Thrift Savings Plan RMD and IRA Planning Strategies

SECURE Act 2.0., passed into law on December 30, 2022, resulted in several changes to retirement plans and to IRAs that were designed to strengthen the retirement system and Americans’ financial readiness for retirement.

One of the major provisions coming out of SECURE Act 2.0 (that builds upon SECURE Act 1.0, passed into law in December 2019) was to raise the age at which time required minimum distributions (RMDs) from qualified retirement plans (including the Thrift Savings Plan) and traditional IRAs must be taken.

SEE ALSO:  How the TSP Calculates the Required Minimum Distribution (RMD)

When SECURE Act 1.0 became law on Jan. 1, 2020, the required beginning date (RBD) for traditional IRA owners and qualified retirement plan owners was changed from April 1 following the year a traditional IRA owner or qualified retirement plan owner became age 70.5 to April 1 following the year the individual becomes age 72. SECURE Act 1.0 affects individuals born after June 30, 1949. SECURE Act 2.0 further increased the RBD as follows: For individuals born between January 1,1951 and December 31,1959, the RBD is April 1 following the year an individual becomes age 73. For individuals born after December 31,1959, the RBD is April 1 following the year they become age 75.

The RBD is the date in which traditional IRA owners and qualified retirement plan participants including TSP participants must make their first of lifetime annual RMD from their retirement accounts. Because RMDs are made from taxable accounts (traditional TSP, traditional IRAs), they are fully taxable. The larger the RMD, the more federal and state income taxes that have to be paid.

There are a number of planning issues surrounding RMDs, not only for federal retirees aged 73 and older who are currently required to take TSP RMDs, but also for employees who are within 5 to 10 years of retiring from federal service and for younger federal retirees in mid-career.

Much of this planning focuses on:

(1) An employee’s current and anticipated future federal income tax bracket; and

(2) Whether a federal retiree will need the money from their TSP RMD to help pay their bills. The increase in the RBD resulting from the recent passage of SECURE Act 1.0 and SECURE 2.0 gives employees and retirees who are currently younger than their RBD more time to develop and implement strategies to minimize future RMDs.

For many employees – especially in mid-career and employees being eligible to retire within the next 5 to 10 years – steps can be taken to reduce their future TSP RMDs. The current low federal marginal income tax rates – a result of the passage of the Tax Cuts and Jobs Act of 2017 (TCJA) – will continue through December 31, 2025. Unless Congress renews the TCJA, individual federal income tax rates will revert back to the higher tax rates they were in 2017, inflation adjusted. As will be explained, there are several suggestions which employees and retirees can perform that utilize these lower tax rates in order to minimize future TSP RMDs.

Needless to say, reducing one’s future TSP RMD should always make sense from a federal employee’s or retiree’s overall planning perspective.

Roth IRA Conversions

In recent years, the topic of converting traditional IRAs to Roth IRAs has gotten more intense among financial professionals. A Roth IRA conversion can definitely be a solid overall planning tool to manage and reduce future RMDs.

Traditional IRA money converted to a Roth IRA, along with future earnings within the converted funds, permanently removes from the pool of funds that are subject to RMDs in future years. If a federal annuitant already is currently taking their traditional IRA RMDs (that is, they are over age 72), any traditional IRA RMD due in 2024 must be first taken before a Roth IRA conversion can be performed.

Federal employees aged 59.5 and older and federal retirees should be aware that traditional TSP accounts cannot be converted to a Roth IRA. In order for a traditional TSP participant to convert a portion of their traditional TSP account to a Roth IRA, the TSP participant must first request a direct rollover of a portion of their traditional TSP account to a traditional IRA. Once the direct rollover is accomplished, then all or a portion of the traditional IRA can be converted to a Roth IRA.

The decision as whether a federal employee should perform a Roth IRA conversion depends on the following financial planning objectives:

(1) Current-year income and overall federal and state tax liability. Years in which an individual’s income is lower than expected, and therefore fewer federal and state income taxes are expected to be paid, can be considered good years to perform a Roth IRA conversion. For example, during the rest of 2024 and all of 2025 immediately after a federal employee has retired but before the retired employee starts receiving Social Security retirement benefits and make withdrawals from their traditional TSP account. Retired employees immediately after they retire often find themselves in a lower marginal tax brackets at that time compared to their marginal tax brackets in future years when retirement income (CSRS or FERS annuity, TSP, and Social Security) is coming in.

(2) Are there potential non-spousal heirs to a federal employee’s traditional IRAs? If so, a Roth IRA conversion can save the employee’s heirs on potential income taxes that would be due had they instead inherit a fully taxable traditional IRA. The analysis should determine the overall family tax situation to see if it makes sense for an individual to prepay income taxes for the next generation.

(3) Will a soon-to-be federal retiree need the money from the traditional IRA RMDs? If the answer is no, then paying the income taxes now on converted Roth IRA funds and allowing the converted Roth IRA funds to continue to grow tax-free (and with no RMD required on a Roth IRA) can definitely be a good trade-off.

Roth IRA and Roth TSP Contributions

Contributions to a Roth IRA or Roth TSP can be a means for federal employees to limit future RMDs. For many federal employees, Roth TSP contributions are especially useful because unlike Roth IRAs, there are no income limitations on federal employees to make contributions via payroll deduction to the Roth TSP. It is important to stress that the Roth IRA is the only type of retirement account not subject to RMD requirements.

