The Tax Traps, Timing Mistakes, and Withdrawal Risks That Derail TSP Retirement Plans

Key Takeaways

• Timing TSP withdrawals incorrectly can expose you to significant tax liabilities, mandatory penalties, and lost income potential.

• Understanding the rules around RMDs, Roth conversions, and early withdrawal penalties is essential to preserving the value of your retirement savings.

Tax Rules Are Not Optional—And They Can Be Expensive

Your Thrift Savings Plan (TSP) account is a powerful retirement asset, but it is also a tax-deferred account, which means the IRS is watching. If you don’t follow the rules precisely, you could unintentionally trigger large tax bills or penalties. And unlike investment risk, tax mistakes are avoidable with proper knowledge and planning.

Here are the main tax elements you need to keep track of:

• Traditional TSP contributions are made pre-tax, so withdrawals are fully taxable as ordinary income.

• Roth TSP contributions are made with after-tax dollars, and qualified withdrawals are tax-free.

• Required Minimum Distributions (RMDs) begin at age 73 in 2025 (formerly 72), and failure to take the full amount results in a 25% penalty.

• Early withdrawals before age 59½ from a traditional TSP are subject to a 10% IRS penalty unless an exception applies.

Taxes won’t be withheld correctly by default in many cases. If you don’t plan carefully, you may owe more than expected come tax season.

Timing Mistakes That Cost You Money

It’s not just about what you withdraw, but when you do it. Timing errors are among the most damaging and common pitfalls for TSP account holders nearing or in retirement. Even with a healthy TSP balance, a poor timing decision can cascade into penalties, higher taxes, and reduced income.

Withdrawing Too Early

Withdrawing before you reach age 59½ generally leads to a 10% early withdrawal penalty on top of regular income tax. There are exceptions if you:

• Separate from service in or after the year you turn 55

• Have certain qualifying expenses like medical bills

• Choose substantially equal periodic payments (SEPP)

But if you miscalculate or misclassify, the IRS won’t forgive the error.

Waiting Too Long to Withdraw

If you wait too long, RMDs will start automatically once you turn 73, whether or not you need the money. For retirees with large TSP balances, this can result in forced taxable income that pushes you into a higher tax bracket. In 2025, the IRS penalty for failing to take an RMD is 25% of the shortfall—a steep price to pay.

You must take your first RMD by April 1 of the year following the year you turn 73. After that, annual RMDs must be taken by December 31.

Making a Large One-Time Withdrawal

Taking a lump sum distribution in one year can create a spike in taxable income that:

• Triggers higher Medicare Part B premiums

• Pushes Social Security benefits into taxable territory

• Causes you to pay a higher marginal tax rate

Careful sequencing and spreading distributions over multiple years is often smarter than going for a single large withdrawal.

Withdrawal Options Are Flexible—But Not All Smart

The TSP allows considerable flexibility in how you take money out once you retire, including:

• Single withdrawals

• Partial withdrawals

• Installment payments (monthly, quarterly, or annually)

• Annuity purchases

But flexibility doesn’t automatically mean suitability. Some methods may not match your income needs or may generate unwanted taxes.

For example:

• Monthly payments that are too high can deplete your account prematurely.

• Quarterly payments might leave you cash-strapped in between.

• Annual payments may be too large at once, creating a tax hit.

Also, you can make changes to installment payments only once per year. That lack of agility can cause problems if your needs change mid-year.

Roth Conversions: Timing Is Everything

Converting some or all of your traditional TSP to a Roth IRA can offer significant long-term tax benefits. But the process must be handled correctly. The TSP does not allow in-plan Roth conversions, so you must roll funds to a traditional IRA and convert from there.

If done strategically:

• You can reduce future RMDs

• Create tax-free income in retirement

• Minimize your taxable estate

But if done poorly:

• You could trigger a tax bracket jump

• Lose eligibility for certain tax credits or deductions

• Increase Medicare premiums for two years (due to income-based thresholds)

Ideal windows for conversions include low-income years, especially between retirement and when RMDs begin at 73.

Don’t Forget About State Taxes

Many TSP holders focus exclusively on federal taxes, but state income tax also matters. Your retirement destination affects your after-tax income. Some states:

• Fully exempt TSP and other retirement income

• Partially tax retirement distributions

• Treat TSP like ordinary income with no deductions

If you move across state lines in retirement, your TSP distribution strategy might need adjusting.

The Risk of Outliving Your Money

Tax mistakes and timing errors don’t just affect how much you owe—they can shrink your nest egg over time. If your withdrawals are inefficient, or you start too early, you may find your TSP balance dropping faster than anticipated.

You may think:

• “I have enough in my account.”

• “I’ll adjust later if needed.”

But time and compounding don’t wait. Without proper withdrawal planning:

• Inflation erodes purchasing power

• Healthcare costs increase

• Markets may underperform for extended periods

TSP is designed to support you for decades. A misstep in your 60s or 70s could impact your 80s and 90s.

Required Minimum Distributions Can Throw Off Your Entire Plan

The IRS rules on RMDs apply to traditional TSP balances but not Roth IRAs. That distinction matters.

If you don’t need the RMD income but have to take it, your choices are limited:

• Pay the tax and invest the remainder in a taxable account

• Donate it if you’re charitably inclined (qualified charitable distribution)

• Convert more funds to Roth before RMDs begin

Many retirees wait until RMD age before realizing how disruptive these distributions can be. Modeling your RMDs starting at age 73 can help avoid surprises.

Social Security and TSP: A Taxable Combo

Social Security benefits may be taxable if your combined income exceeds IRS thresholds. TSP withdrawals count toward that combined income. If you draw from TSP and start Social Security at the same time, you might:

• Owe federal tax on up to 85% of your Social Security benefits

• Trigger Medicare IRMAA surcharges

• Climb into a higher tax bracket unintentionally

You can avoid some of this by:

• Delaying Social Security past full retirement age

• Drawing from TSP strategically to fill lower tax brackets

• Using Roth accounts to supplement income without raising your taxable income

Don’t Forget About Spousal Considerations

Your withdrawal strategy can affect your spouse’s future income and tax situation as well. If you pass away first, your spouse may inherit your TSP or IRA, but will likely file taxes as a single individual—potentially doubling their tax burden.

To plan for this:

• Consider joint life expectancy for withdrawal pacing

• Use Roth assets for survivor income if possible

• Make use of spousal beneficiary options and timing rules

The Role of Professional Guidance

The TSP is a powerful retirement tool, but without guidance, it can be more of a puzzle than a plan. Every withdrawal decision, conversion strategy, and timing choice has downstream effects on your taxes, income, and long-term financial stability.

Working with a licensed professional who understands public sector retirement can help you:

• Minimize tax exposure

• Maximize lifetime income

• Create a coordinated strategy for TSP, Social Security, and other retirement accounts

How to Protect Your Retirement From Tax and Timing Mistakes

If you’re nearing retirement, it’s time to move from accumulation to distribution strategy. That shift involves more than just deciding when to retire. You must coordinate:

• Withdrawal sequencing

• Tax planning year by year

• Account types and RMD rules

• Healthcare costs and Social Security timing

You only retire once, but the IRS plays every year. Avoiding costly mistakes requires detailed, proactive planning.

Get in touch with a licensed professional listed on this website to review your current strategy and prepare for the road ahead.