CFP® Professional Katelyn Murray breaks down which financial accounts are the best for inheritances… and which types aren’t.

Katelyn Murray, CFP®, ChFEBC®, FBS®, CFT-1™, ECA -

When it comes to financial planning for federal government employees and retirees, considering the types of accounts to inherit is a crucial aspect often overlooked. The impact of inheriting certain accounts can significantly affect the financial wellbeing of beneficiaries, whether they are spouses or non-spousal heirs. In this guide, we'll explore the best and worst types of accounts to inherit for federal employees and retirees.

Worst Types of Accounts to Inherit

Health Savings Account (HSA)

By far, the worst type of account for a non-spouse beneficiary to inherit is a Health Savings Account (HSA). HSAs are often applauded -- and rightly so-- for offering triple-tax benefits to their owners. Feds can put money into an HSA on a pre-tax basis, invested funds can then grow tax-free, and any distributions from an HSA for qualified health expenses are 100% tax-free. If utilized correctly, then, one may never have to pay taxes on contributions and growth in an HSA. In this way, the HSA functions as a sort of financial planning unicorn when compared to the usual dichotomy that forces investors to choose between taking an upfront tax deduction and paying income tax on future distributions from a Traditional IRA OR paying taxes upfront in favor of future tax-free distributions in the case of a Roth IRA. It's not hard to see the benefits provided by HSAs to their original owners; however, this "dream" account can turn into a nightmare for non-spouse beneficiaries inheriting the funds.

It's important that we make the distinction between spousal beneficiaries and non-spousal beneficiaries in this case. If a spouse inherits an HSA, the spouse becomes the new account owner, and the transfer of ownership is not taxable. The funds can stay invested and growing tax-free, and distributions from the HSA will continue to be tax-free, provided that they are used for qualified medical expenses. No RMDs are required either. When a spouse inherits an HSA, it is as though they were always the owner of said account.

Check out our webinars for federal employees!

For a non-spouse beneficiary, though, it's a very different story. In the event that an HSA passes to a non-spouse beneficiary, the HSA immediately ceases to be an HSA, is fully liquidated, and is distributed to the non-spouse beneficiary. The fair market value of the account assets as of the date of the account holder’s death is includible in the non-spouse beneficiary’s taxable income for the current tax year as well, likely resulting in a large portion of the account's assets going to cover the taxes due on the mandated lump sum distribution. This problem can be particularly devastating if 1) your beneficiary is already in a pretty high tax bracket and/or 2) if you have a rather large HSA balance that could bump your beneficiary into a higher tax bracket if/when the HSA is paid out to them a lump sum. (If the beneficiary is the deceased account holder’s estate, this amount is includible in the decedent’s gross income for the year in which the death occurred.) For this reason, we recommend immediately beginning to use your HSA in retirement for any and all qualified medical expenses -- ideally, you want to spend this money down before you pass away so that your beneficiaries don't have to deal with this tax bomb.

Out of State Real Estate Property

Alright, I know we titled this article “The Best (and Worst) Types of Accounts to Inherit, but any discussion about inheritance vehicles would be incomplete without mentioning out-of-state real estate property. These are the beloved vacation homes in the Outer Banks, at the mountains, etc. which hold so many family memories. Although these properties can carry a lot of sentimental value, the reality is that inheriting out-of-state real estate without proper estate planning can lead to probate complications and liquidity issues for beneficiaries. Without a trust in place, out-of-state properties are subject to probate, causing delays and additional expenses for heirs. Setting up a trust and retitling properties can help Feds avoid the challenge of the probate process, but this importantly does not address the liquidity issue of beneficiaries having to sell the property in order to cash out.

TSP Funds (Thrift Savings Plan)

Remember that the TSP is the largest employer retirement plan in the world, and, as such, service isn't very personalized or fast. That said, the process of a spousal beneficiary inheriting a TSP is fairly straightforward. When a spouse inherits a TSP, the funds are simply rolled into an inherited TSP account for the benefit of the spouse, and they can continue to use the funds as though they were the original account owner. No RMDs are required.

The problem arises when the surviving spouse later passes away and the TSP funds pass to that person's beneficiary. In most cases, these are the children of the original account owner and the now-deceased spouse. These "second-generation" beneficiaries are NOT offered the option to roll the inherited funds into an inherited TSP account. Instead, the TSP balance is fully liquidated, and the beneficiary is forced to take a lump sum distribution, which, in the case of pre-tax or Traditional TSP funds, means that the distribution is fully taxable at the beneficiary's income tax rate (inclusive of the TSP distribution). From a tax perspective, this can result in substantial tax liabilities for beneficiaries.

