The stock market reached all-time highs during 2023. For many federal employees and retirees, the result is their IRAs and Thrift Savings Plan (TSP) reached their highest values ever at the end of 2023.
While that is encouraging news for TSP participants and IRA owners, it also suggests some IRA and TSP tax-planning moves that federal employees and retirees should consider.
Larger Required Minimum Distributions (RMDs) During 2024
For retired federal employees with traditional TSP and/or traditional IRA accounts and who have reached their required beginning date (RBD), the year 2024 will likely mean larger required minimum distributions from the TSP and their traditional IRAs. The RBD increased from age 72 to age 73 for individuals born between January 1,1951 and December 31, 1959.
The record 2023 year-end stock values will mean larger RMDs because 2024 RMDs are based on the December 31,2023 traditional IRA and/or traditional TSP account values. Larger RMDs result in more taxable income, thereby resulting in higher federal and state income liabilities for traditional TSP participants and traditional IRA owners.
Those employees and retirees (no matter their age) who inherited traditional IRAs from IRA owners who died after December 31,2019 are also subject to RMDs from their inherited traditional IRAs. Estimated federal and state income tax payments during 2024 will likely have to be adjusted upward as a result of the larger RMDs stemming from the enhanced inherited IRA balances as of December 31, 2023.
The larger RMDs during 2024 may have a “silver lining” for two reasons.
First, individual federal tax rates are historically low and will remain low throughout 2024 and 2025. On January 1, 2026, the low tax rates (in existence since January 1, 2018 as a result of the passage of the Tax Cuts and Jobs Act of 2017) are due to revert back to what they were in 2017, inflation adjusted.
The second reason is that the higher RMDs forces more IRA and TSP funds to be distributed during 2024 likely resulting in smaller RMDs in the future because of lower account balances.
2024 Roth IRA Conversions
Larger traditional TSP and traditional TSP balances may be an indication that a federal employee or retiree has too much building up in tax-deferred accounts, increasing the eventual federal and state tax liabilities when the funds are withdrawn.
With potentially higher federal tax rates, the higher traditional TSP and traditional IRA account balances will result in TSP participants, IRA owners and their beneficiaries with less later when taxes are paid when the retirement accounts are withdrawn.
Roth IRA conversions can be especially effective during 2024 and 2025 not only to take advantage of current lower tax rates, but also to reduce these growing traditional TSP and traditional IRA accounts.
Roth conversions should ideally be done before TSP and IRA RMDs begin. This is because RMDs cannot be converted to Roth IRAs.
Under SECURE Act 1.0 which took effect January 1, 2020, most beneficiaries who inherit a traditional IRA are not able to withdraw their inherited IRA over their life expectancy. They instead are required to withdraw the entire inherited IRA by December 31st of the 10th year following the death of the original IRA owner.
This is known as the “10-year rule”, meaning that these beneficiaries will have to pay all the federal and state income taxes due by the end of the 10th year following the death of the original IRA owner.
If a traditional IRA owner were to convert a traditional IRA to a Roth IRA during 2024, the IRA owner would relieve the beneficiaries of that future tax bill. While Roth IRA beneficiaries are still subject to the 10-year rule – an inherited Roth IRA also must be withdrawn no later than December 31st of the 10th year following the death of the original Roth IRA owner – Roth IRA beneficiaries are not required to take annual RMDs during the 10-year period. This allows all the accumulation in the Roth IRA through the end of the 10th year to be withdrawn tax-free.
A beneficiary of a traditional IRA cannot convert an inherited IRA to an inherited Roth IRA. Therefore, inheriting a Roth IRA can lower the overall estate tax liability for the original IRA owners and eliminate the income tax bills for IRA beneficiaries had the inherited IRA have not been converted.
Larger stock market values also mean potentially larger estates for those federal employees and retirees invested in the stock market both inside and outside of the TSP and IRAs. A TSP participant over age 59.5 who requests a direct rollover of a portion of their traditional TSP to a “rollover” traditional IRA and then converts the “rollover” traditional IRA to a Roth IRA can reduce his or her gross estate by the amount of federal and state income taxes paid.
The same is true for any employee or retiree who converts a traditional IRA to a Roth IRA. During 2024, the federal estate tax exemption has increased to $13.61 million per individual ($27.22 million per married couple).
While these exemptions are rather large and most federal employees and retirees likely do not have estates of that amount, many employees and retirees live in states with estate taxes in which the state tax exemptions are much lower. For example, Massachusetts and Oregon have a state estate tax exemption of $1 million. The estates of employees and retirees who died in these states could be subject to state estate tax, a result of their enhanced traditional TSP and traditional IRAs invested mostly in stocks.
How Qualified Charitable Distributions Can Benefit Traditional IRA Owners
Those employees and retirees who are charitably inclined and who note the enhanced value in their traditional IRA balances due to the stock market surge currently or in the future may want to consider qualified charitable distributions (QCDs) to reduce their traditional IRA balances.
QCDs are available to traditional IRA owners and IRA beneficiaries of traditional IRA owners who are at least age 70.5. As a result of the passage of SECURE 2.0 in December 2022, the annual $100,000 QCD limit has been increased to $105,000 for the year 2024.
QCDs must be performed as a direct transfer from a traditional IRA to a qualifying charity. QCDs can be done only by individuals who are at least age 70.5. Since RMDs must be done by IRA owners starting the year they become age 73, the period from age 70.5 to the year an IRA owner becomes age 73 is an ideal time for a traditional IRA owner to perform QCDs. The QCDs do not result in income for the IRA owner and lower the traditional IRA balances, resulting in lower future traditional IRA RMDs.
Most individuals no longer receive tax benefits for charitable donations they make because (according to the latest IRS statistics), approximately 90 percent of individuals take the standard deduction and do not itemize (file Schedule A). Itemized deductions include charitable donations. If an individual takes the standard deduction, the individual gets no tax benefit when the individual makes charitable donations.
QCDs can replace the lost tax benefit of charitable donations not in the form of a deduction but as an exclusion from income. An exclusion from income is better than a tax deduction because an exclusion from income lowers adjusted gross income (AGI) which in turn can maximize other tax benefits including tax credits and tax deductions. A lower AGI can also reduce Medicare IRMAA charges.
The strategy for using QCDs is best accomplished by performing QCDs early in the calendar year, for traditional IRA owners who are subject to RMDs. Doing the QCD early in the calendar year allows the QCD to satisfy the traditional IRA owner’s RMD for that year. If the RMD is taken first before the QCD then the QCD cannot offset the RMD income.