For older Americans, required minimum distributions (RMDs) from qualified retirement accounts are undergoing some major changes. Many of these older Americans include federal employees and annuitants who own Thrift Savings Plan (TSP) accounts. A large number of TSP participants have sizeable TSP accounts. There are tens of thousands of TSP participants whose TSP accounts are valued over 1 million dollars.
This column discusses how recent changes in the RMD rules may affect the future value of federal annuitants’ TSP accounts.
The first major change to the RMD rules came as a result of the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act in December 2019. One of the provisions coming out of the SECURE Act passage is the age rising to 72 from 70.5 for when RMDs must begin, effective Jan. 1, 2020.
In particular, for individuals becoming age 70.5 any time after December 31, 2019, the “required beginning date” (RBD) (the latest date in which the first RMD must be taken) is April 1st following the year the individual becomes age 72. This means that any individual born after June 30, 1949 has an RBD of April 1st following the year they become age 72. Subsequent RMDs must be taken every year by December 31 of that year.
The RMD rules apply to traditional IRAs, to qualified retirement plans such as the 401(k) and 403(b) retirement plans (both the traditional and the Roth version), and to the Thrift Savings Plan (TSP), both the traditional and the Roth version of the TSP. The only type of retirement account that is not subject to the RMD rules are Roth IRAs. Roth IRAs do not come with required withdrawals until after the Roth IRA owner’s death.
Under the SECURE Act, a retired federal employee with a TSP account who reached age 70.5 before Jan. 1, 2020 (and was therefore born before July 1, 1949) must continue to annually take their TSP RMDs. Although these individuals were not required to take their TSP RMDs for the year 2020 because of the CARES Act, TSP RMDs are resuming in 2021.
The TSP has sent out a notice to any retired or departed federal employee born before July 1, 1949 with a TSP account what their 2021 RMD is. If these individuals have other retirement accounts such as traditional IRAs and 401(k) retirement plan accounts they own, RMDs must also be taken from each of these accounts as well before Dec. 31, 2021, and every year thereafter. Note that individuals who do not take their RMDs in any year by December 31st are subject to a 50 percent IRS accumulation penalty.
For retired federal employees born after June 30, 1949 and who own a TSP account (and perhaps other retirement accounts such as traditional IRAs), the age change of the RBD to age 72 from age 70.5 is a small change but obviously helpful. Perhaps the most helpful part to this change is the fact that it allows for another one to two years of tax-deferred growth. Another helpful thing is that it allows a TSP participant and traditional IRA owner additional time to do something with their tax-deferred retirements accounts in order to minimize the tax consequences of future RMDs when they start in one to two years.
For example, converting their traditional IRAs to Roth IRAs and paying the income tax due on the conversions at a lower federal tax rate now compared to had they not converted and having to include the traditional IRAs in their RMDs. Given the current reduced individual federal ordinary tax rates, it is quite possible federal ordinary tax rates will increase within the next 10 years. Traditional TSP and IRA withdrawals will likely then be taxed at a higher tax rate compared to the current federal ordinary tax rates. Traditional TSP participants can also transfer their traditional TSP accounts to rollover Roth IRAs, paying the federal and state income tax now when income tax rates are probably lower than they will be in the future.
Retired federal employees with Roth TSP accounts should also consider transferring their Roth TSP accounts to “rollover” Roth IRAs before they reach their RBD. The reason is that as mentioned above, both the traditional TSP and the Roth TSP is subject to the RMD rules. But only one RMD has to be taken each year based on the combined balance of each account. In other words, only one RMD has to be taken – not one from each type of TSP account.
If the TSP account owner directly transfers their Roth TSP account to a rollover Roth IRA (this can be performed with no tax consequences), then two things will be accomplished, namely;
(1) Removing the Roth TSP account in the calculation of the TSP RMD once the TSP account owner reaches his or her RBD; and
(2) by transferring the Roth TSP to a rollover Roth IRA, the Roth TSP account will not be indirectly subject to the RMD rules because the entire account is within the Roth IRA and therefore subject to the Roth IRA (non-RMD) retirement rules.
The second major change to the RMD rules will take effect in 2022 when updated life expectancy tables, (originally proposed by the IRS in 2019) take effect. The updated life expectancy tables will affect the calculation of a qualified retirement plan owner’s, a retired TSP participant’s and a traditional IRA owner’s RMD each year.
To understand how the updated life expectancy tables will affect the RMS calculation, it is important to review how the RMD calculation is performed each year.
The RMD of a particular retirement account is calculated each year by dividing the balance of that retirement account as of December 31st of the previous year by a life expectancy (distribution period) factor, as defined by the IRS. The IRS life expectancy factors currently used (the “Uniform Lifetime Table”, found in IRS Publication 590-B) have not changed since 2002. When the updated tables take effect in 2022, it will therefore mark the first change in the life expectancy table in 20 years and, as can be seen when comparing Tables 1 and 2, reflect increasing life expectancy.
Table 1. Current Life Expectancy Tables Used to Calculate RMD
Table 2. New Life Expectancy Tables Used to Calculate RMD Taking Effect in 2022
The charts below show how RMD amounts, and account balances, would differ over time using the current (2002) IRS life expectancy table and the soon-to-be (2022) IRS life expectancy table. Assume the following: Suppose there is a retired federal annuitant with a TSP account. The annuitant become age 72 during 2021 and therefore must take his or her first TSP RMD during 2022. The annuitant withdraws only his or her RMD and no more every year until he or she becomes age 95. Each year whatever remains in the TSP account grows at an investment annualized rate of 6 percent.
Chart I. TSP RMDs Under Current IRS Life Expectancy Table
Note that under the current IRS life expectancy tables, a person who is age 72 and who: (1) Has a starting TSP account balance of $500,000; (2) begins the RMD and withdraws only the RMD each year until age 95; and (3) whatever remains in the TSP grows at annualized investment rate of 6 percent, will have remaining in his or her TSP account nearly 75 percent ($375,000) of the starting balance of $500,000 at the start of the year he or she becomes age 96.
Chart II is the same as Chart I except that it uses the updated IRS life expectancy factors taking effect in 2022.
Chart II. TSP RMDs Using Updated IRS Life Expectancy Factors Taking Effect in 2020
By comparing Chart I and Chart II, the following observations are made:
1. A retired TSP participant with a starting TSP account balance at age 72 who were to only take the RMD each year and live into their mid-90’s would have higher RMDs starting in their mid to late -80’s under the new IRS life expectancy factor starting in 2022. Basically, this is due to lower RMDs at the beginning (starting at age 72 to age 85) which leaves more in the account to grow, resulting in higher account balances which will eventually result in higher RMDs later in life.
2. A $500,000 TSP account at age 72 whose only withdrawals are RMDs which would be worth about $44,000 more at age 95 under the new IRS life expectancy tables taking effect in 2022, based on the growth assumptions used in the charts. By age 95, the RMD would be $3,563 more than under the current IRS life expectancy tables.
Finally, the SECURE Act changed the rules for inherited retirement accounts. Under the pre-SECURE Act, a non-spousal beneficiary of a TSP account had the option of directing transferring the inherited TSP accounts to an inherited (“death”) IRA. Once in the inherited (“death”) IRA, the non-spousal beneficiary had the option of lifetime withdrawals based on their own life expectancy. Under the SECURE Act, most non-spousal beneficiaries must have the money in an inherited(“death”) IRA withdrawn within 10 years of its establishment.