Posted on Monday, 20th June 2011 by

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TSP Conversions and Taxes

The key to what taxes, if any, are due is in the type of IRA that you wish to convert to.  When you rollover any investment account that hasn’t yet been taxed (TSP, traditional IRA, 401k) to an after-tax investment account, such as a Roth IRA, taxes must be paid to Uncle Sam at the time of the rollover.  If you want to avoid being taxed on the entire rollover amount, you can leave the funds in TSP (provided the amount is over the minimum) or roll the account over to a Traditional IRA.

Before electing to rollover the entire amount out of TSP you should consider the administrative expenses of the new investment.  If you leave a minimum balance of at least $200 in TSP and keep the funds in a pretax account (traditional IRA), you will be able to roll funds back into TSP if you elect to do so.  Also carefully examine the withdrawal reasons and age for withdrawal, as they are different in TSP than other IRA type accounts.

The 10% early withdrawal penalty does not apply to payments after you separate from service during or after the year you reach age 55. Therefore, if you retire at age 55 or later you don’t pay the 10% penalty. However, the mandatory tax withholding on all eligible rollover distributions of $200 or more paid in a single year is 20%. The 20% is tax withholding, not actual tax due; therefore, when you file your annual Federal income tax return, you may be entitled to a refund of a portion of this amount, or you may be required to pay an additional amount.

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I Bonds Revisited

Are you earning close to 5% on your CDs today? I mentioned in previous columns the benefits of I Bond investing and just how easy they are to purchase and last month the current rate increased to 4.6%! Much better than what you can earn on CDs today.  You can purchase I Bonds online at www.treasurydirect.gov or you can purchase paper copies through your local bank by completing a PD F 5374 form (available at banks). With Treasury Direct you don’t receive a paper bond, all of your holdings are listed online in book entry and you purchase the bonds through direct deposit from your personal bank account. The Treasury will send bonds in the mail if you purchase paper copies through your local bank.

Why I Bonds! First and foremost the yield is indexed to inflation which we all know is here with more on the way. Just consider what we are paying for a pound of coffee, gasoline, and just about everything else today. As inflation increases I Bond Yields follow suit and are locked in for 6 months at a time and readjusted semiannually every May and November.

I Bond investment rates are based on a fixed and inflation rate. The original I Bonds, first issues in 1998, had a fixed rate of 3.4% whereas today the fixed rate is zero percent. You add the two rates together to determine the  current yield and the original first issue I Bonds are earning 8%, 3.4% (fixed rate) + 4.6% (inflation rate)! I started buying I Bonds when they first came out through payroll deduction.

Even with today’s zero fixed rate I continue to buy I Bonds because inflation is projected to be with us for some time. The I Bond inflation rate alone is better than what you can get anywhere else for a fixed income investment for the most part. There are a few things to consider before buying I Bonds:

  • The annual purchase limit per person is $5,000 in paper bonds and $5,000 through the online Treasury Direct program. You and your spouse can purchase a total of $20,000 a years if you purchase them separately. Typically a married couple adds each other as the “Pay on Death” beneficiary designation for each bond purchase or you can add your children or whomever you desire as beneficiary.
  • You can’t cash I Bonds in for the first year.  If you cash them in the first five years a penalty consisting of the current 3 months interest is assessed. They mature in 30 years.
  • You are allowed to defer claiming the interest income for tax purposes until you cash them in.
  • I Bonds are exempt from local and state taxes, another benefit which raises the effective yield.
  • Unlike E Bonds I Bonds are purchased at face value.

The Treasury is trying to encourage paper bond holders to convert them to the Treasury Direct book entry system and they have a tool you can use online to effect this change. I prefer having both online book entry and paper bonds available just in case the Treasury Direct web site goes down for an extended time. If you only have an online account, you can’t cash in any of your bonds if the site is malfunctioning or unavailable.

There are other options for purchasing Treasury Inflation Protected securities such as the Exchange Traded Fund (ETF) stock symbol TIP. These can be purchased through any stock broker for a small fee. There are no purchase limits and you can trade them daily just like stocks. Morningstar reports that, “IShares Barclays TIPS Bond is ideal for investors looking for easy and low-cost access to Treasury Inflation-Protected Securities. TIPS’ principal is linked to changes in the Consumer Price Index and provides an effective hedge against inflation in an investor’s portfolio relative to standard Treasury bonds.”  The current yield on TIP is 3.8%.

Updates

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The information provided may not cover all aspect of unique or special circumstances, federal regulations, and financial information is subject to change. To ensure the accuracy of this information, contact your benefits coordinator and ask them to review your official personnel file and circumstances concerning this issue. Retirees can contact the OPM retirement center. Our articles are not intended nor should they be considered investment advice. Our reply is time sensitive. Over time, various dynamic economic factors relied upon as a basis for this article may change.

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