Understanding Tax Exempt Contributions and Withdrawals to the TSP

The Thrift Savings Plan allows for tax deferred and tax exempt contributions and withdrawals. What is the difference and how do you calculate it?
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TSP contribution investing

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 ½ 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,

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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  1. Luke says

    I am shocked, blown away and dismayed that the growth on a tax exempt contribution cannot be separated from the taxable part of the account. I made Traditional contributions and Tax-exempt contributions during combat deployments only. (Never a Roth option TSP). When I log into the system and go to the “contributions” page with the new system I see something like this (using fake numbers)
    Contribution Balances (as of ….)
    Your Contributions and Earnings
    Percent of Balance Vested Percent
    Traditional 400,000 80% 100%
    Tax-Exempt 80,000 20% 100%
    Vested Balance 480,000

    Nontaxable Balances (as of …)
    Contribution Type Amount
    Tax-Exempt Contribution 25,000

    To the Right of the top table, there is a pie chart that shows 80% of the account is Traditional and 20% is Tax-Exempt.

    To me that is pretty clear that they have separated the contribuion below from the growth. I have been assuming that in this example, if I roll out the entire account into my current employer’s 401K, that 80,000 would be tax-exempt, but as I worked my way through the online screens and it gets to the part where you have to decide on which accounts to send the money… it says that the tax exempt amount is 25,000 and the taxable amount is 455,000 (in line with what you wrote in this article).

    I called the TSP line to ask what’s up and the fine gentleman that I got on the phone could not even understand the question, let alone answer it. He allegedly forwarded my number to someone who can answer “tax questions” (I really didn’t think this was a hard one) but not suprisingly, no one has called me back.

    That is my long winded way of asking, if only the contribution remains tax-exempt, why show that the contribution and growth are tax-exempt? Is it saying that if I hold it in there until RMDs that 20% would be tax exempt but if I roll it out, only 5% (my original contribution). In what universe does that make sense? Why show a nice color table splitting the traditional from tax-exempt balances if it means nothing of the kind?

    I know that I sound a little bitter. I am more confused and frustrated that the TSP people are like deers caught in headlights. Any light you can shine on this would be greatly appreciated.

  2. Tad says

    The Traditional and Roth options are well understood. What I can’t understand is why you would contribute tax-free income from combat pay into an account where are the gains would be taxed as ordinary income rather than capital gains in a brokerage account. If I contribute $18,000 into my TSP pre-tax and $18,000 in from combat pay and it all grows at the same rate let’s say it doubles. When I take it out $18,000 principal comes out without taxes and the remaining $54,000 (original pre-tax savings and all earnings) is all taxed as income. If I had invested in a brokerage account rather than the TSP for everything after the first $18,000 pre-tax, the $18,000 in gains would be taxed at capital gains rate which is always lower than earned income rate. I need the $18,000 pre-tax now to reduce current taxable income so I can’t do Roth. And I would rather pay capital gains than regular income and I am disciplined enough to not raid my brokerage account. Why would I use the tax exempt pay making gains subject to higher tax rates? What am I missing here?

    • USMC Ret says

      Hoosier, you are not missing anything on the surface but DO contribute as much as you can and consider restructuring your TSP at a later date. It does NOT make sense to leave tax-exempt deployment contributions in the TSP for longer than you have to (because the earnings on the tax-exempt basis will be taxed on withdrawl), but it DOES make sense to contribute as much as possible while deployed because the combat contribution limit is significantly higher than the standard yearly limit.

      It is true you cannot specify what percentage of your tax-exempt or taxable earned income goes into TSP as DFAS sends an equal percentage of each. That said, if you are contributing to the (tax-deferred) Traditional TSP in order to lower your AGI and subsequently lower your tax liability, you cannot avoid at least some of your tax-exempt pay from going into the tax-deferred traditional TSP. However, if while deployed to a tax-exempt area with the higher contribution limits, you can max out your Roth TSP (and Roth IRA if you have one) contributions first and then have the overflow go into the traditional TSP, you will be able to minimize the amount of tax-exempt pay that goes into the tax-deferred TSP.

      Whew, ok, now the restructuring I mentioned. In order to separate your tax-exempt contributions from those those that are tax-deferred, you can make either a full withdrawl or a ONE-time partial withdrawl from your TSP after you become eligible (ie: separate from the service). Keep in mind that in order to avoid the 10 percent penalty, you will need to rollover your TSP funds into another qualified retirement account. Now, if you rollover 100 percent of your TSP into a traditional IRA your new IRA would then become a non-deductible IRA which would perform much as your TSP did with the tax-exempt contributions only it would have additional restrictions (you don’t want this). What you need to decide is if you want to keep your TSP open so that you can roll your tax-deferred contributions back in or if you are going to close your TSP and just maintain a traditional IRA or even convert some or all into a Roth IRA.

      If you wish to keep your TSP open so that you can extract your tax-exempt contributions and then roll the remainder of your tax-deferred contributions back in, you would make a partial-withdrawl to a “receiving account, leaving maybe 200 dollars in the TSP in order to keep it open, extract the dollar amount equal to your tax-exempt contributions and Roth TSP contributions (these amounts are on your TSP statements), and then roll the remainder (tax-deferred contributions) back into your TSP or into either a traditional or Roth IRA (Roth conversion subject to taxes on the converted amount). You now can invest your tax-exempt contributions into a Roth-IRA, or even use them to pay off debt.

      If you wish to convert your entire TSP to a Roth-IRA (which is what I did after I retired from the USMC) you would take a 100 percent TSP withdrawl into a receiving account, extract-your tax-exempt contributions, pay income tax on the tax-deferred contributions and earnings, and roll into a Roth IRA. Obviously you would want to do this in a year that your tax liability is at its lowest because the converted tax-deferred portion will add to your earned income for that year.

      All of this however, is soon to be a moot point, as TSP is working with the IRA to approve “in-house” conversions from the traditional tax-deferred TSP to the Roth TSP (you just pay the tax on the tax-deferred portion). You will then be able to enjoy tax-free earnings and tax-free distributions on ALL of your TSP monies (except for FERS employer matching contributions).

      And to end with a little disclaimer, always consult with a professional financial advisor and tax expert because timelines, tax laws, and restrictions apply and do change.

  3. Itsjestme says

    Having done a lot of checking on this topic — here are the rules as I understand them:
    There are FOUR versions of TSP rather than the two most folks know about.
    First — Traditional — Tax deferred contributions and taxed distributions
    Second — ROTH TSP — Taxed (normally) going in and tax-free distributions
    Third – Combat Pay tax-free going in Traditional, Principal tax exempt coming out, earnings taxed
    Fourth – Combat Pay tax -free going in the ROTH TSP, tax exempt coming out (limited to $18K)

    The differences are that combat troops can contribute significantly more (about $55,000 – this is especially great for reenlistment bonus contribution) into the TSP, but are limited to the IRS limit of $18,000 into the ROTH with the balance going into the Third version of TSP mentioned above.

  4. Jarhead says

    MajH and Ryan

    I believe that you are correct. I believe that it is similar to the way that the TSP disperses the funds that you have contributed. Like in above situation the 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 same time you are also reducing your taxable income by the amount that is tax deferred.

    That Jarhead

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