The nest egg that we diligently build up over the course of our careers becomes one of three things when we retire from the work force: income, legacy for loved ones, or tax payments to Uncle Sam. Ideally, we either enjoy spending that money ourselves or enjoy knowing that our loved ones, rather than the IRS, will benefit from the majority of anything left over.
This is why having a plan to efficiently guide your hard-earned money to your beneficiaries without losing the lion’s share to the IRS is so important – especially as we hear more and more talk about taxing inter-generational wealth and implementing higher future tax rates.
“What happens to my TSP if I don’t utilize it during retirement?”
For married TSP participants who pass with their spouse as the primary beneficiary, the account is retitled in your spouse’s name as a Beneficiary Participant TSP Account (so long as it has a minimum remaining balance of $200). The TSP also automatically reallocates the account into the Lifecycle Fund that is most appropriate for your spouse’s age. Spousal beneficiaries generally have the same investment funds and similar distribution options as the original TSP owner.
A Beneficiary Participant TSP Account allows the spousal beneficiary to continue deferring taxes on the majority of the account – which is informally known as “stretching” the tax liability – over the rest of his or her life expectancy by basing the Beneficiary Participant account’s Required Minimum Distributions (RMD’s) on their own life rather than the life expectancy of the (deceased) original owner.
The ability to “stretch” the tax deferral over a longer period of time means that the money that would have initially been lost to taxes has the opportunity to continue compounding in your beneficiary’s account for years! It also means Uncle Sam does not generate as much tax revenue in the short term.
That delay has become a problem as we near $29 Trillion in national debt and head towards another collision with the Debt Ceiling this fall. Uncle Sam no longer wants to wait for decades on end to collect the tax revenue owed on an Inherited IRA. As such, it should be no surprise that the SECURE Act of 2019 eliminated the opportunity for nearly all non-spousal beneficiaries to stretch an Inherited IRA for more than 10 years (with a handful of exceptions).
The TSP does not offer the option to stretch the tax deferral using a Beneficiary Participant TSP Account to non-spousal beneficiaries. Any TSP Death Benefit that is left to a non-spousal beneficiary is distributed as a single lump sum payment and can have massive tax implications if swift action is not taken.
“Who is the biggest beneficiary of my TSP account after I pass?”
Let’s assume you have a $1,000,000 tax-deferred TSP account at the time of your passing that you want to leave to your two children. Let’s also assume that you love the kids equally and want the proceeds from your TSP balance to be paid 50% to each child.
If no further planning is done, then each of your children would receive $500,000 of taxable income. These distributions would skyrocket each into the 35% marginal tax bracket for that year (assuming tax rates have not increased from 2021). If the kids have their own careers, then their household income gets added to the taxable TSP distribution and could increase their marginal tax bracket even further! Let’s also assume they live in a state that charges income tax of 5%. This means our combined tax rate would be as much as 40% (35% federal, 5% state) which generates a whopping tax bill of $400,000!
That only leaves $600,000 to be split between the kids, providing each with only $300,000 after the hefty tax bill is siphoned off the top. In this unfortunate example, the unintended beneficiary – Uncle Sam – has benefited the most from your decades of hard work.
How can I minimize the tax bill on my Legacy?
If the inherited funds in question were proceeds from a normal TSP and the kids are properly listed as beneficiaries then they typically have a 60-day window to open an Inherited IRA and transfer the inherited funds directly into the new account before the TSP mails out a Death Benefit. Opening an Inherited IRA allows a qualifying beneficiary to stretch the tax liability over as many as 10 years under the new SECURE Act rules. This may very well help keep them out of the higher marginal tax brackets – which in turn lowers the total amount of your legacy that gets lost to taxation.
Important note: TSP proceeds must be directly transferred from TSP to the Inherited IRA. Death Benefit proceeds sent to the non-spousal beneficiary will automatically have 20% withheld for taxes, the death benefit cannot be indirectly rolled into an Inherited IRA, and the TSP does not allow the funds to be returned for a do-over.
If the inherited funds came from a Beneficiary Participant TSP Account, then the TSP rules specify that upon the surviving spouse’s death, the entire account balance of a Beneficiary Participant TSP must be paid directly to the beneficiary(ies) and cannot be rolled over into an Inherited IRA. This creates the same tax problem we explored in the previous example and leads many surviving spouses to explore transferring their Beneficiary Participant TSP Account into an Inherited IRA. Having your surviving spouse transfer the funds to an Inherited IRA may make sense as it can qualify the next generation of beneficiaries to stretch the tax deferral of their inheritance over 10 years using an Inherited IRA.
Also consider the benefits of contributing to Roth accounts and utilizing Roth conversions to help mitigate tax rate risk during your own retirement as well as to keep higher future tax rates from potentially decimating the legacy your loved ones inherit. If the legacy your kids were to inherit came from a qualifying Roth TSP or Roth IRA then they would receive a tax-free distribution of every single penny left in the account which means properly established and vested Roth accounts will not generate a tax bill upon your death even if tax rates trend higher in the coming years!
The SECURE Act beneficiary eligibility rules and distribution timelines are very complicated and mistakes can have costly penalties so professional guidance is highly recommended. Join our upcoming educational webcast entitled “The Thrift SPENDING Plan” to learn more about optimizing the tax diversity of your portfolio for retirement and beyond!
This material is educational in nature and not intended to be specific legal, financial, or tax advice. Walker Capital is not affiliated or endorsed by the US Government or any Government Agency.