Understanding Tax Exempt Contributions and Withdrawals to the TSP

The Thrift Savings Plan (TSP) is one of the best investment vehicles for military members because it is low-cost, user-friendly, and straightforward. It’s also one of the best ways for military members to invest while deployed. Why? Because you can contribute tax-exempt combat zone pay to your TSP on a tax-exempt basis.

Here’s how it works: Say you’re deployed, and your entire $6,000 monthly paycheck is tax-exempt combat pay. You contribute 50% ($3,000) to your TSP. Since 100% of your pay is tax-exempt, 100% of your contribution stays tax-exempt forever. When you withdraw that money in retirement, you won’t pay any taxes on those contributions.

Let’s take a closer look at how tax-exempt contributions work and how they’re treated when you make withdrawals.

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 that 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, at which point 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. So if you want to keep track of those amounts you contributed tax-free, your LES and TSP statements keep a running tally. 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 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

Thank you for contacting us, MAJ H., and thank you 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.

During the times I deployed, I believe 100% of my pay was considered tax-exempt, so 100% of my contributions at the time were also classified as tax-exempt. This is important because it simplifies the calculations – 100% tax-exempt income equals 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 may alter the numbers enough that it appears there is no 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 you 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 to 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.

Conclusion

Tax-exempt TSP contributions from combat zone pay give you a unique tax advantage that few civilian retirement savers can access. While the mechanics can be confusing (especially when your pay mixes taxable and tax-exempt income), the benefit is straightforward: the money you contribute from tax-exempt pay stays tax-exempt when you withdraw it in retirement.

Just remember that your contributions get split proportionally based on your total income mix, and your withdrawals work the same way. If you’re planning to roll over your TSP to an IRA, you have options to separate tax-exempt from tax-deferred balances. Understanding how these rules work now can help you make smarter decisions about your TSP contributions during deployment and your withdrawal strategy in retirement.

Meet the Author

Ryan Guina

Ryan Guina is The Military Wallet's founder. He is a writer, small business owner, and entrepreneur. He served over six years on active duty in the USAF and is a current member of the Tennessee Air...

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