Estate planning for federal employees: Maximize benefits and minimize taxes

Estate planning is a critical aspect of financial management, ensuring that your assets are distributed according to your wishes after you pass away. 

For federal employees, there are specific considerations to keep in mind to optimize benefits and minimize taxes for your beneficiaries, such as the importance of selecting beneficiaries for the Thrift Savings Plan, trusts versus wills, and tax implications of traditional versus Roth accounts, and how the Roth TSP can benefit your beneficiaries.

Selecting Beneficiaries for the TSP

When it comes to estate planning, selecting beneficiaries for your TSP is crucial. There’s a common misconception that, if you have a trust or will in place, you don’t need to worry about updating your beneficiaries, but having that stance could lead to a huge mistake. 

First, did you know that the beneficiaries on your TSP overrule a trust or will? 

Yep, let’s imagine you’ve gone through a divorce, and you’ve updated your will to remove your ex-spouse, but you forgot to update your beneficiaries on your TSP, and they’re still listed. 

In that scenario, your ex-spouse would still be entitled to that money if you were to pass away. It would then be up to your true beneficiaries to file a lawsuit and convince the court that they’re the ones rightfully entitled to the account. What a mess, right? 

The second reason it’s helpful to have beneficiaries is that they avoid probate. 

Having a beneficiary on your TSP, or any other account is the most seamless way to pass that money along. There’s no court process involved, and it’s kept completely private. It’s also much faster because no documents have to be interpreted.

So, o check your TSP beneficiaries and make sure they’re up to date. It’s an easy step and could save you and your loved ones a whole lot of hassle. 

Trust vs. Will

After setting your beneficiaries on any account that allows them, the most common decision in estate planning is whether to use a trust or a will to distribute your remaining assets. Both serve similar purposes but have distinct features and implications. 

A will is a legal document that outlines how your assets should be distributed after your death. It goes through the probate process, where a court oversees the distribution of assets according to your wishes. 

A trust, on the other hand, allows you to transfer assets to a trustee who manages them on behalf of your beneficiaries according to the terms you specify. Trusts can offer more flexibility, privacy, and control over the distribution of assets compared to wills. However, they may involve more complex legal processes and incur additional costs.

If you’re wondering which option is best for you,speak with an estate planning attorney. Many offer free initial consultations where you can learn more about which option makes the most sense for you, and compare the costs of each. 

Tax Implications of Traditional vs. Roth Accounts

Another critical consideration in estate planning is understanding the tax implications of your retirement accounts on your beneficiaries. 

Traditional retirement accounts, such as traditional TSP or traditional IRAs, are funded with pre-tax dollars, and withdrawals are taxed as ordinary income when distributed to beneficiaries. 

In contrast, Roth retirement accounts, including the Roth TSP and Roth IRAs, are funded with after-tax dollars, and qualified withdrawals are tax-free. This key difference can have significant implications for your beneficiaries' tax liabilities.

Consider this situation:

Let’s imagine that you have a $500,000 Traditional TSP balance that’s passed on to your child when you die. 

Under the current rules, they have 10 years to withdraw all of that money. And every distribution they take is added to their income for the year, and taxed as such. 

In other words, if they already make $100,000 a year, and they choose to take the distributions evenly over the next 10 years, that would bump their income (and tax liability) by at least 50% a year depending on market growth. It could also send them into higher tax brackets. 

Here’s the alternative:

Instead of a $500,000 Traditional TSP balance, you pass on a $500,000 Roth TSP to your child. 

They still have 10 years to distribute this money, but it’s tax-free to them for the whole 10 years, including any growth that happens over that time period. 

If they chose to leave it invested for those 10 years and it grew at 7% per year, they would have $983,575 tax-free. 

Pretty amazing right? 

Now, you can’t make all your decisions based on what’s best for your beneficiaries, but there are many instances where Roth contributions to the TSP or even conversions make sense for the contributor as well. 

Estate planning is a crucial aspect of financial planning for federal employees, ensuring that your assets are distributed according to your wishes and minimizing tax liabilities for your beneficiaries.

By carefully selecting beneficiaries for your TSP, understanding the differences between trusts and wills, and considering the tax implications of traditional versus Roth accounts, you can create a comprehensive estate plan that maximizes benefits and minimizes taxes for your loved ones. 

And, once again, it's essential to review and update your estate plan regularly to reflect changes in your financial situation and personal circumstances, ensuring that your wishes are accurately reflected, and your beneficiaries are well protected.

Austin Costello is a certified financial planner with Capital Financial Planners. If you’d like help deciding if Roth TSP contributions could be beneficial to you and your beneficiaries, you can register for a complimentary check up. For topics covered in even greater depth, check out our YouTube page.