Unexpected complications with IRS rules on direct rollovers for non-spouse plan beneficiaries

By Ed Slott

Transfers to non-spouse company retirement plan beneficiaries under the Pension Protection Act of 2006 are effective for 2007, but it turns out there may be problems and challenges in obtaining the intended benefits.

On Jan. 10, 2007, the IRS issued Notice 2007-7, which contains guidance for many provisions of the Pension Protection Act of 2006 (PPA 2006) and provides new and unexpected interpretations of the rules for non-spouse direct rollovers from employer plans to inherited IRAs. On Feb. 13, 2007, the IRS released a clarification of Notice 2007-7 regarding the rules for non-spouse company plan beneficiaries.

The original problem

Before PPA 2006, a non-spouse beneficiary, including a trust, was not able to move funds out of an employer plan other than by taking a taxable distribution, which would result in the loss of any extended payouts to the non-spouse plan beneficiary or trust beneficiary.

If the plan allows a life expectancy payout, there would be no problem and the beneficiary would not need the relief provision in PPA 2006. In that case, the beneficiary could take lifetime distributions from the employer plan. There also would be no problem for a spouse beneficiary since a spouse can do a rollover and move the inherited plan funds to his or her own IRA. A non-spouse beneficiary could not do a rollover to an inherited IRA since that option was not available under prior law.

The solution created by PPA 2006

Effective for distributions in 2007, the new provision in the law gives a non-spouse beneficiary, including a qualifying trust, the ability to do a direct rollover (a trustee-to-trustee transfer) of inherited employer plan funds to an inherited IRA. The Congressional intent of the new law was to give the non-spouse beneficiaries the ability to stretch distributions over his or her own life expectancy after the funds were in the inherited IRA, the same as if he or she had inherited an IRA rather than an employer plan.

IRS Notice 2007-7 makes it clear that this provision applies to 401(k)s, 403(b)s and Section 457 plans. In addition, the notice clarifies that the IRA receiving the inherited plan benefits must be a properly titled inherited IRA, which keeps the name of the decedent in the account title. The example they use is, “Tom Smith as beneficiary of John Smith.”

But then the notice gets a bit dizzying and some of these rules may create a situation that would negate what Congress had intended. According to the notice, a plan does not have to allow the non-spouse beneficiary a direct transfer option, and that could diminish the intended impact. The notice did not say whether or not the plan must be amended to allow the direct transfer option. If the plan does offer the direct transfer option, it must do so on a non-discriminatory basis.

The ‘special rule’ trumps the general rule

The Feb. 13, 2007 IRS clarification stated that the "special rule" introduced in IRS Notice 2007-7, Q&A, 17 (c)(2), is the exception to the general rule in Q&A 19. It trumps the general rule in Q&A 19.

The general rule (from Q&A 19) is that even if the company plan funds are transferred directly from the company plan (assuming the plan allows it) to an inherited IRA, the plan distribution rules still apply to the IRA. The transfer to the inherited IRA does not break you free of the more restrictive plan rules.

The special rule states that if the first-year required distribution is taken by the end of the year following the year of the plan participant’s death, the general rule does not apply and the non-spouse plan beneficiary can stretch distributions over his own life expectancy.

However, the IRS clarification also states that in order for the special rule to allow the non-spouse beneficiary to break free of the plan rules, the plan funds must be directly transferred from the plan to the inherited IRA by the end of the year following the year of death.

Every advisor must know this special rule because it is the key to taking advantage of this provision.

No relief for pre-2006 deaths

This rollover deadline means the provision will not work for a pre-2006 death if the plan requires the five-year rule. This provision was not effective until 2007, so the first year a direct rollover to the inherited IRA could have possibly been done is 2007. And, the direct rollover must be done by the end of the year following the year of death in order to break free of the plan rules. So, the provision will only work for plan participants dying in 2006 and later.

Rollover and RMD timing rules

The IRS clarification of Notice 2007-7 provided more information on the timing of the direct rollover. Although we know the direct rollover has to be done no later than the end of the year following the year of death, the beneficiary’s first required minimum distribution (RMD) must be taken and cannot be rolled over. The question then is, "When should the direct rollover from the plan to the inherited IRA occur?"

The IRS clarification provides this example:

"For example, if a participant in a § 401(k) plan dies in 2007 before his required beginning date and under the plan the five-year rule applies for determining required minimum distributions, the participant’s nonspouse designated beneficiary is permitted to roll over the deceased participant’s entire account balance into an IRA in 2007 and take required minimum distributions from the IRA under the life expectancy rule. If the account balance is rolled over in 2008, the amount eligible for rollover must be reduced by the amount of the required minimum distribution for 2008, determined using the life expectancy rule. After 2008, the nonspouse designated beneficiary may still roll over funds from the § 401(k) plan, but would have to take required minimum distributions from the IRA under the five-year rule. No amount can be rolled over after 2011."

This tells us that the direct rollover can be done either in the year of death or in the year after death. If it is done anytime after the year after death, the plan rules will apply to the funds in the inherited IRA. If the five-year rule applies in the plan, the inherited IRA funds must also be withdrawn under the five-year rule. The stretch IRA will be lost and the tax deferral will end with the end of the five-year period.

To avoid this, every advisor must make sure that if the plan does allow the direct rollover, it is done by the end of the year following the year of death, and make sure that the beneficiary’s first RMD is also taken by the end of that year.

If the direct rollover is done in the year of death, the entire plan amount can be rolled over to the inherited IRA and the beneficiary’s first RMD (for the year after death) must be taken from the inherited IRA.

If the direct rollover is done in the year after death, the first RMD must be withdrawn from the plan and cannot be rolled over to the IRA. Everything but the first-year RMD can be rolled over.

But what if the plan says it will make only one distribution from the plan and will not provide a separate check for the first RMD?

There may be a solution for this problem. If the plan refuses to issue a separate check for the required minimum distribution, roll the entire plan balance into the IRA (as a trustee-to-trustee transfer, of course) and remove the RMD (plus earnings) from the IRA as an excess contribution.

On the tax return, the beneficiary will show a gross distribution from the plan for the entire amount and the taxable amount will only be for the excess amount withdrawn (which will be the RMD amount plus or minus any earnings). That should be OK as long as the RMD (the excess) is withdrawn by the end of the year following the year of death.

Do the IRA rollover

Your clients need a sure thing and the beneficiaries don’t need any headaches after a client dies, only to find out that the non-spouse rollover provision won’t be available to them. The bottom line, then, is to have your clients do the IRA rollover rather than rely on the company retirement plan. Even if the plan says it will allow the rollover, it can always change the policy in the future, so there is still no guarantee.

Ed Slott, CPA, of in Rockville Centre, NY, is a nationally recognized IRA distribution expert, professional speaker and author of several IRA books, including Your Complete Retirement Planning Road Map (Ballantine Books; 2007) and Ed Slott’s IRA Advisor, a monthly IRA newsletter. Ed Slott has also created “The IRA Leadership Program” and “Ed Slott’s Elite IRA Advisor Group,” developed specifically to help CPAs, financial advisors, financial advisor firms and insurance companies become recognized leaders in the IRA marketplace. Visit his Web site at www.irahelp.com.