The Hidden Taxes and Penalties That Can Erode TSP Withdrawals Without You Realizing It

Missy E
November 14, 2025

Key Takeaways

TSP withdrawals in 2025 are subject to a range of taxes and penalties that could significantly reduce the amount you keep if you are not properly prepared.
Strategic planning, including attention to required minimum distributions (RMDs) and early withdrawal rules, can help you retain more of your retirement savings.

How Taxes and Penalties Impact TSP Withdrawals

When you think about withdrawing from your Thrift Savings Plan (TSP), it’s natural to focus on the balance you see on your statement. However, what you actually get to keep may be much less after federal income taxes, potential state taxes, and penalties take their share.

Understanding how these hidden costs work in 2025 is critical if you want to avoid unpleasant surprises and preserve your financial security in retirement.

Federal Income Taxes on TSP Withdrawals

TSP withdrawals are generally taxed as ordinary income at the federal level. In 2025, the same federal tax brackets apply to TSP distributions as they do to your salary or other earned income. This means that:

Withdrawals are added to your taxable income for the year.
A large withdrawal could push you into a higher tax bracket.
TSP accounts made with traditional (pre-tax) contributions are fully taxable upon withdrawal.

If you contributed to a Roth TSP, your qualified withdrawals are tax-free, but non-qualified withdrawals may still face taxes and penalties.

Early Withdrawal Penalties Before Age 59½

If you are under age 59½ when you make a withdrawal from your traditional TSP, you may be subject to an additional 10% early withdrawal penalty from the IRS. This penalty is in addition to your regular federal income tax.

Exceptions to the penalty exist, but you must meet very specific criteria such as:

Permanent disability
Substantially equal periodic payments (SEPP)
Separation from service in or after the year you turn 55

Without planning, an early withdrawal could cost you far more than you expect.

State Income Taxes Add Another Layer

In addition to federal taxes, many states also tax TSP withdrawals as ordinary income. The rules vary widely by state:

Some states fully tax TSP withdrawals.
Some offer partial exemptions for retirement income.
A few states do not tax retirement income at all.

Ignoring state taxes can lead to underpayment penalties and financial stress when filing your returns.

Required Minimum Distributions (RMDs) at Age 73

Under current law in 2025, you must begin taking RMDs from your traditional TSP starting the year you turn 73. If you do not take your RMD:

You face a 25% penalty on the amount you failed to withdraw.
If corrected timely, the penalty may be reduced to 10%.

RMDs are based on your account balance and life expectancy, and they are mandatory. Even if you do not need the income, you must withdraw it and pay taxes on it.

Hidden Costs of Large Lump Sum Withdrawals

Some retirees choose to withdraw a large lump sum from their TSP all at once. While this may seem like a good way to “lock in” your savings, it can result in:

Pushing your income into the highest federal tax brackets.
Increased Medicare premiums due to higher income (Income-Related Monthly Adjustment Amounts or IRMAA).
Reduction in eligibility for certain tax credits or deductions.

Carefully planning the timing and amount of your withdrawals can minimize these impacts.

The “Separation at 55” Exception

If you separate from government service in the year you turn 55 (or later), you can make withdrawals from your TSP without the 10% early withdrawal penalty. However, misunderstanding the rules can still lead to penalties if:

You roll your TSP into an IRA and then withdraw before 59½ (losing the 55 rule advantage).
You miscalculate your eligibility.

Proper timing of separation and withdrawals is essential.

Spousal Beneficiaries and TSP Taxes

If you pass away and leave your TSP to your spouse, they have several options. Each choice has tax implications:

Spousal beneficiaries can keep the TSP account in their name.
They can transfer it into their own IRA or TSP account.
They can take distributions, but taxes apply depending on their age and how they withdraw.

Failing to understand beneficiary rules can lead to unintended tax bills for your loved ones.

Roth TSP Withdrawals Are Not Always Tax-Free

Many participants assume that Roth TSP withdrawals are tax-free. This is true only if:

You are at least age 59½.
You have held the Roth TSP for at least five years.

If you do not meet both conditions, earnings withdrawn from a Roth TSP could be subject to income taxes and penalties.

Mandatory 20% Withholding on Direct Payments

When you request a lump-sum withdrawal paid directly to you from your traditional TSP, the plan is required by law to withhold 20% for federal taxes.

This withholding is not necessarily the exact amount of tax you owe.
You may owe more (or receive a refund) when you file your return.

This mandatory withholding can reduce your immediate liquidity and complicate tax planning if you were expecting a different net amount.

Taxes on Partial Withdrawals and Installments

Choosing installment payments instead of a lump sum can help spread the tax burden across multiple years, but:

Each installment is fully taxable as income in the year received.
If you increase the amount of installment payments, it can affect your tax bracket.

Careful attention to how you structure your withdrawals is key to minimizing overall tax exposure.

Missed Opportunities for Tax-Efficient Rollovers

If you are not careful, rolling over your TSP into another retirement account improperly can trigger unnecessary taxes.

Direct rollovers are non-taxable.
Indirect rollovers (where you receive the money first) must be redeposited within 60 days to avoid taxation and penalties.

Missing the 60-day window could turn a tax-free rollover into a fully taxable event.

Timing Withdrawals with Other Income Sources

Coordinating your TSP withdrawals with other retirement income—such as pensions, Social Security, or annuities—can help you stay in lower tax brackets.

Taking larger withdrawals in low-income years can save taxes.
Minimizing TSP withdrawals when you have higher income from other sources can reduce overall tax costs.

A strategic approach requires reviewing your expected income each year and adjusting your withdrawal strategy accordingly.

Medicare and TSP Withdrawals

Large TSP withdrawals in retirement can also affect your healthcare costs. In 2025, if your income exceeds certain thresholds, you will pay higher premiums for Medicare Part B and Part D.

These increased premiums are called IRMAA.
IRMAA assessments are based on your income from two years prior.

Understanding how TSP withdrawals in 2025 impact your Medicare premiums in 2027 can help you avoid unexpected healthcare expenses.

How to Prepare for a Tax-Efficient Withdrawal Strategy

To shield your TSP savings from unnecessary erosion due to taxes and penalties, you should:

Plan withdrawals to minimize tax brackets.
Time distributions carefully based on age and employment separation.
Coordinate TSP withdrawals with other sources of income.
Stay ahead of RMD requirements starting at age 73.
Seek professional help when considering complex transactions like rollovers or large lump sums.

The right strategy can preserve more of your hard-earned retirement savings for you and your beneficiaries.

Protecting Your Retirement Future From Hidden Costs

Taxes and penalties have the potential to chip away at your TSP savings faster than you might expect. Proactive planning, staying informed about the rules, and coordinating withdrawals with your total income picture are crucial for preserving your financial freedom in retirement.

If you are unsure about the best withdrawal strategy, consider speaking with a licensed professional listed on this website for personalized advice tailored to your situation.