Answers to Tricky Tax Questions for the Thrift Savings Plan and IRAs

For the vast majority of federal employees, the issue of how to save and invest for retirement and spend in retirement is one of the biggest financial challenges. Congress has not made this challenge any easier to deal with. Through the years, when Congress can agree at all they pass poorly drafted law upon law, leaving the IRS and retirement savers to confront a maze of confusing tax provisions.

This column presents the answers to some of the most often asked questions pertaining to the Thrift Savings Plan (TSP) and Individual Retirement Arrangements (IRAs).

READ: End-of-Year 2023 and Pre-2024 TSP Moves Federal Employees Should Consider

1. Will Children or Grandchildren Have to Take Required Minimum Distributions (RMDs) When They Inherit a Parent’s or a Grandparent’s TSP Account or an IRA?

In general, non-spousal beneficiaries of a TSP account (this includes both the traditional TSP and the Roth TSP) must withdraw their inherited portion of the TSP within five years of the death of the TSP participant.

Beneficiaries of a traditional TSP account pay full federal income tax and in most states full state income tax on the amounts. Beneficiaries of Roth TSP accounts do not pay any federal income and state income taxes upon withdrawing their inherited Roth TSP accounts.

Those TSP participants who elect to directly rollover or transfer their entire TSP accounts to IRAs (traditional TSP to a traditional IRA; Roth TSP to a Roth IRA), allow more flexibility to beneficiaries of their IRA accounts compared to had they not directly rolled over or transferred their TSP accounts.

For that reason, it is assumed that a retired TSP participant at some point of his or her retirement has directly rolled over their entire TSP account to an IRA – traditional TSP rolled over to a traditional IRA (a “rollover” traditional IRA), or a Roth TSP rolled over to a Roth IRA (a “rollover” Roth IRA).

The following are rules applicable to non-spousal beneficiaries of “rollover” Roth IRAs:

• If the “rollover Roth IRA” owner died before January 1, 2020, then the beneficiaries must take annual payouts. But these annual payouts (based on a beneficiary’s life expectancy) are often small, can last for decades, and are income tax-free. That is why mandatory inherited Roth IRA payouts are sometimes called a tax-free “stretch” Roth IRA.

• If the “rollover Roth IRA” owner died after December 31, 2019, then the beneficiaries have 10 years to withdraw the entire inherited Roth IRA account with no annual RMDs. That means that account assets can grow tax-free during the 10-year period.

Beneficiaries of “rollover traditional IRAs” face more complex problems:

• If the “rollover traditional IRA” owner died before January 1, 2020, then the beneficiaries must take annual payments called required minimum distributions usually based on the beneficiary’s life expectancy. The payments are fully taxable. For 2023, there is no waiver of RMDs.

• If the “rollover traditional IRA” owner died after December 31,2019 and was already required to take IRA RMDs (the owner was born before July 1, 1949), then beneficiaries typically have 10 years to withdraw their inherited IRA account.

They will also have to take annual payouts during that period for years one through nine. Often this results in smaller withdrawals before a large final payout at the end of year 10. There is no prohibition on withdrawing more than required during years one through nine, only less.

A law change has resulted in confusion over RMDs for these beneficiaries. The Internal Revenue Service has therefore waived these payouts for the years 2021, 2022 and 2023.

If the “rollover traditional IRA” owner was not required to take IRA RMDs, then the “rollover traditional IRA” beneficiaries do not have to take annual payouts during years one through nine. However, they may want to make some withdrawals during years one through nine in order to avoid a large tax bill in year 10, a result of taking a large final withdrawal.

More generous rules apply for some groups of heirs such as minor children (but not grandchildren) of traditional IRAs whose owners died after December 31, 2019. For more information see IRS Publication 590-B (Distributions from Individual Retirement Arrangements).

2. Can “Rollover Traditional IRA” or “Rollover Roth IRA” Owners Still Contribute to a Traditional IRA or to a Roth IRA?

The answer is yes provided the “rollover IRA” owner has earned income from salary/wages or net self-employment income that is at least equal to their IRA contribution.

If the traditional IRA owner has reached his or her required beginning date (RBD which is age 73 starting January 1, 2024) the traditional IRA owner must continue to take an annual IRA RMD.

To contribute to a Roth IRA, the Roth IRA owner’s adjusted gross income (AGI) must be below certain limits. For more information see IRS Publication 590-A (Contributions to Individual Retirement Arrangements) This AGI limitation is in addition to the earned income requirement.

3. What is the “Widow/Widower” Tax Penalty and Which Married Couples Are Affected by It?

The “widow/widower tax penalty” occurs when one spouse dies, and the surviving spouse usually must switch from married filing joint tax status to single filer tax status starting in the year after the spouse dies. As a result of this change, higher marginal tax rates take effect at lower taxable income levels.

However, if both spouses own traditional IRAs and both have reached their required beginning date and have to take their IRA RMDs, the RMDs will not decrease when the first spouse dies.

In fact, if the surviving spouse is named as the sole beneficiary of the deceased spouse’s IRA, the RMDs of the surviving spouse will increase, especially as RMDs increase with age. Some tax advisors say it is not unusual for the surviving spouse’s top federal marginal tax rate to jump from 12 percent to 22 percent or from 24 percent to 35 percent.

A solution to the “widow/widower tax penalty” is for one spouse to leave all or part of a traditional IRA to other beneficiaries and not to the other spouse. This could reduce the surviving spouse’s marginal tax rate. Needless to say, leaving a traditional IRA to other beneficiaries assumes the surviving spouse will have enough income to live off of without the deceased spouse’s traditional IRA.

4. How Does a Large Balance in One’s Traditional TSP and Traditional IRA Result in Larger RMDs and Affect One’s Federal Tax Bracket and Medicare Part B Monthly Premiums? What Can Be Done to Manage This?

The larger one’s traditional TSP and traditional IRA balance, the larger one’s RMD from both accounts, resulting in a higher tax bracket and larger Medicare Part B monthly premiums.

To manage this, assistance from a tax professional is recommended. One suggestion is to perform Roth IRA conversions in order to reduce the balance in one’s traditional TSP and traditional IRA accounts.

Ideally, this process of Roth IRA conversions will start when an individual is in his or her early 60’s before one enrolls in Medicare at age 65 (if retired). But the Roth IRA conversions should be at least 5 to 10 years before one’s required beginning date (RBD) which is age 73 starting January 1, 2024.

Doing Roth IRA conversions while taking RMDs is allowed. However, the annual RMD cannot be converted. That means the conversion amount will be added to the RMD, possibly pushing the individual into a higher federal marginal tax bracket.

Another suggestion is for individuals who are age 70.5 and older to make Qualified Charitable Distributions (QCDs). QCDs provide a tax break and remove pre-tax traditional IRA funds without creating taxable income that can raise Medicare Income Related Monthly Adjustment Amounts (IRMAA), or other taxes.

5. Can a FERS-Covered Employee’s Agency Automatic One Percent Contribution and Agency Matching Contributions Be Contributed into the Roth TSP?

One of the provisions passed into law as part of SECURE Act 2.0 allows employers who offer a qualified retirement plan (such as a 401k retirement plan), to contribute to an employee’s Roth account. As of 2023, some private employer contributions are put into an employee’s Roth 401(k) account.

However, the TSP has decided not to allow FERS-covered employee’s agency matching contributions, and automatic 1 percent of gross contributions, to be put into the employee’s Roth TSP account.

No matter which TSP account a FERS-covered employee contributes to – the traditional TSP, the Roth TSP or a combination of both – the employee agency TSP contribution will always be put into the employee’s traditional TSP account.