Previous columns discussed the new withdrawal options for Thrift Savings Plan (TSP) participants that began Sept. 15, 2019. The new TSP withdrawal options are also available for spouses of TSP participants who are designated TSP beneficiaries.
But non-spouse beneficiaries (such as children, grandchildren or siblings) of TSP participants are not allowed to use the new withdrawal options.
Unless the non-spouse beneficiary requests a direct transfer of his or her inherited TSP account to an inherited (“death”) IRA within five years of the TSP participant’s death, the TSP sends a single payment for the full amount of the inherited TSP assets to the designated beneficiary. This column discusses the inherited (“death”) IRA transfer and how it benefits a non-spouse beneficiary. Also discussed is legislation that would curtail the full benefit of the inherited (”death”) IRA.
Before discussing the tax advantages of a non-spouse beneficiary transferring an inherited TSP account to an inherited IRA, it is important to review the tax consequences of receiving a TSP death benefit payment. The tax consequences of receiving a TSP death benefit payment are determined based on the type of TSP account (traditional or Roth), the type of account from which the TSP payment is made (civilian, uniformed services, or beneficiary participant) and the type of beneficiary (spouse or non-spouse).
Type of TSP account.
A deceased TSP participant may have contributed to the traditional TSP using before-taxed salary and/or Roth TSP using after-taxed salary funds. A traditional balance of a TSP account contains contributions that the participant made, and for FERS-covered employee an automatic contribution and matching contributions from the participant’s agency. All of these traditional TSP contributions and the earnings on these contributions grow tax-deferred. A Roth balance of a TSP account contains contributions that the participant made on an after-tax basis with the earnings on these contributions growing tax-free assuming certain conditions are met. All death benefit payments will be disbursed upon the TSP participant’s death proportionately from any traditional TSP and Roth TSP balances in the participant’s account. Any money that is disbursed from the traditional balance will be subject to mandatory federal income tax withholding. Any Roth contributions that are part of a death benefit payment are not subject to federal income taxes. Accrued earnings on Roth contributions may also be paid tax-free if five years has passed since January 1st of the year that the deceased participant made his or her first Roth TSP contribution.
Type of account from which the TSP payment is made.
The taxable amount of any death benefits paid directly from a civilian-owned or uniformed services-owned TSP traditional account to the named beneficiaries may be subject to 20 percent mandatory federal income tax withholding.
Type of beneficiary.
A spouse beneficiary whose inherited share is $200 or more will avoid mandatory tax withholding and defer tax liability by keeping the funds in the established spousal beneficiary participant account, or by having the TSP transfer all or part of the eligible fund directly to the spouse’s own traditional IRA or to an eligible employer-sponsored retirement plan. Eligible employer-sponsored retirement plans include the spouse’s own pre-existing TSP account if the spouse beneficiary is a federal employee or uniformed services member with a TSP account.
A non-spouse beneficiary can avoid mandatory federal income tax withholding and defer tax liability by requesting that the TSP transfer all or part of the inherited TSP funds directly to an inherited (death) IRA. Note that the traditional TSP would be directly transferred to an established inherited traditional IRA and the Roth TSP would be directly transferred to an established inherited Roth IRA.
With an inherited IRA, the owner (beneficiary) is required to withdraw the IRA funds and is neither allowed to contribute to nor rollover funds from a “contributory” traditional or Roth IRA. But the inherited IRA owner has the option under current rules to request that the inherited IRA funds be paid out over the life expectancy of the IRA owner. This means, for example, if the inherited IRA owner is 25 years old, then with a life expectancy of 60 years the IRA owner could possibly receive a check for 60 years until he or she dies in his or her middle 80’s. This has led to the concept of the “stretch IRA” (that is, “stretching out” the IRA over the life of the IRA owner).
In recent months, Congress has considered legislation that would put a damper on “stretch” IRAs. The House of Representatives earlier in 2019 passed its version of the Setting Every Community Up for Retirement Enhancement (SECURE) Act. Among the features of the SECURE Act would be to reduce “stretch” IRAs to 10 years for non-spouse beneficiaries such as children, grandchildren and siblings. Critics of “stretch” IRAs have said that they are a boom for the wealthy who can afford to not have retirement savings. Moreover, critics of “stretch” IRAs say they should not be wealth succession management tools. The Senate is currently considering the House of Representatives’ bill and one of its own.
While there are similarities and differences in the House and Senate versions of the SECURE Act, both versions allow the “stretch” for a number of eligible heirs. These eligible heirs include surviving spouses, disabled or chronically ill non-spouse beneficiaries, and heirs close in age to the IRA owner such as siblings, and minor children of the IRA owner.
The previously passed House of Representative version of the SECURE Act puts a 10 year limit on the “stretch” provision for non-eligible heirs such as grandchildren or children who are not minors. While there would be no RMDs from inherited IRAs during the 10 year term, there can be distributions during the 10 year period with a full distribution of the inherited IRA balance at the end of the 10 years.
The difference between a lifetime IRA “stretch” versus a limited 10 year IRA “stretch” can be enormous. For example, the present value of a 23 year old individual inheriting a $1 million IRA and having a lifetime “stretch” payout is nearly $23 million. With a 10 year “stretch” the present value is $8.5 million, 63 percent less.
The Senate version of the SECURE Act is to allow non-eligible heirs such as siblings and grandchildren to use the current “stretch” rules on up to $400,000 of inherited IRA assets. Beyond that, IRA assets for these heirs must be withdrawn within five years. Note the Senate has not yet voted on its version of the SECURE Act.
For TSP participants who would like to bequest their TSP assets to non-spousal beneficiaries, both the House and Senate versions of the SECURE Act puts a damper on a TSP participant’s goal of giving perhaps lifetime income to their children, grandchildren or siblings.