The TSP is a great savings plan due to its low-cost investment options (I should know – I was a participant years ago while in the Foreign Service).
However, offsetting all the great TSP features is a very serious negative that could cost your heirs thousands of dollars in taxes.
This may give participants second thoughts about staying in the plan after they retire, especially if their account has a significant balance.
It’s not unusual for participants to accumulate sizable TSP balances of well over $500k+ resulting from years of careful savings and annual government matches.
By the way, our thanks to Valerie Mawdsley, owner of Smart Money Management-VA, a daily money management firm in Northern Virginia, for first bringing this TSP issue to our attention. Valerie’s firm assists seniors and busy professionals with their daily financial needs. Numerous people in the Northern Virginia area, like many of our clients here, are enrolled in the TSP and could fall victim to this TSP money-trap.
Here’s the problem in a nutshell:
“Stretch Out” with an IRA
With a typical IRA, you can name a beneficiary (for example, your spouse) to inherit the account at your death. They, in turn, can name their own beneficiary (let’s say, your two children) to receive the account balance at their death. Instead of taking out all the money at once and paying thousands in taxes, those two children – and maybe even their children – have the option of “stretching out” withdrawals over many years.
That minimizes taxes, ensures maximum growth, and gives them a lifetime source of income.
In brief – minimum taxes, maximum growth – leading Sheyna Steiner, writing for Bankrate.com, to call the stretch IRA “the tax equivalent of the treasure at the end of the rainbow.”
The TSP pitfall that could destroy your legacy
Now contrast this with the TSP.
TSP participants also have the right to name a beneficiary who’ll inherit the account at their death. So far, so good.
However, if that beneficiary leaves the money in the TSP account, she will lose the ability to “stretch out” distributions after her own death. Her beneficiaries will be required to take all the money out, incurring potentially thousands in tax bills.
Here’s what TSP sponsors say:
“In the event of your death, the funds in your beneficiary participant account cannot remain in the TSP. Your account will have to be distributed to the beneficiary(ies) … 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 transferred or rolled over into 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.”
Tammy Flanagan of the National Institute of Transition Planning, who specializes in working with retiring government employees, agrees that “this could create a tax burden.”
She recounts how one associate’s client inherited her husband’s TSP account, which had grown to $700,000. At the wife’s death, the account was payable to her two adult children with the understanding they could “stretch” it out for decades. Bad surprise! The TSP doesn’t allow this type of stretch, meaning the kids owed $200,000 in taxes on their inheritance.
“If the widow had rolled her husband’s TSP into an IRA upon his death, her children wouldn’t have to pay immediate taxes on $700,000. They would have been able to set up an inherited IRA and stretch the tax burden over their own life expectancy. A costly lesson learned.”
The takeaway: If you have a TSP account, this might make you very nervous. Everyone’s situation is different, but let’s talk about what’s right for you … before it’s too late.