Dying with a Large TSP or IRA Balance

Client: If I died with a $425,000 balance in my traditional IRA, that would be good, right?
Advisor: Well…yes and no.
Client: Okay, but what if I also had $350,000 in my TSP? Wouldn’t that show I did a good job providing for my family?
Advisor: That would be a great job of saving. But here’s the thing: If you die with a large amount of traditional IRA or traditional TSP money, there can be some unintended (and unpleasant) consequences. 

What is this advisor talking about? Shouldn’t we all want a lot of money in our TSPs and IRAs? What “unintended consequences” is she talking about?

Unintended Consequence #1: Tax Brackets

Let’s say your actual income is $114,200, but you take the standard deduction of $29,200. That gives you a taxable income of around $85,000. And let’s say you’ve got a sizable balance in your TSP or traditional IRA (or both). You plan to leave that money to your spouse when you die. 

But suppose your spouse passes away first? In that case, you’d continue drawing your pension and either your Social Security benefits or your spouse’s–whichever is larger. And you’d still be taking distributions from your traditional TSP or traditional IRA. 

What if you, as a federal retiree, die first? Your spouse will get your pension–likely cut in half as a survivor benefit. And your spouse will get the larger of the two Social Security payments. Add whatever traditional distributions your spouse decides to take. For this example, let’s assume they still want an income of roughly $85,000. 

Here’s the problem. In both cases, the surviving spouse will have to file taxes as a single person. And that income level I just mentioned exceeds the maximum amount allowed in the 12% bracket. This effectively pushes the surviving spouse into the 22% tax bracket. Talk about a tax increase–that’s almost double!

Here we see one of the unintended consequences of dying with a large amount of money in a traditional IRA. In this example, any taxable distributions that push your income above $47,150 will mean paying taxes at a significantly higher rate.

Another widowed retiree, already in the 22% bracket, might be bumped up into the 24% bracket. It’s only a slight increase, but it is an increase, nevertheless.

The key takeaway here is that having a large amount of traditional IRA or TSP money can eventually lead to tax trouble. The death of a spouse moves you to the single tax bracket, which is not nearly as advantageous as the married filing jointly bracket. In short, depending on the bracket you’re in now–and the bracket you find yourself in later–you could be in for a small tax increase. Or, you could be facing a major shock!

That’s one unintended consequence of dying and leaving a large amount of traditional TSP or IRA money to your spouse: adverse tax ramifications. 

But that’s not all.

Unintended Consequence #2: Inheritances  

A second unpleasant consequence often occurs when retirees leave traditional TSP or IRA money to the next generation–to children. 

Anytime someone who is not a spouse inherits traditional IRA money, they are subject to the 10-year rule which says they have to take the entire balance out by the 10th year. 

What about passing on traditional TSP money? Suppose you die and leave your TSP account to your spouse…and your spouse keeps that money in the TSP as a beneficiary participant account…and then dies and leaves that money to children (or grandchildren). That scenario can also lead to some huge unintended and undesirable tax consequences. 

TSP rules stipulate that the next beneficiary cannot keep the account at the TSP. They are required to take a full distribution, all in one year. That’s just how the TSP rules work. 

You can see how this might result in huge tax consequences. An adult child, inheriting $200,000 of TSP money in this way–and forced to take it all in one year–could suddenly find themselves in the 35% tax bracket. That could mean $70,000–over a third–of their inheritance going straight to Uncle Sam!

This consequence for your heirs can be avoided by you not holding the money in the TSP. As a TSP account owner, you are allowed to move your money into an IRA. Or, if you die and you leave your TSP to your spouse, they can move the money out of that TSP to take advantage of the more lenient tax rules that govern IRAs. 

Here’s another little twist to consider. When the second beneficiary–let’s say your children–inherits your traditional IRA, they’re suddenly subject to the 10-year rule. Okay, but suppose your children aren’t so wise with their money. They don’t want to take that money gradually over a decade. They want to get it right away and spend it fast. 

This isn’t far-fetched. The Soto Law Group published an article about how quickly people tend to spend their inheritance. In their words, “Though you may like to think of them spreading it out for years, really making use of what you’ve left behind, the reality is that most people usually spend it in a year or less.” 

How much money are we typically talking about? This chart from Inheritance Advanced shows that the average inheritance in the U.S. is around $50,000. 

That figure makes me feel better when I hear about heirs spending their inheritance in one year. (It’s the kids who blow through $500,000 or more in one year who worry me.)

Sadly, that’s all too common. In a piece for MarketWatch, Elizabeth O’Brien noted that one of every three Americans who gets an inheritance squanders it.

What does all this mean for you? If you have a child who is likely to spend any inheritance they get ASAP, just remember that any distributions they take from your traditional account will be 100% taxable at whatever tax bracket that child is in. They’ll be paying higher taxes than if you’d done more careful planning. 

Okay, what about the child who’s so disciplined with their money, they don’t touch it for years? Remember, the 10-year rule says that by the tenth year, they must withdraw every dollar from that traditional IRA. 

And all that money is taxable–meaning, if an heir postpones distributions until the tenth year and then does one, lump-sum distribution, it can result in a tax liability every bit as large as the child who spent all the money in the first year!  

This is why most financial planners typically advise: If you have 10 years to get that traditional money out, then take one-tenth of the balance each year. There are always exceptions, of course. Every situation is different, and you should always discuss such matters with your CPA and/or financial advisor. But the basic idea is that by doing it this way, you spread out the tax liability evenly. 

To recap: When you die with traditional money, especially lots of traditional money, you can inadvertently push your spouse or heirs into a higher tax bracket by keeping all that money in a traditional account. 

This is why it’s so important to develop a smart tax strategy and implement that plan. For example, you may want to begin shifting money from your traditional TSP or IRA to a tax-free Roth account because of the unintended consequences of dying with a large traditional balance. 

Again, these negative consequences can be avoided–or greatly minimized–through careful planning.  That way, the money you’ve worked so hard to earn, save, and invest, will go where you want it to go. You–and your heirs–may be able to save tens of thousands in taxes. 

For the record, a TSP won’t allow you to do this sort of planning. You cannot shift money from traditional to Roth inside of your TSP. 

If you haven’t yet done this sort of planning…or if you aren’t sure of all your options and still have questions, visit our website, christycapital.com. There–in the top right corner of the page–you’ll see a green TALK WITH AN ADVISOR button. Click it, and leave us a short message. We’ll be in touch right away. 

At Christy Capital Management, we help our clients create and implement sound retirement strategies. We’d love to help you too.