Death benefits paid from the accounts of deceased TSP participants are taxable income for federal income tax purposes in the year the payment is made. The person receiving the payment is responsible for paying the tax. They may be eligible to reduce the tax through the five-year or 10-year options, however, and may either transfer or roll over all or a part of the payment to an IRA.
Any death benefit payment not transferred directly to an IRA is subject to 20 percent federal income tax withholding. This cannot be waived (except that there is no mandatory withholding if the total death payment to the surviving spouse is less than $200). Additional amounts may be withheld by filing a Form W-4P with the TSP service office. Actual tax liability may turn out to be higher or lower than 20 percent, so your survivor might owe or get a refund on federal taxes for the year.
The early withdrawal penalty imposed under tax law does not apply to TSP death benefit payments.