One of the provisions of the SECURE Act (which became law Jan. 1,2020) is the end of the so-called “stretch” IRA for most nonspousal IRA beneficiaries.
Before the SECURE Act’s passage, upon the death of a traditional IRA or Roth IRA owner, a named beneficiary or beneficiaries (no matter the age of the beneficiary) had the option of transferring the inherited IRA assets to an “inherited”(also known as a “death”) IRA, in which the beneficiary could receive lifetime distributions from the inherited IRA. A beneficiary would receive each year a required minimum distribution (RMD) from the inherited IRA calculated based on the beneficiary’s life expectancy and inherited IRA balance.
In other words, a beneficiary could receive lifetime income from an inherited IRA, paying tax each year in the case of an inherited traditional IRA, and not having to pay tax in the case of an inherited Roth IRA. Thus, the concept of the “stretch” IRA for IRA beneficiaries.
But the SECURE Act changed the rules for most inherited (“death”) IRA beneficiaries effective Jan. 1, 2020. The SECURE Act’s rules apply to beneficiaries of IRA or qualified retirement plan owners (and the Thrift Savings Plan) who die after Dec. 31, 2019. The SECURE Act divides IRA beneficiaries into one of three groups, namely:
- ”non-designated” beneficiaries – this includes charities and most trusts;
- “eligible designated beneficiaries” (EDB) – this includes spouses, minor children (children younger than age 18) and beneficiaries with a qualifying disability; and
- “non-eligible designated beneficiaries” (non-EDB) – this include any individual who is a designated beneficiary but not an EDB.
Withdrawal rules and tax consequences associated with TSP beneficiaries
In general, any individual can be named as a beneficiary of one’s TSP account. This includes a spouse, children, siblings, other relatives, and a qualifying trust or charity. Upon the death of the TSP participant, the following rules apply to a TSP beneficiary.
· A spousal beneficiary can leave the inherited TSP assets in the TSP and treat the account as his or her own. The spouse can make withdrawals and/or transfer the TSP assets to his or her own IRA. Starting at 70.5 (if the spouse was born before 7/1/1949) or age 72 (if the spouse was born after 6/30/1949), the spouse is subject to the RMD rules of the TSP (both traditional TSP and Roth TSP are subject to RMD).
· A nonspousal beneficiary is required to withdraw all of his or her inherited TSP assets within five years following the death of the TSP participant. In the case of the traditional TSP, full federal and state income taxes would have to be paid on the amount withdrawn. In the case of the Roth TSP, no taxes would have to be paid on the withdrawn Roth TSP assets assuming that the Roth TSP withdrawals are “qualified” Roth TSP withdrawals.
A nonspousal TSP beneficiary also has the option of directly transferring his or her inherited TSP assets to an inherited (“death”) IRA. The traditional TSP can be directly transferred to an inherited traditional IRA (with no tax consequences in the transfer) and the Roth TSP can be directly transferred to an inherited Roth IRA (also with no tax consequences in the transfer). Once the inherited TSP assets are transferred to an inherited (“death”) IRA, then the TSP beneficiary becomes subject to the rules of the inherited (“death”) IRA.
Withdrawal rules and tax consequences associated with inherited (“death”) IRAs
Any earnings in an inherited traditional IRA grow tax-deferred while any earnings in an inherited Roth IRA grow tax-free. The assets in the deceased’s IRA (or TSP) must be transferred into a new inherited IRA held in the beneficiary’s name. A nonspousal beneficiary of a TSP account can request that the inherited TSP assets be directly transferred to an inherited IRA; that is, a direct transfer of traditional TSP account to an inherited traditional IRA, and a direct transfer of the Roth TSP account to an inherited Roth IRA.
Under the SECURE Act, the rules have changed for a nonspousal beneficiary of an IRA (or a nonspousal TSP beneficiary) who transferred his or her inherited IRA or his or her inherited TSP assets to an inherited IRA. Any nonspousal beneficiary who inherited an account of an IRA owner or a TSP participant in which the IRA owner or TSP participant died after Dec. 31, 2019 generally has 10 years from the date of the IRA owner’s death to withdraw the entire assets from the inherited IRA.
While the inherited IRA owner is permitted to make penalty-free withdrawals from the inherited IRA during the 10-year period, there is no annual RMD. However, the inherited IRA assets must be withdrawn in their entirety by the end of the 10th year following the death of the original IRA or TSP owner. The following examples illustrate:
Marsha, age 76, died in January 2020. At the time of her death, Marsha had a traditional IRA whose value was $250,000. Marsha named her two children, Alice and Peter, as equal beneficiaries of her IRA. Both Alice and Peter directly transferred their portion ($125,000 each) to an inherited (“death”) IRA. Alice and Peter (both non-EDB) have until January 2030 to withdraw their inherited IRA assets and pay tax on any withdrawal. Each can make withdrawals at any time between 2020 and 2030, paying federal and state income taxes on the amounts withdrawn. But both Alice and Peter must withdraw all their inherited IRA assets by the end of January 2030, paying federal and state income taxes on the amounts withdrawn.
