Beneficiary Beware

You might want to keep this column attached to your TSP-3 beneficiary designation form.

My associate Joe Sullender, senior vice president for investments at Wells Fargo Advisors, recently became aware of a potential tax consequence of leaving your Thrift Savings Plan balance to your spouse in a beneficiary participant account. After reading what comes next, you might decide you need to consult a CPA, an estate planning attorney and a financial adviser if you inherit an IRA, 401(k) or TSP account.

If you are married, it is most likely you would want your spouse to inherit the balance of your TSP account. This would happen automatically through the standard order of precedence if there is no designated beneficiary on file, in which case the spouse is first in line to inherit the benefit. If your spouse's share is $200 or more, the TSP would maintain the beneficiary participant account and invest the entire share in the Government Securities Investment (G) Fund until your spouse makes a different investment choice or withdraws the money as a single payment, monthly payments, annuity or a combination of these options.

In the case of a non-spousal TSP participant account -- which is different from a TSP beneficiary participant account --  the beneficiary could establish an inherited IRA, in which the funds could be stretched over the life expectancy of the beneficiary and taxes would be due as payments are made.  In a recent personal finance column in Forbes, Deborah Jacobs notes there are some important things you need to know when inheriting an IRA. Jacobs outlines five rules for maximizing tax benefits for beneficiaries. A non-spousal beneficiary of a TSP participant account could take advantage of an inherited IRA, for example, to avoid the immediate taxation of the inherited account balance.

Be aware that these rules for establishing an inherited IRA do not apply when inheriting a spousal beneficiary participant account from the TSP.

Here is the language that will explain this further from the TSP Beneficiary Participant Booklet:

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. (Your beneficiaries will not owe taxes on Roth contributions, qualified earnings on Roth contributions, and tax-exempt contributions in the account.) For detailed information about the rules associated with death benefit payments, read the TSP tax notice “Important Information about Thrift Savings Plan Death Benefit Payments.” You may also want to consult a tax advisor.

In order for your beneficiaries to receive your account balance after your death, they (or their representatives) must complete Form TSP-17, Information Relating to Deceased Participant, and send it to the TSP along with a copy of the certified death certificate. Once the TSP processes this information and determines the beneficiaries for your account, we will contact them with additional information and instructions.

In a recent example, one of Sullender’s clients inherited her husband’s TSP balance in a beneficiary participant account. She decided to leave the money in the account, and upon her death the balance had grown to $700,000. Her account was then payable to her adult children in equal shares. Sullender advised the heirs to establish beneficiary IRA accounts so they could continue to defer taxes on the money and stretch the payments and taxes due over their life expectancy.

The problem arose when they attempted to transfer the balance to the beneficiary IRA. Under TSP regulations, transfers from a beneficiary participant account to an inherited IRA are not tax-deferred.  This means the surviving children owe about $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.