Potential TSP Tax Bomb
Want to avoid having your kids lose 50% of your TSP the very first year? This article explains how to do that.
Fair warning, it starts off simple enough but quickly becomes complicated. Take it one step at a time. When you get lost, go back a step.
Some stories start at the beginning. This one starts at the end.
Point 1: You die.
Your TSP will go to whomever your beneficiary is, assuming you have one. It doesn’t matter at all what your will says, what your trust documents say, who you are married to, or what your dying declaration was. Your TSP will go to whomever is on the beneficiary form.
If you don’t have a beneficiary form on file (which you ABSOLUTELY SHOULD!), then it goes by order of precedence. And then it will matter who you’re married to if you’re married. (Spouse, child in equal shares with any deceased child distributed among that child’s descendants, parent(s), executor of estate, next of kin).
Point 2: The treatment of that TSP inheritance to your beneficiary depends on if they are a spouse or non-spouse.
(Time Out: For one or two people in each of my retirement classes, this is a surprisingly hard concept to grasp. A spouse is the person you’re married to. Period. You would think that is sufficient. Everyone and everything else in the world is a non-spouse. That sounds simple enough. But this statement immediately kicks off a flurry of questions. “What if we are separated?" “What if we are engaged?” “What if it’s going to a trust?” “What if I want it to go to my ex-wife?”
In each one of those questions, the answer seems extremely simple to me. If you are married to a person, that is your spouse. If you are not married to that person, that is a non-spouse. Your trust is a non-spouse. Your ex-wife or your future wife is a non-spouse. Kids, parents, friends, and Carl down at the Waffle House are all non-spouses.
OPM must have gotten tired of getting these questions as well, so they now include a definition on your retirement application: “A marriage exists until ended by death, divorce or annulment.”
Only two groups exist in this scenario: Spouse and Non-Spouse. Hopefully we can all get past this point of clarification.)
Let’s deal with spouses first. Enter the Beneficiary Participant Account, aka the BPA.
If your spouse inherits your TSP, the TSP will allow them to keep the money inside the TSP. It will be inside a special type of TSP called a BPA. Your TSP money goes into that BPA, but it’s still inside the TSP. Your spouse will still have access to G, F, C, S, and I. And all the L Funds. They can move money around inside the TSP. They can do TSP Roth Conversions. They can make withdrawals from TSP (penalty-free at any age, by the way). They can take the BPA and roll it into their own TSP if they already have their own TSP. They can take the BPA and roll it into a private IRA at Schwab, Fidelity, Edward Jones, etc. Or they can just leave it in the BPA for the rest of their life, taking withdrawals when they want, and for sure being forced to take Required Minimum Distributions at the correct age (an article for another time).
The TSP has a great booklet that explains the BPA in clear language. It is entitled, TSPBK33 “Your TSP Account. A guide for Beneficiary Participants.” and is available HERE. Please read it.
Now, let’s say that the person inheriting your TSP is NOT your spouse. They would be categorized as what, again???? That’s right…a non-spouse.
A non-spouse cannot keep the money in the TSP. That bears repeating. The non-spouse cannot keep the money in the TSP. They are not eligible for a Beneficiary Participant Account. Because that is for spouses. And we are now talking about non-spouses. Remember: A non-spouse does NOT get a BPA. A non-spouse cannot keep money in someone’s TSP they inherited.
So what can a non-spouse do? They have 2 options:
Immediately take the full withdrawal from the TSP. Yes, like ALL of it. None of it can stay in TSP. They would withdraw all of it. That would generate taxes for that year. And it could generate an absolute ton of taxes. If there were $2 million in that TSP, then that’s $2 million in taxable income for that heir for that one year. If they lived in California, they’d be pretty much losing close to half in federal and state income taxes. Or……
Within 90 days, they can have the TSP money they are inheriting rolled over into a special kind of IRA with a special set of rules called an “Inherited IRA”. An Inherited IRA is not simply an IRA that you inherited. It’s a special type with its own special rules—a sped up withdrawal requirement in many cases. This goes with that other article for another time.
So, to recap so far:
Spouse can keep money in the TSP, inside a BPA.
Non-spouse cannot keep money in the TSP, the best they can do is move it to a private IRA called an Inherited IRA.
Probably everyone is with me so far up until this point.
