Is TSP Withdrawal Considered Earned Income for Tax Purposes?
Understand how TSP withdrawals are taxed and whether they count as earned income, plus key implications for reporting, withholding, and potential penalties.
The Thrift Savings Plan (TSP) is a key retirement savings option for federal employees and military personnel. Understanding how TSP withdrawals are taxed is essential to avoid surprises during tax season.
One common question is whether TSP withdrawals count as earned income for tax purposes. This distinction matters because earned income affects eligibility for certain tax credits and Social Security benefits.
Tax Classification of TSP Withdrawals
The taxation of TSP distributions depends on whether the funds come from a traditional or Roth account. Each type of withdrawal has different tax implications.
Traditional TSP Distributions
Withdrawals from a traditional TSP are taxed as ordinary income. Since contributions are made with pre-tax dollars, taxes are deferred until funds are withdrawn. When distributions occur, they are taxed at the account holder’s federal income tax rate for that year, which can range from 10% to 37%, depending on taxable income.
Some states also tax TSP distributions, while others offer exemptions for retirement income. Pennsylvania and Illinois, for example, do not tax retirement withdrawals, while California and New York treat them as taxable income. Checking state tax laws is essential to determine any additional liability.
Roth TSP Distributions
A Roth TSP is funded with after-tax dollars, meaning taxes have already been paid on contributions. Qualified withdrawals are tax-free if the account holder is at least 59½ and at least five years have passed since the first Roth contribution. If both conditions are met, neither the contributions nor the earnings are subject to federal income tax.
If a withdrawal is taken before meeting these requirements, only the earnings portion is taxable. Contributions can be withdrawn tax-free at any time. While Roth TSP distributions generally avoid federal taxes, state tax treatment varies. Some states follow federal rules and exempt qualified withdrawals, while others may tax a portion of the earnings.
Early Withdrawals
Taking money from a TSP account before age 59½ can result in additional costs. The IRS typically imposes a 10% early withdrawal penalty on the taxable portion of the distribution. However, exceptions exist, such as separating from federal service at age 55 or later or qualifying under IRS hardship rules, including total and permanent disability.
Hardship withdrawals, allowed in financial emergencies, are still subject to income tax and may incur the early withdrawal penalty. Additionally, TSP loans that are not repaid on time are treated as taxable distributions and may also be subject to the 10% penalty if the account holder is under 59½.
Relation to Earned Income Status
TSP withdrawals are not classified as earned income. Earned income includes wages, salaries, tips, and self-employment earnings, which are subject to payroll taxes like Social Security and Medicare. Since TSP distributions come from retirement savings rather than active employment, they do not count as earned income.
This distinction affects eligibility for tax credits and retirement contributions. The Earned Income Tax Credit (EITC) is only available to individuals with wages or self-employment income. Because TSP withdrawals do not count as earned income, they cannot be used to qualify for or increase this credit. Similarly, contributions to traditional or Roth IRAs require earned income, meaning retirees relying solely on TSP withdrawals may not be eligible to contribute.
Social Security benefits are also impacted. Earned income can reduce Social Security payments for individuals who claim benefits before full retirement age, but TSP withdrawals do not count toward this limit. However, TSP distributions can still affect the taxation of Social Security benefits. If total income, including TSP withdrawals, exceeds certain thresholds, up to 85% of Social Security benefits may become taxable.
Reporting Distributions on Taxes
TSP withdrawals must be reported as income on a tax return. The IRS issues Form 1099-R to document retirement account withdrawals, which TSP participants receive by the end of January following the year of distribution. This form details the total amount withdrawn, the taxable portion, and any federal income tax withheld.
The taxable portion of a TSP withdrawal is reported on Form 1040 in the section for pensions and annuities. The full amount of a traditional TSP distribution is included in taxable income, while Roth TSP withdrawals may be partially or fully tax-free, depending on IRS qualification rules. Reviewing Form 1099-R carefully ensures that only the taxable portion is included in adjusted gross income (AGI), which affects tax bracket placement and eligibility for deductions or credits.
For those rolling over TSP funds into another retirement plan, such as an IRA, the reporting process differs. A direct rollover, where funds are transferred without the account holder taking possession, is not considered taxable, though it will still appear on a 1099-R with a distribution code indicating a non-taxable rollover. If the funds are withdrawn and then deposited into another retirement account within 60 days, the IRS treats this as an indirect rollover. Because mandatory withholding applies to indirect rollovers, individuals must use personal funds to replace the withheld amount to avoid taxation on the shortfall.
Potential Withholding or Penalties
TSP withdrawals are subject to mandatory federal tax withholding, which varies by distribution type. Lump-sum withdrawals require automatic withholding of 20% on the taxable portion, even if the funds are intended for a rollover. If the actual tax liability is lower than the withheld amount, the taxpayer may receive a refund. If it is higher, additional taxes may be due.
For installment payments, the withholding rate depends on the payment schedule. If payments are expected to last less than ten years, the 20% mandatory withholding applies. If they extend beyond ten years or are based on life expectancy, withholding is treated like regular wage income and can be adjusted based on the taxpayer’s Form W-4P election. Those who do not specify a withholding preference may have taxes withheld at the default rate for a married individual with three exemptions, which may not align with their actual tax liability.
Understanding these tax rules can help individuals plan withdrawals strategically, minimizing tax burdens and avoiding unexpected liabilities.