Until January 1, 2024, a TSP participant’s Roth TSP account was included in the calculation of the TSP participant’s TSP RMD. This was the case even though qualified withdrawals from the Roth TSP were not taxable. The result was that a TSP participant with both a traditional TSP and a Roth TSP account and who reached his or her TSP RBD had a larger RMD (and therefore had to pay more in federal and state income taxes). But another provision of SECURE Act 2.0, effective January 1,2024, the Roth TSP account balance will no longer be included in the calculation of the TSP RMD. This means that TSP participants can lower their future TSP RMDs by contributing to the Roth TSP.

Note that funds in a Roth IRA are not only exempt from RMDs for the account holder, but also for the account holder’s spouse if the spouse inherits the Roth IRA.

The trade-off for federal employees who elect Roth TSP contributions versus traditional TSP contributions is the tax current year benefit of making pretax contributions into the traditional TSP while they are working (and getting immediate tax savings when they are presumably in a higher overall marginal tax bracket) versus making after-tax contributions into the Roth TSP (with no Roth RMD) and being able to make tax-free withdrawals in retirement. If a federal annuitant dies with a Roth TSP account and names a non-spouse as a beneficiary, then while the non-spouse has to withdraw the inherited Roth TSP account within five years of the Roth TSP participant, the withdrawals will be federal and state income tax-free.

Qualified Charitable Distributions

Qualified charitable distributions (QCDs) allow individuals aged 70.5 and older to withdraw during 2024 up to $105,000 (increased from the $100,000 limit during 2023 and previous years) from their traditional IRAs and direct the funds to qualified charitable organizations. The benefit is that QCDs are not taxed.

With respect to RMD planning:

• QCDs taken between age 70.5 and age 73 will reduce the amount in the traditional IRA that will in the near future be subject to traditional IRA RMD.

• Using QCDs for some or all of an individual’s RMD will reduce the amount of the RMD that is taxable in addition to helping accomplish the individual’s charitable giving goals.

With respect to the traditional TSP, a QCD cannot be made using traditional TSP funds. However, those traditional TSP participants aged 70.5 and older are permitted to make tax-free direct rollovers of their traditional TSP account to a traditional IRAs with no dollar limitation. In so doing, they then will be able to make QCDs from their rollover traditional IRAs. Most importantly, by requesting a direct rollover of traditional TSP funds, they are decreasing the amount in their traditional TSP and therefore the amount of future TSP RMDs.

QCDs are in fact an excellent tool for those federal retirees eligible to make them and who are charitably inclined. This is especially the case for retirees who do not itemize on their federal income tax returns and who want:

(1) A tax-efficient method of making a charitable contribution;

(2) To reduce the amount of their RMDs and therefore the taxes associated with their RMDs; and (3)To lower their adjusted gross income (AGI) and possibly lowering their Medicare Part B monthly premium which is dependent on the amount of their AGI each year.

Qualified Longevity Annuity Contracts

Qualified longevity annuity contracts (QLACs) are annuities that can be purchased only with assets from a qualified retirement plan (such as the TSP or a 401(k)retirement plan) or from a traditional IRA. The maximum that can be contributed to a QLAC from all accounts is $200,000 (an increase from $125,000 resulting from passage of SECURE Act 2.0). Income from a QLAC can be deferred to age 85. This also serves to defer (but not eliminate) the RMDs on the qualified retirement plan and traditional IRA until the individual QLAC annuity owner begins taking distributions from the QLAC.

The main benefit of a QLAC is that it allows a TSP participant who has retired from federal service to defer some of his or her TSP retirement account balance into the future before taking the QLAC annuity payments. This can help a TSP participant to preserve the deferred TSP funds for the later part of their retirement. Deferring TSP RMDs is a side benefit here. A TSP participant therefore has to decide whether transferring a part of their traditional TSP to a QLAC is appropriate for them. Also, the TSP participant must select a QLAC annuity that is in fact appropriate and will meet their financial needs.

Continuing to Work in Federal Service Beyond Age 73

Federal employees who are working in federal service at age 73 or older and beyond can defer their TSP RMD under the “still working” exception. This RMD exception does not apply to money held in a traditional IRA or other qualified retirement plan, such as a 401(k) or 403(b) retirement plan. However, the TSP does allow direct transfers of traditional IRA and qualified retirement plans into the traditional TSP. In transferring the traditional IRA and/or qualified retirement plan funds into the traditional TSP, the TSP traditional participant who continues to work in federal service past age 73 will not have to take traditional IRA and/or qualified retirement plan RMD until the traditional TSP participant retires from federal service. This will allow for additional years of tax-deferred and compound growth in these retirement accounts.

In summary, deferring or reducing a TSP participant’s TSP and traditional IRA RMD should hopefully result in accomplishing the TSP participant’s financial goals.. However, the decision as to whether to undertake any of the above strategies should be analyzed in the context of the TSP participant’s overall tax and financial planning situation. Federal employees and retirees who are interested in performing any of these strategies are highly encouraged to meet with a knowledgeable financial advisor in order to determine which strategies are most appropriate to them.