Roth TSP - Federal News Network

Listen Live

Roth TSP, IRS, retirement, tax, 401(k) — Forex diagrams and stock market rising lines with numbers

Commentary

The Roth TSP advantage: A closer look at tax-free inheritances

First, it may be helpful to explore if Roth contributions to your TSP or Roth conversions outside of your TSP are helpful to you during your lifetime.

TSP

For TSP participants, more changes from SECURE 2.0 are coming soon

Federal Report

Is a Roth IRA one of your New Years resolutions? If not, why not?

Federal Report

2020 taxes, your TSP, mortgage and health premiums

Federal Report

Want your tax break now or later? Or both?

Your Turn

Strategies to grow your retirement nest egg

Federal Report

A million-dollar annuity: Can you afford it?

FILE - In this Friday, June 24, 2016, file photo, people walk by the New York Stock Exchange. Global stocks mostly rose Friday, July 1, as authorities stepped in to ease the uncertainty surrounding the British vote to leave the European Union. Investors flocked to equities in the face of narrowing choices for investments amid low or negative interest rates on many bonds. (AP Photo/Richard Drew, File)

Federal Report

Roth TSP option: What’s not to love?

Mike Causey

Mike Causey

Feds like TSP's Roth option

Imagine this scenario (or maybe you’ve already lived it): A loved one passes away and you are the beneficiary of their estate. Maybe you inherit a house. A car. Maybe some investment accounts.

Because our tax-law is relatively friendly on inherited assets, many of the items that you inherit - including the house and any non-retirement investment account - receive a step-up in basis. This means, according to the IRS, it’s as if you purchased them on the date that your relative passed away and you don’t have to pay taxes on any of the gain that happened during their lifetime. Pretty nice, right?

But if those rules only apply to non-retirement assets, how do retirement investment accounts get considered?

Since the passing of the SECURE Act in 2019, here are the basic rules for inherited retirement accounts for owners that passed after Dec. 31st 2019:
<ul>
<li>If you are the spouse of the original owner, you may move the account into your name and treat it as your own, following the <a href="https://www.capitalfinancialplanners.com/blog/understanding-required-minimum-distributions-rmds">required minimum distribution</a> rules based on your own age.</li>
<li>If you are not the spouse of the original owner you have 10 years to distribute the entire balance of the account.</li>
</ul>
Now this is where the tax considerations come into play.
<h2>Inheriting traditional retirement accounts:</h2>
If the retirement account was “traditional” or “pre-tax” (like the traditional TSP) all of the distributions are taxable to the beneficiary.

In other words, you are required to distribute and pay tax on the entire account balance within 10-years. And the distributions count as income, so the more money the recipient makes, the higher the tax rate on the withdrawals.

For a sizable TSP, 401(k) or traditional IRA, that could be a hefty tax bill each year - especially if the recipient is already a high-income earner.
<h2>Inheriting Roth retirement accounts:</h2>
Because taxes on traditional retirement accounts have been tax-deferred, the IRS wants to make sure they get their hands on those tax dollars eventually. So if they don’t get them from the original owner, they get them from the beneficiary.

Taxes on Roth accounts, on the other hand, have already been paid by the original owner when they funded the account.

Because of that, if you inherit a Roth retirement account, you still have to fully distribute the account within a 10-year period, but the distributions are tax-free for that entire ten years!

Now let’s be honest with each other for a moment.

If you were to inherit a large traditional retirement account and had to pay taxes on the withdrawals, would you be upset about it? Probably not. Paying taxes isn’t the end of the world, especially considering you’re only paying more taxes because you have more money.

That being said, if you knew there was a way that some or all of it could have been tax-free, would you be slightly disappointed? Probably.

Let’s look at an example scenario where recipient 1 receives a $500,000 traditional IRA and recipient 2 receives a $500,000 Roth IRA.

