Tax Article - New Year Brings New Rollover Option for Nonspouse Qualified Plan Distributions

Nonspousal IRA beneficiaries can’t treat an inherited IRA as their own. However, the IRS has long agreed that they can make trustee-to-trustee transfers to another IRA if the new IRA is in the name of the decedent for the benefit of the beneficiary (see, for example, Rev. Rul. 78-406 and PLR 9737030). This gives beneficiaries the option of stretching out the IRA distributions over their lifetime if they want to maximize the tax deferral and minimize the tax impact in any one year.

Beneficiaries of qualified retirement plan accounts [such as a profit sharing or 401(k) plan balance] haven’t historically had the same option unless they were the plan participant’s spouse. Because qualified plans typically force a decedent’s account balance to be distributed in either a lump sum or within a five-year period, this left a nonspousal beneficiary of such an account with no option but to recognize all of the income in a single year or over a compressed period of time. As a result, the benefit of the tax deferral was lost and, depending on the size of the distribution, much of it might be taxed in a high tax bracket. Surviving spouses didn’t have this problem because they could always roll over the distribution into an IRA.

Thanks to the Pension Protection Act of 2006, however, inheriting a qualified retirement plan account from someone other than a spouse became significantly more tax friendly at the start of this year. In recently issued Notice 2007-7, the IRS provides guidance on how to interpret this new law.

Let’s look at the new rules and how the IRS believes they should be applied—which, surprisingly and not without controversy, is less favorable then you might expect given the history of the law change.

New Rules for Nonspouse Beneficiaries

Under the post-2006 rules, the benefits of a beneficiary other than a surviving spouse may be transferred directly to an IRA. The IRA is treated as an inherited IRA of the nonspouse beneficiary. Thus, for example, required minimum distributions (RMDs) from the inherited IRA are subject to the RMD rules applicable to beneficiaries. This provision applies to amounts payable to a beneficiary under a qualified retirement plan, government Section 457 plan, or a tax-sheltered annuity [IRC Sec. 402(c)(11)(A)].

Example 1:

Sam Adams, who is unmarried, is age 60 and a participant in Acme’s 401(k) plan at the time of his death in 2006. Acme’s plan specifies that a decedent’s 401(k) balance will be paid in a lump sum to the appropriate beneficiary. The beneficiary of Sam’s plan balance is his niece, Sarah Stephens, who is age 38. She receives a lump sum pay-out from the plan in 2006.

Although the plan distribution Sarah receives isn’t subject to the 10% early distribution penalty [IRC Sec. 72(t) (1)(A)(ii)], it is subject to income tax. Depending on its size and Sarah’s other income, the distribution may be taxed at a federal rate as high as 35%, plus state taxes.

Example 2:

Assume the same facts as in Example 1, except that Sarah waits until 2007 to take the lump sum. Here, Sarah will have the option (assuming the Acme plan allows it) of telling the Acme plan administrator to do a trustee-to-trustee transfer to an IRA that Sarah establishes for the purpose of receiving the distribution. (According to IRS Notice 2007-7, Q-13, the IRA must be established in a manner that identifies it as an IRA with respect to a deceased individual and also identifies the deceased individual and the beneficiary, for example, “Sarah Stephens as beneficiary of Sam Adams’ IRA.”) Because this IRA is treated as an inherited IRA, the RMDs for it must be calculated separately from RMDs for any other IRAs of which Sarah is the beneficiary. In addition, this IRA can’t accept any other contributions or be rolled over into an IRA solely in Sarah’s name.

If Sam’s 401(k) balance (which we’ll assume to be $100,000) is paid to Sarah as a lump sum in 2007 and is taxed at a blended rate of, say 25%, this will leave Sarah with $75,000. Investing this amount at an 8% pre-tax (6% post-tax) rate will result in a $240,000 nest egg after 20 years.

What if instead, Sarah asks (and the Acme plan allows) for a trustee-to-trustee transfer of the $100,000 (less the 2007 RMD calculated using her life expectancy) to a new inherited IRA? Based on Sarah’s age of 39 in the year after Sam’s death, if she only takes the RMD based on her life-expectancy each year from the IRA (assuming this is allowable under the rules we’ll discuss shortly), she should have about $125,000 outside the IRA and $258,000 inside it after 20 years. (This assumes that she is taxed on the distribution and her other income at a 25% rate, and earns 6% on the after-tax distribution proceeds outside of the IRA and 8% on the funds inside the IRA.) Even if 35% of the IRA were lost to taxes at the end of 20 years, the other 65% ($168,000) plus the $125,000 outside the IRA still totals about $53,000 more than the immediate lump sum option.Note that for this purpose, Sarah’s life expectancy is found in the Single-Life Table at Reg. 1.401(a)(9)-9, Q-1 [Reg. 1.401(a)(9)-5, Q-6].

