Avoiding the TSP Tax Trap

A Thrift Savings Plan (TSP) is a tax-advantaged defined-contribution retirement plan available to U.S. federal government employees and members of the uniformed services. It functions similarly to 401(k) offered by private-sector employers. For many federal employees, their TSP will be the largest asset they leave for the next generation.

Upon death of a participant, Thrift Savings Plans provide a smooth transition to a surviving spouse. However, they can create significant limitations when assets pass to subsequent beneficiaries.

How the First Death and Inheritance Works:

When the TSP participant dies and the spouse is the primary beneficiary, the spouse receives a Beneficiary Participant Account (BPA). The surviving spouse can leave the assets in the BPA or rollover the funds to an IRA. Due to the smooth transition and ease of leaving the funds, many widows/widowers choose to leave the assets with TSP. The tax trap does not occur here – it occurs at the death of the surviving spouse if they decide to leave the assets in a TSP BPA account instead of rolling to an IRA.

The Tax Trap

If the surviving spouse dies while inherited assets remain in a TSP BPA account, the successor beneficiaries (typically children) will be subject to more restrictive distribution requirements and less favorable tax treatment than if the assets were rolled and held in an inherited IRA.

How Non-Spouse Inherited IRAs Work (exceptions apply see more at https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary):

• Non-spouse beneficiaries must empty the account by December 31 of the 10th year following the year of the original owner's death
• Annual RMD requirement: If the original owner died after starting their own RMDs, the non-spouse beneficiary must take annual RMDs in years 1 through 9, followed by a full withdrawal in year 10
• No annual RMD requirement: If the original owner died before starting RMDs, no annual withdrawals are mandated during years 1 through 9, provided the account is fully cleared by year 10

How TSP BPA Accounts Work:

• Successor beneficiaries generally cannot roll the BPA account to an inherited IRA to continue tax-deferred treatment and qualify for the 10-year liquidation rules stated above
• The TSP is legally required to distribute the entire remaining balance of the BPA directly to the successor beneficiaries as a one-time lump-sum payout
• The entire traditional (tax-deferred) balance of the BPA distributed is treated as ordinary taxable income to the successor beneficiary in a single tax year

Receiving a massive, involuntary lump sum all at once often spikes the beneficiary into the highest federal and state income tax brackets, significantly reducing the net inheritance.

Let’s run through an example:

1. Spouse leaves TSP in a BPA account after the first death

Robert has a TSP with a value of $1,000,000. He passes away in 2026, and his wife Sarah is the primary beneficiary.

Susan inherits a TSP BPA account with $1,000,000 and leaves it in the TSP BPA account. Sarah then lists her two kids, John and Emma, as the primary beneficiaries of her TSP BPA.

Susan dies in 2030, and the TSP BPA account has grown to $1,500,000.

In 2030, Emma and John each inherit $750,000. Both John and Emma must withdraw the entire account balance in 2030, adding $750,000 to their earned income. This will likely jump them into the highest tax bracket and thereby significantly decreasing their net inheritance.

2. Spouse receives TSP in BPA account and rolls it to an inherited IRA

Just as the example above, Robert dies with a $1,000,000 TSP.

Susan inherits his TSP BPA account with $1,000,000 and instead rolls it over to an IRA. Sarah again lists her two kids, John and Emma, as the primary beneficiaries of her IRA, which has again grown to $1,500,000.

John and Emma each receive Inherited IRAs which are tax deferred accounts that utilize the 10-year liquidation rule. They can strategically spread-out withdrawals over the 10-year time period to minimize taxes owed.

Big Takeaway

The reason most people are not aware of the TSP Tax trap is because this will not occur during the lifetime of the TSP holder or the surviving spouse. Understanding the trap at the second passing allows for the preservation of wealth for the next generation and decreasing the taxes sent to the IRS and Uncle Sam.

As always, please reach out to your advisor to explore your retirement plan rollover options.

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