your contributions made while deployed to a CZTE area will not be taxed, the earnings on those contributions will be taxed if they were made into a tax-deferred election within your TSP account. Here is a break down illustrating the tax implications based on whether money is contributed or earned segmented by contribution election:
On your statement, you may see tax-exempt balances but it is important to understand that those balances include both contributions and earnings. In the example below, the "Nontaxable Balance" in the box on the top right of page two on a TSP statement is the portion which includes only contributions. The "Tax-exempt" line is misleading because it also includes Earnings which under current law would be taxed when withdrawn or converted.
Hypothetically, in the example above, this person would only ever have access to $3,641.10 of tax-free withdrawals from their TSP account.
Minimums and Maximums - The 500-500 Rule
For some reason that is unknown and bewildering to me, the TSP has decided that conversions must be at least $500 in size and that any conversion must leave at least $500 remaining in the original taxation category. For my purposes, I will call it the 500-500 Rule in which participants in the TSP who elect to perform an in-plan Roth conversion must convert at least $500 and leave a minimum of $500 in the original tax category status. I'm confident this has to do with some antiquated plumbing in how transactions with the TSP are handled. The TSP is very far behind the times when it comes to technology.
26 Conversions Per Calendar Year
Another example of antiquated systems here, but the TSP is maxing out the frequency of in-plan Roth conversion to 26 per calendar year. Honestly, this seems reasonable because in-plan Roth conversions are usually either done with After-Tax Contributions immediately after the contribution is made or in the lead up to RMD's and SSI for retirement.
RMD's Before Conversions
If you happen to be one of the many people who are already mandated to take RMD's then you must take those RMD's before you execute your in-plan conversion. The reasoning here is that the conversion will not count towards your RMD requirement. I'm not sure how much of a burden this will be but I can imagine more than a few people will run afoul of this rule. I'll be interested to see how they control for this.
The Five Year Rule
As with any Roth accounts, any money that is pulled out of a Roth account before five years has passed may be subject to ordinary income taxes or a 10% penalty fee. Converted amounts would be subject to the penalty fee of 10% if withdrawn before the 5-year period. No income taxes because you had already paid those. However, for amounts withdrawn before five years that were attributable to earnings you may have to pay income taxes for.
Do try to avoid this pitfall if at all possible as it can quickly turn a good thing upside down.
Is a TSP Roth In-Plan Conversion Right for You?
The question of whether or not to perform an In-Plan Roth Conversion in your TSP account is a complicated one with serious tax and investment implications. If you have questions about whether or not it makes sense for you to perform an in-plan conversion or not please reach out to a professional that can help you make an informed decision while taking into account the many risk factors associated with this type of financial move.
Want to perform an in-plan Roth conversion in your TSP?
If I can ever be of service with helping you to navigate an In-Plan Roth Conversion in your TSP please feel free to schedule time with me for a consultation. Or, contact me using my contact page.
Disclaimer: This blog post is intended for educational purposes only; it should not be construed as legal advice, tax advice or financial planning. Consult a professional for legal, tax or financial planning advice before making any changes. All photos are from open-source domains, generated by artificial intelligence or are the property of Stars & Stripes Financial Advisors.