Understanding Tax Exempt Contributions and Withdrawals to the TSP

The Thrift Savings Plan is one of the best investment vehicles for military members because it is low cost, easy to use, and easy to understand. It is also one of the best ways for military members to invest while deployed. Why? Because of a feature that allows military members to contribute tax-exempt military income to the Thrift Savings Plan on a tax exempt basis.

Why does that matter? Let’s take a look at how the TSP works, then we can better understand why tax exempt contributions can be so valuable to military members.

TSP – Tax Deferred Contributions vs. Tax Exempt Contributions

The Thrift Savings Plan works in a similar manner to a  Traditional IRA. That is, you make contributions which are tax deferred – meaning you get a tax deduction in the year you make the contribution, your income in your TSP account grows without the drag of taxes until you reach retirement age, then your withdrawals are taxed when you make them.

The TSP allows you to make contributions with tax-exempt income, which is earned in a tax free zone. Since your income is not taxed, the contributions you make will not be taxed when you withdraw that income in retirement years. This gives you some of the same features of a Roth IRA. However, there is one major difference – only the contributions are tax free upon withdrawal, not the earnings. The funds are co-mingled within your account and there is no way to determine where the income growth came from. Still, this is a great opportunity for military members to get an additional tax break that will help them now, and in retirement.

Understanding Tax Exempt Contributions and Withdrawals to the TSP

Tax exempt and tax deferred contributions can be a little tricky to understand if you have irregular income while you are deployed. Here is a recent e-mail we received from a Soldier deployed to Afghanistan. Let’s take a look at his situation, and see how if we can get a better understanding of how the process works.





Hey, Ryan. If you can answer this one you’ll be the only person who can- and I’ve tried just about everyone. I have been deployed to Afghanistan since the beginning of October. I aggressively paid into my TSP over the last 4 months by allotting 50% of my base pay and incentive pay to the fund. Although roughly 70% of what I make every month is tax exempt, my TSP states that only a little over 1/2 of what I put in is tax exempt, the remainder being tax deferred. This makes no sense to me at all and no one can explain this seemingly arbitrary allocation. If 7 of every ten dollars that I make per month are tax-free, and I put 5 of those into TSP, why isn’t everything in my TSP tax-free? I contacted TSP and they said to talk to my Finance Office. Unfortunately, they didn’t have a firm answer either.

Respectfully Yours,
MAJ Eric H., USAR
Afghanistan

Thanks for contacting us, MAJ H., and thanks for your service! I’m not 100% certain regarding your situation, but I’ll add my two cents, and we’ll see if anyone else out there has a better answer than I can provide.

The times I deployed, I believe 100% of my pay was considered tax exempt, so 100% of my contributions at the time were classified as tax exempt. This is important because it makes the calculations easy – 100% tax exempt income = 100% tax exempt contributions. However, since your income is mixed, it may change how your contributions are classified.

My best guess (not a firm answer – only speculation) is that since 100% of your pay is not tax exempt, then the TSP is using a combination of all income earned to determine the split of tax exempt contributions and tax deferred contributions. In other words, you can’t choose which income you use to make the contributions, you have to make the contributions as a proportion of your earnings.

Making contributions from your bonus pay might change the numbers enough that it appears there isn’t a correlation between your earnings, contributions, and the tax exempt amount. For example, if your base pay is 70% tax exempt and your bonus is 100% tax exempt, but your contribute 50% of each, then the ratio of tax exempt contributions wouldn’t equal 50%, or 60%, or 70%. It would be somewhere in between those numbers, especially if the bonus pay is substantially lower than your base pay. Play around with the numbers on your LES and see if the tax exempt earnings and contributions add up using this theory.

Tax exempt Thrift Savings Plan withdrawals

The process works in a similar manner when you make withdrawals.




The TSP website states, “If your beneficiary participant account includes a tax-exempt balance, the TSP will make all withdrawals from your account on a pro rata basis from both the taxable and the tax-exempt balances.” (source)

You cannot choose how and when to withdraw the tax exempt income, it is paid out in proportion to your total holdings. For example, if you have $100,000 in your TSP and $10,000 of that is tax exempt, you would receive 90% of your withdrawal as taxable income, and the other 10% as tax exempt. Keep in mind this is a rough example, and will change based on unique situations.

Does anyone have anything to add to this?

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Date published: February 4, 2011.

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Ryan Guina is the founder and editor of this site. He is a writer, small business owner, and entrepreneur. He served over 6 years in the USAF and also writes about money management, small business, and career topics at Cash Money Life. You can also see his profile on Google

Comments

  1. Jarhead says:

    MajH and Ryan

    I believe that you are correct. I believe that it is similar to the way that the TSP dispurses the funds that you have contributed. Like in above situation tha payout is 90% taxable and 10% nontaxable (you don’t get to choose.)

    SInce some of your pay is taxable and some is not they make the contributions in the same ratios. So if 55% is non-taxable and 45% is taxable then only 55% of your contributions will be tax exempt and the others will be tax deferred. You are actually getting the best of both worlds as you are getting some tax exempt but at the saem time you are also reducing your taxable income by the amount that is tax deferred.

    That Jarhead

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