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Think Twice Before Cashing Out of Your Thrift Savings Plan

May 26, 2006

If you are thinking about cashing out your Thrift Savings Plan (TSP) when you leave the uniformed service, think twice. Or maybe three times. You might be about to forsake a financially secure retirement. FINRA is using this Alert to educate servicemembers to the potentially devastating impact cashing even a modest amount of TSP assets can have on retirement savings.

When you switch jobs before retirement, you usually can choose among several things to do with your TSP nest egg:

It may be tempting to choose the last option and use the money to buy a new television, take a cruise or even to pay off a debt. And you would not be alone in thinking that way: A recent study indicates that 45% of employees cash out their employer's retirement plans when they change jobs.*

But cashing out before you are 59 ½ can cost you dearly, both immediately and in the long run:

  • If you do not transfer your money to a traditional IRA or your new employer's plan within 60 days of receiving it, your current employer is required to withhold 20% of your account balance to prepay federal taxes.
  • If you keep the money, you must pay federal income tax on your entire withdrawal (except for tax-exempt contributions from combat zone pay). In addition, you may also owe state tax on your distribution.
  • Plus, the IRS will consider your payout an early distribution, meaning you could owe a 10% early withdrawal penalty on top of combined federal, state, and local taxes.

When all is said and done, you could end up with a little more than half of your original TSP savings! In addition, you will owe tax annually on any future earnings your lump sum generates.

The High Cost of Cashing Out

The repercussions of cashing out of your TSP could be enormous. For example, let's assume you are 30 years old, and have a TSP balance of $20,000. If you leave that money in your TSP account or put it in a traditional IRA, and your account averages a 6% rate of return over the next 32 years, your balance at retirement will be $129,068, even if you do not make any additional contributions during that time. Even if you have a shorter time horizon, you will forgo significant savings opportunities by cashing out your TSP. For example, if you are 45, your $20,000 will grow to $53,855 in 17 years. Keep in mind that even if you really need the money, you may be better off borrowing from your TSP account. You may be able to borrow at a lower rate from your account than you could from a bank or other lender, especially if you have a low credit score. You must be in pay status to obtain a loan, because your regular monthly loan payments are made through payroll deductions. To learn more about TSP loans, click on the TSP Features/Uniformed Services button of the Thrift Savings Plan website.

When you leave military service, carefully examine the short and long-term consequences before cashing out of your TSP account. After all, when talking about tax-deferred savings plans, time is money.

Resources

For additional information on the Thrift Savings Plan, read TSP Features for Uniformed Services.

For additional information on saving for retirement, read FINRA's Smart 401(k) Investing.

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*Hewitt Associates study of large-company 401(k) plans