Traditional IRAs

Traditional IRAs are not the worst possible inheritance vehicles, but they aren’t terribly tax-efficient when inherited by non-spouse beneficiaries. As is the case with TSPs, spouses can inherit with no RMDs imposed. It is important to remember that every dollar distributed from a Traditional IRA is taxed at your beneficiary's income tax rate; however, and that your death may likely result in your spouse being pushed into a higher tax bracket due to the different in income brackets between Married Filing Jointly filers and Single filers. This could mean that there's actually less net funds available for your spouse in your Traditional IRA than you think.

The picture gets even less rosy for non-spouse beneficiaries. These folks are subject to the "10-year rule" imposed by The Secure Act of 2020, further revised by The Secure Act 2.0 of 2022. According to this rule, not only are non-spousal beneficiaries forced to take RMDs from Inherited IRA balances starting the year after the original account owner's death, they also must fully distribute all assets in the Inherited IRA, regardless of size, within 10 years from the date of the original owner's death. For beneficiaries who are already in a high tax bracket due to their own income, these RMDs and the mandate to drain the account within 10 years can result in them being kicked up into a higher tax bracket, with the end result being that more of the inherited funds end up going to cover taxes owed. In cases where folks have multiple children in different tax brackets, you may consider leaving pre-tax assets like Traditional IRAs to those in a lower tax bracket, and tax-advantaged accounts like Roth IRAs and brokerage accounts to those in a higher tax bracket, keeping in mind that you'll need to account for the taxes owed on pre-tax accounts if the goal is to have assets distributed evenly between kids.

Best Types of Accounts to Inherit

Roth IRAs

Roth IRAs stand out as the best type of account to inherit due to their tax-free growth and distributions. Although the IRS still requires Required Minimum Distributions (RMDs) to be taken from Roth IRAs inherited by non-spouse beneficiaries and the account must still be zeroed out within 10 years of the original owner's date of death, beneficiaries need not worry about any impact to their taxable income, since these funds are tax-free.

Brokerage Accounts

While not as advantageous as Roth IRAs, brokerage accounts are still attractive inheritance vehicles inherit due to the automatic set up in cost basis as of the original owner's date of death that is provided under current tax law. If the original owner's cost basis (i.e., the amount of total lifetime principal they saved to the IRA) is $600,000, and the IRA is valued at $1,100,000 on the date of their death, the beneficiary who inherits the account will receive a "step-up" in cost basis to the $1,100,000 value. This means that, in theory, the beneficiary could then fully liquidate the account and have no tax implications (not that that would be advisable in most cases). Brokerage accounts also do not carry any RMD requirements or imposed timeline for total liquidation as is the case with retirement accounts.

Federal government employees and retirees should carefully consider the implications of inheriting different types of accounts and take these issues into consideration when doing their estate planning. While some accounts offer tax-efficient benefits for beneficiaries, others may lead to significant tax liabilities and complexities. Proper estate planning and strategic beneficiary designations can help mitigate these challenges, ensuring a smoother inheritance process for your loved ones.

**Written by Katelyn Murray, CFP®, ChFEBC®, FBS®, CFT-1™, ECA. The information has been obtained from sources considered reliable but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Katelyn Murray and not necessarily those of RJFS or Raymond James. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy suggested. Every investor’s situation is unique and you should consider your investment goals, risk tolerance, and time horizon before making any investment or financial decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. **

****The Thrift Savings Plan (TSP) is a retirement savings and investment plan for Federal employees and members of the uniformed services, including the Ready Reserve. The TSP is a defined contribution plan, meaning that the retirement income you receive from your TSP account will depend on how much you (and your agency or service, if you're eligible to receive agency or service contributions) put into your account during your working years and the earnings accumulated over that time. The Federal Retirement Thrift Investment Board (FRTIB) administers the TSP.****

About the Author:

Katelyn Murray is a CERTIFIED FINANCIAL PLANNER™ (CFP®) professional, a Certified Financial Behavior Specialist® (FBS®), a Certified Financial Therapist™ (CFT-1™), and an Equity Compensation Associate (ECA). A lifelong student, she also holds a Masters Degree in Business Administration as well as a graduate certificate in financial psychology and behavioral finance.

Katelyn has been helping Feds and contractors build the retirement of their dreams for almost a decade. Her unique approach merges financial psychology with traditional wealth management expertise to create an integrated financial planning approach that helps clients make the most of the one resource they can’t get more of: time.

Katelyn has appeared as a speaker on The W Pulse podcast, The Liquidity Event podcast, and has led multiple break-out sessions at national industry conferences. Here at STWS, she writes on financial planning and behavioral finance topics. When she’s not writing for our blog, you can find her serving as a financial advisor and Relationship Team Lead for our STWS clients.