Matthew, age 74, died in February 2020. At the time of his death, Matthew had a Roth IRA whose value was $300,000. About $50,000 of the $300,000 came from a transfer of Matthew’s Roth TSP to his Roth IRA when he retired from federal service in 2018. Matthew named a niece (a non-EDB) as beneficiary of his Roth IRA. The niece directly transferred the inherited Roth IRA to a separate inherited Roth IRA. The niece has until February 2030 to withdraw the inherited Roth IRA assets, but she will not pay any income tax on her withdrawals.
Before the SECURE Act passage, any beneficiary of an IRA had the option of receiving lifetime distributions for the inherited IRA account (receiving an RMD each year based on the beneficiary’s life expectancy, no matter the age of the beneficiary).
The recent passage of the SECURE Act removed the “stretch” provisions. For those IRA owners (or TSP participants) who die after Dec. 31, 2019), any non-EDB must withdraw all inherited IRA assets within 10 years following the death of the IRA owner (or TSP participant, if the TSP beneficiary elects to directly transfer the inherited TSP assets to an inherited IRA). This can possibly lead to higher tax consequences in the case of the inherited traditional IRA.
The reason: After 10 years following the death of a traditional IRA owner, a non-EDB (such as an adult child) must withdraw whatever remains of the inherited traditional IRA assets. If the beneficiary has not made any or taken any withdrawals from the inherited IRA during these 10 years, then after the 10-year anniversary the entire amount left in the traditional IRA must be withdrawn in a lump sum payment. Federal (and state) income taxes must be paid on the lump sum withdrawal.
The resulting lump sum payment could possibly push the non-EDB into a higher marginal federal tax bracket. In addition, federal marginal tax rates will most likely increase after Dec. 31, 2025 when the current lowered tax rates under the Tax Cuts and Jobs Act of 2017 expire (and federal individual tax rates revert to what they were in 2017, inflation adjusted) meaning than the non-EDB will likely pay higher federal income taxes after 2025 compared to what would be paid presently..
While the inherited Roth IRA rules for mandatory withdrawal by the end of the 10th following the death of the Roth IRA owner are the same as for the inherited traditional IRA, the difference is that no federal and state income taxes have to be paid when inherited Roth IRA assets are distributed to the beneficiaries. While the tax-free growth associated with the Roth IRA ceases upon its withdrawal, it is welcome news for a non-EDB of the inherited Roth IRA that no federal and state income taxes are due when Roth IRA assets are withdrawn. This is true no matter how much is withdrawn and when it is withdrawn by the end of the 10th year.
For federal employees who have sizeable TSP accounts and who may be planning to retire within the next five years, perhaps now is a good time for these employees to reassess which TSP account (traditional or Roth) to contribute to and in what amounts. If they plan to bequeath their TSP accounts to their children and perhaps grandchildren, they are encouraged to contribute more to their Roth TSP accounts. The logic is that while the TSP participant will have to pay tax on his or her contribution to the Roth TSP, federal tax rates are lower now compared to what they will be by the time the TSP assets are withdrawn (this includes TSP contributions and accrued TSP earnings) in the next 10 to 30 years.
A Roth TSP participant’s children and grandchildren will therefore avoid paying more in federal and state income taxes by inheriting the Roth TSP rather than inheriting the fully taxable traditional TSP. The recommended strategy is that an employee will continue to contribute more to the Roth TSP each year until they retire. While their children or grandchildren would have to withdraw any inherited Roth TSP assets withing five years of the death of the Roth TSP participant (or within 10 years of the Roth TSP participant whose beneficiaries transferred the inherited Roth TSP to an inherited Roth IRA), at least no federal or state income taxes would have to be paid on inherited Roth IRA withdrawals.
Note that in 2020 an employee younger than 50 can contribute as much as $19,500 to the TSP (to the traditional and/or Roth TSP, or a combination with the total contribution not exceeding $19,500) while an employee over age 49 during 2020 can contribute a maximum $26,000 ($19,500 regular contribution plus $6,500 “catch-up” contribution).
Upon retiring from federal service, the TSP participant can transfer all his or her Roth TSP account to a Roth IRA. The TSP participant can choose to leave the Roth TSP alone and not withdraw it (until they are subject to TSP required minimum distributions) or to directly transfer the Roth TSP account to a Roth IRA. At the death of the Roth TSP participant, a non-EDB such as an adult child has the option of directly transferring the inherited Roth TSP to an inherited (“death”) Roth IRA, as is true with a Roth IRA upon the death of the Roth IRA owner. While the inherited Roth IRA would have to be withdrawn within 10 years of the death of the Roth TSP participant or Roth IRA owner, at least no federal or state income taxes would have to be paid.
The same cannot be said of the inherited traditional TSP or inherited traditional IRA assets. Taxes would have to be paid by an EDB or a non-EDB. This could prove to be a substantial tax liability for a sizeable traditional TSP account which many employees own at this time.
In short, TSP participants with sizeable TSP accounts (more than $500,000) should consider the future direction of federal and state taxes and what will happen to their inherited TSP accounts upon their (and a spouse’s) death. If they have named their children as the contingent beneficiaries or primary beneficiaries of their TSP accounts, they should be aware that federal tax rates will likely increase in the not-to-distant future, and how this will affect what their designated adult children beneficiaries will end up with when it comes to their TSP accounts. Given the no tax liability associated with Roth accounts, the beneficiaries, especially those beneficiaries who are in the higher marginal brackets, will likely benefit more from inheriting the Roth TSP.