In both scenarios, we’ll assume that the account grows at 5% per year.
<h2>Recipient 1: Traditional retirement plan</h2>
<img class="alignleft wp-image-4931332 size-full" src="https://federalnewsnetwork.com/wp-content/uploads/2024/03/Traditional-retirement-plan.jpg" alt="Roth TSP, retirement" width="624" height="173" />

 

 

 

 

 

In this scenario, the recipient decides to distribute the account in equal portions over the 10-year period to make sure they don’t spike their income in any given year.

They’re able to take a $60k distribution each year, which comes out to $46k after taxes (assuming they’re in the 24% tax bracket).

In the end, they’re able to receive a net after-tax total of $460,000.
<h2>Recipient 2: Roth Retirement Plan</h2>
<img class="alignleft wp-image-4931345 size-full" src="https://federalnewsnetwork.com/wp-content/uploads/2024/03/Roth-Retirement-Plan.jpg" alt="Roth TSP, retirement" width="624" height="217" />

 

 

 

 

 

 

In this scenario, the strategy changes.

Because a Roth retirement plan can continue to grow for 10 years without any tax liability, the beneficiary decides to wait until the very last year to withdraw the funds.

Since the entire balance is able to grow over that time period, recipient 2 is actually able to withdraw $815,000 from the account tax free.

That’s a difference of $355,000.

And 5% is a relatively conservative growth rate. Imagine if the growth was higher.
<h2>Planning with the end in mind</h2>
So what should you do, now that you know it’s so much nicer to inherit a Roth retirement account instead of a traditional account?

First, it may be helpful to explore if Roth contributions to your TSP or Roth conversions outside of your TSP are helpful to you during your lifetime. Because of our current “friendly” income tax brackets, there are many scenarios where making Roth contributions now can save an individual tens of thousands of dollars over your lifetime alone.

We don’t have enough space here to take a deep dive into the individual benefits of Roth contributions and conversions, but we wrote <a href="https://www.capitalfinancialplanners.com/blog/roth-conversions-when-do-they-make-sense">another article</a> that does just that.

If it’s mutually beneficial, and choosing Roth benefits you and your loved ones, then your answer becomes pretty easy.

There are, however, situations where Roth contributions and conversions may not be beneficial to you in your lifetime. Then the question becomes what would the contributions or conversions cost me, and am I willing to pay that cost to ultimately provide a larger benefit to my heirs?

In our work with federal employees, we run into retirees all the time who are fully supported by their pension and social security, and have no need to touch their TSP. In this scenario, some may say “well, since I’m not going to need it, and I have an opportunity to pay the taxes at a lower rate than my beneficiaries will, I’ll go ahead and convert this to Roth as a ‘gift’ to my heirs.”

Of course, this decision is unique to each individual and there’s no right or wrong answer, but for those that want to be mindful of how they pass down money to the next generation, it’s a question that’s worth considering.

It’s also worth noting that this article only explores accounts being passed to individuals - not charities, trusts or any other entities. If passing funds to one of those other entities is in your plans, the strategies mentioned above could change.

<a href="https://www.capitalfinancialplanners.com/financial-planning-team/austin-costello"><em>Austin Costello</em></a><em> is a certified financial planner with Capital Financial Planners. </em>

Your Turn

Is the Roth TSP right for you?

Capitol

All News

Kim Weaver: Two TSP bills are an 'exciting development'

Mike Causey

So, you wanna be a millionaire? Is 2015 the year of your Roth TSP?

Pay & Benefits

Survey: Retirees want greater flexiblity in TSP accounts

Federal Acquisition, GSA

Mike Causey

Shutdown, furlough, what next?

Federal Drive

25 years later, FERS still 'excellent' plan for feds

All News

TSP mulls mutual-fund option

Defense

Roth TSP now open to active-duty servicemembers

All News

Coming soon to YouTube -- Videos about TSP accounts

All News

DoD civilians, others can now make Roth TSP contributions

All News

TSP funds not enjoying springtime in Europe

Mike Causey

Roth TSP is NOT a Roth IRA!

All News

In Depth - May 4

Federal Drive

5 things feds should know about Roth TSP