Now we get to the potential tax bomb that so many people don’t realize:
If your spouse passes away while still having money in the BPA, there is one option and one option only for the person that inherits that BPA. They can’t do anything but this: Take the full distribution from the BPA immediately. End of story. You can’t roll it over. You can’t put it into an IRA. You can’t spread withdrawals out over a period of years. You cannot do a single thing other than receive a check from TSP for the full balance of the BPA.
As mentioned before, this would make the full distribution taxable in that one year. All of it. As ordinary income. If there is $1 million left in the BPA, whoever the beneficiary of that BPA is, they will have an additional $1 million of taxable income for that year on top of whatever their regular income was going to me they were already making. They literally just bumped up their taxable income by 7 figures.
“Chris—where are you getting this? My financial advisor told me otherwise.” Have your soon to be well-informed financial advisor read the BPA booklet I posted above.
Specifically Page 12. First sentence: “In the event of your death, the funds in your beneficiary participant account cannot remain in the TSP”.
And then also later down on Page 12 under “TSP Distribution of death benefits. Death benefit payments made from your beneficiary participant account must be paid directly to your beneficiary(ies). These payments are subject to certain tax restrictions and cannot be rolled over to an IRA or eligible employer plan. In addition, your beneficiary(ies) will have to pay the full amount of taxes on the taxable portions of the payment in the year it is received.”
As a side note, the 37% tax bracket (the highest we have right now) begins at $768k for married and only $640k for single. So several hundred thousand of that is going to be taxed at the highest federal rate of 37%. Any state taxes would be on top of that as well. Not a big deal in FL, TX or TN. A pretty stinking big deal in CA.
To add insult to injury, the TSP will only withhold 10% for the IRS on the recipient’s behalf. Suffice it to say, that’s what would be called a woefully low under withholding in this example. Imagine being in the 37% bracket and having 10% withheld? That would be one shocking bill your CPA will serve you with next April. “Chris, that can’t be right—only 10%???” I totally understand your skepticism. Please look at Page 22 HERE.
I can hear all the questions now. So let’s address them:
“What if my beneficiary is a trust?” That’s a non-spouse so non-spouse rules apply. If the trust is the beneficiary of the BPA, then it doesn’t matter, all of it has to be paid out of TSP and taxed in the same year. There seems to be some sort of misunderstanding out there about trusts somehow being a silver bullet against taxes? Here’s a real-world example someone was struggling through last year:
Husband was a FERS retiree. Husband passed away. Husband had 50% of his TSP go directly to his wife. The other 50% he had go to a trust as the beneficiary. Not super unusual I guess. But the beneficiary of the trust was also his wife. She contacted me because she was able to keep 50% of the TSP in a BPA since she was the spouse, but she was being forced to pull the other 50% out over the next 10 years since it went to a trust. Specifically the trust was required to pull the TSP money out of the Inherited IRA over the next 10 years, but that was essentially her. She didn’t want to take out 50% of the TSP over the next 10 years, but because it wasn’t left to her directly 100%, it couldn’t stay in a BPA. Only 50% could.
“What if I inherit a TSP/BPA and then later I remarry and my wife is the beneficiary of my BPA? I mean, she’s a spouse right?” See Page 12 of the booklet stating that you cannot keep money in the BPA, and you can see that that applies to married people as well, since the beneficiary of the BPA can be a spouse that you married after losing your first spouse. That spouse will still have all of the money paid out.
“What about a Roth TSP?” Set that question aside and I’ll address it at the end.
“Is there a way to mitigate this tax bomb?” I’m glad you asked. On to the next point.
Point 3: The BPA can be rolled over PRIOR to death.
So, let’s go back to the beginning. You’ve kicked the bucket. Your spouse has inherited your TSP and they’ve set up a BPA for them. The spouse has the option of taking that BPA and rolling it into their own TSP if they have one, or into a private IRA somewhere. Obviously they have to do this BEFORE they die! Either of these options effectively kills the BPA. It no longer exists. If the spouse dies with their BPA already rolled into their own TSP because they had been a federal employee too, then this whole thing starts over again. We go back to the beginning of the article and we find out who is the beneficiary of that TSP: A spouse or non-spouse.
If the surviving spouse rolled their BPA into an IRA before they died, then when they die, their beneficiaries will not be forced to take all of the money out immediately. They can use the rules of Inherited IRAs which allow to spread out the withdrawals over at least a 10-year period, and in some cases, even longer.
So basically to defuse the potential tax bomb, the person holding the BPA should not die before moving the BPA to some other account that is more easily able to be inherited. Could be a TSP if they have their own, or could be an IRA if they don’t have their own TSP. But leaving it in the BPA means when they die, whoever gets their BPA has to take a full, immediate taxable distribution.
