Q: I'm a 68 year-old with zero tax deductions who is still working. I'm maxing out on my contributions to my Thrift Savings Plan retirement account, plus doing my over 55 catch-up contribution to reduce my taxable income. I'm considering withdrawing about $60,000 from my account to pay off my mortgage. I owe about $26,000 on the house at 6.75%. I'd convert the rest into my Roth IRA. I do have funds to pay the taxes on this withdrawal.
I have two questions. First, what's the most I could withdraw without going into a higher tax bracket? Second, I've heard that if you take a withdrawal while still working, when you do retire and turn 70 and a half, you must withdraw the whole account. That would mean a big tax bill. If this is true, is there a way around it? --RC, via email
A: You should take the first question to your tax accountant. Even a tax professional can't tell you how much you can withdraw without being bumped into a higher tax bracket without more information about your situation.
But you don't have to worry about the second question. You won't be hit with a big tax bill at 70 and a half.
Let's make things clear to other readers by explaining that the Thrift Savings Plan (TSP) is the defined contribution plan for federal government employees. In many respects, it resembles a 401(k) plan -- but not in all respects.
For example, 401(k) plans only permit pre-retirement withdrawals under very specific conditions of financial hardship. By contrast, the TSP allows its participants to do a one-time pre-retirement transfer of money to an IRA after turning 59 and a half.
This is called an 'in-service age-based withdrawal'. That's what will let you withdraw $60,000 from your account. (To comply with the rule, you'll probably have to transfer the entire $60,000 to the Roth IRA, and then use $26,000 to pay off the mortgage.)
The same TSP rule that permits this type of pre-retirement withdrawal says that if you use it, you must take the rest of your money when you retire.
But that doesn't mean you'll have to pay taxes on the entire amount. All you need to do to preserve its tax-deferred status when you retire is transfer it from the TSP into a traditional IRA.
By April 1 of the year after you turn 70 and a half, you must start taking minimum annual withdrawals from your tax-deferred retirement accounts. (This is true whether your money is in the TSP, a 401(k), or a traditional IRA). But only the amount you withdraw is taxable. The balance remains tax-deferred.
You're never required to take withdrawals from your Roth IRA; but any withdrawals you do take are tax-free after you're 59 and a half and have owned the account for five years. The five year clock starts on January 1 of the year you open your first Roth IRA, and that date applies to all your subsequent Roth IRA contributions to that account, as well as to Roth IRA accounts you open later. (As far as the Internal Revenue Service is concerned, you have only one Roth IRA, no matter how many accounts it's divided in.)
Your $60,000 withdrawal will be subject to income taxes since you're not going to transfer it into a traditional IRA. Even so, using this money to pay off the mortgage can make financial sense:
You say you have zero tax deductions. In other words, you aren't deducting the 6.75% interest you're paying on the mortgage. (Your mortgage is almost paid off, which means the interest portion of your payment is very small. The interest is probably less than your standard income tax deduction, says Barry C. Picker, a Brooklyn NY tax accountant.)
Since you aren't getting a deduction for that interest, using $26,000 to pay off the mortgage is like investing the money at a risk-free 6.75%. You can't beat that these days!
One suggestion: Convert the withdrawal into a new Roth IRA. Don't put this money in an existing Roth IRA. Here's why:
If you do a Roth IRA conversion in 2010, you have until October 15 2011 to change your mind and move some or all of the converted amount back into the tax-deferred retirement account it came from. (This is called 'recharacterizing' the conversion.) It's much, much simpler to do this if you haven't commingled the converted money with an existing Roth IRA.
After the recharacterization deadline has passed, you can always consolidate your Roth IRAs if you wish. Even if you don't, the five year clock that started with your first Roth IRA will apply to the new one too.
Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are only addressed online.
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