However, there is an advantage to the BPA if you remember—-penalty free withdrawals at any age….so keep that in mind. That might be a very good reason for keeping TSP money in a BPA, depending upon the age of the individual. A young, single mom of three for example might need some of that money to get back on her feet. Personal finance is very personal. Each situation requires an individual solution. Just don’t die with a huge balance in your BPA.
Let’s do an example or two:
Jack is a federal employee. He’s married to Diane. They have a child, Jack, Jr. Jack, Sr. has been a faithful congregant of the C Fund Denomination and currently has $2m in his TSP. Unfortunately, walking into work and daydreaming about his upcoming retirement boat he’s gonna buy, he didn’t see the bus that slammed into him. Diane consoles herself at the Range Rover dealership, picking out trim levels, knowing all the while the $2m BPA account is hers for the using.
Unfortunately, Diane passes away a few months later, after only being able to spend $500k in 6 months. Jack Jr. gets the full $1.5m. He doesn’t have a chance to have it roll into an IRA or anything else. Jack Jr. now has $1,512,000 of taxable income for this year (when you include his $12k Chipotle job). He went from not owing any federal income taxes for the year to being in the 37% bracket with taxable income of a million and a half. Jack Jr. had no other option in this because the BPA has to be paid out.
Tommy and Gina are married. They are both federal employees. They have 2 kids. Tommy dies. Gina initially gets a BPA set up for Tommy’s TSP. But Gina decides to roll the BPA into her TSP. Now, the BPA is gone and Gina just has one (much larger) TSP. Gina dies. The 2 kids can inherit Gina’s TSP and set up Inherited IRAs. Each one can spread the withdrawals out over 10 years (maybe longer if they were minors initially), lessening the tax burden by spreading the taxes out over a longer period of time than one year.
Mary is a single parent. She passes away. Her TSP will not have a BPA because she is single. Her child does not get forced to take everything out, because that only happens to a BPA and a BPA never existed in this case. Mary’s child can roll their TSP into an Inherited IRA and spread the withdrawals out over a 10 year period, at least.
Point 4: What about the Roth TSP?
Everything discussed above is regarding the Traditional TSP. Remember that is the one that is full of never-taxed money. So any withdrawals coming out would be taxable withdrawals. Whether they come from the TSP, the BPA, or an Inherited IRA. Traditional means taxable withdrawals.
Roth TSP withdrawals that are qualified are not taxed. Roth contributions are never taxed, and the Roth earnings that are qualified that make up the rest of the withdrawal would not be taxed as well. The main concern of this article is not the Roth TSP that may end up being completely non-taxable. The focus is on the Traditional TSP that absolutely 100% will be completely taxable to someone. As always, you’re going to want to plan for this using a good team of CPAs, Financial Planners, and/or Estate Planning Attorneys.
Is there anything else to know?
Oh, boy is there ever! This falls solidly in the arena of a non-DIY project. Please, please, please talk to an estate planner or some financial professional familiar with federal and state laws regarding taxes, TSP, and investment accounts that might be able to set up a plan for this sort of thing. If a person dies after RMDs have started, then you may have an immediate RMD situation on your hands. What if the child is a minor? Typically minors can’t inherit money of any type and a trust has to be set up, either before or after death. That might change certain tax implications, but it won’t change the TSP rules: Spouses get BPAs, non-Spouses don’t get BPAs.
This might be obvious, but just in case….if your TSP is turned into a BPA, unfortunately you are no longer with us. You’ve shuffled off this mortal coil. Which means, you aren’t around to be giving your widow or widower all this advice contained within. You’ve missed your opportunity. So any planning that needs to be done to educate them needs to be done while you’re still vertical.
One last piece of advice that applies to this situation as well as pretty much every other situation I can think of: GET YOUR INFORMATION FROM TSP.GOV Or IRS.gov or OPM.gov Stop asking complete strangers on social media what you should do with your life savings, particularly in the realm of tax planning. Just a quick glance at the varying answers to literally every single question ever asked there should be enough to scare you from taking any advice or information from random people.
Some other resources to follow up with and discuss with your financial professional:
TSPBK26 Tax Rules about TSP Payments
TSPBK25 Distributions: Installments, Total and Partial Distributions, Life Annuities
IRS Publication 590-B Distributions from Individual Retirement Arrangements