Notice 2007-7 Obstacles
This is all well and good, but Notice 2007-7 has thrown in some obstacles that you’ll have to jump over before reaping these rewards. Fortunately, most of these are surmountable with a little advance planning. Unfortunately, some clients may simply be out of luck.

1. Hurdle 1—Only Trustee-to-Trustee Transfers Qualify but The Plan Doesn’t Have to Provide this Option.

To qualify for these favorable new rules, the client must arrange a trustee-to-trustee transfer of the funds—they cannot receive the cash and then make a rollover. So, rule one is no cash. Unfortunately, according to Notice 2007-7, plans are not required to provide a trustee-to-trustee transfer option. If the plan requires that the beneficiary be issued a check, is your client out of luck? Possibly, but you might try requesting a check payable to the new inherited IRA trustee that could then be given by the beneficiary. Although not sanctioned by Notice 2007-7, this could be a way to work around this problem. Unfortunately, only time will tell for sure.

2. Hurdle 2—The Plan’s RMD Rules Must Apply to the Inherited IRA.

This is not a problem when plan participants die after their required beginning date (i.e., April 1 of the year after they reach age 70½ or, if later, retire). In this case, RMDs must generally be made over a period not longer than the beneficiaries’ life expectancies starting the year after death. There really aren’t any other options. However, having to use the plan’s RMD rule can be problematic when plan participants die before their required beginning date. In this case, some plans allow lifetime distributions (which is good) while others require the unfavorable five-year rule (which is bad). Fortunately, there’s a window of opportunity during which a beneficiary otherwise stuck with five-year rule (because the plan requires it) can switch to the lifetime rule, but timing is critical here.

Observation:

Given the legislative history of new IRC Sec. 402(c)(11), which indicates it was intended to be a favorable provision, it’s questionable whether these IRS positions jive with Congressional intent. However, unless the IRS backs down from its stance, we may see qualified plans take a wait-and-see attitude toward adopting the new provision and, even when they do, beneficiaries may receive less benefit from the new provision than intended.

Overcoming the Five-year Rule Problem

As discussed, when a participant dies before the required beginning date, post-death RMDs are calculated under one of two methods: (1) five-year rule or (2) life expectancy rule. The five-year rule requires the entire account to be distributed by December 31 of the year in which the fifth anniversary of the owner’s death occurs. The life expectancy rule allows the account to be distributed over a period no longer than the beneficiary’s life expectancy beginning by December 31 of the year after the participant’s death. The life expectancy method is preferable in that it maximizes the potential tax deferral period as illustrated in Example 2.

Here’s the rub—the plan may dictate which rule applies or it may allow participants to elect whichever method they want. If the life expectancy method is required or elected, no problem—it can be continued in the inherited IRA. (The transfer can be done at any time as long as RMDs are taken each year beginning the year after the participant’s death from the plan or IRA, depending on where the funds are at the time. Only the amount in excess of the year’s RMD can be rolled over.)

The potential problem arises when the five-year rule is required under the plan. This is because Notice 2007-7 says that the plan’s RMD rule (in this case the five-year rule) must apply to the inherited IRA. Fortunately, Notice 2007-7 also provides an exception to this rule—the participant can effectively elect the life expectancy rule by completing the transfer from the plan to the IRA before the end of the year following the year of the participant’s death. If this is done, the life expectancy rule applies to the inherited IRA. (See Notice 2007-7, Q-17.)

Example 3:

Assume the facts in Example 1, except Sarah does not take a distribution in 2006 (the year of Sam’s death). Also, assume that the 401(k) plan requires that Sarah use the five-year rule to calculate her RMDs. According to Notice 2007-7, Sarah can transfer her entire inherited 401(k) account to an IRA any time before 1/1/11. (None of the account is eligible for roll over during 2011, the fifth year after Sam’s death, because the entire account is treated as an RMD for that year.) However, the five-year rule will also apply to the IRA. Therefore, the entire IRA balance will also have to be distributed to her by 12/31/11. (Maximum deferral period is five years—not great.)
However, if, before the end of 2007 (the year after Sam’s death), Sarah transfers the entire balance in the 401(k) plan (less her RMD for 2007 calculated using the life-expectancy rule), she will have effectively elected the life-expectancy rule. In this case, RMDs from the IRA can be calculated using the life-expectancy rule. (Maximum deferral period is now about 44 years based on a Sarah’s life expectancy—much better.)

Bottom Line

If the participant died in 2006 and the plan requires the five-year rule, the beneficiary can prevent this rule from applying to the inherited IRA by taking a cash distribution from the plan at least equal to the RMD calculated under the life expectancy rule and then transferring the remaining funds in the account to the IRA before the end of 2007. If the participant died in 2007 and the plan requires the five-year rule, the beneficiary can prevent this rule from applying to the inherited IRA by (1) completing the transfer of the entire 401(k) account to the IRA by the end of 2007 or (2) waiting until 2008 and then taking a cash distribution from the plan at least equal to the 2008 RMD calculated under the life expectancy rule and transferring the remaining funds in the account to the IRA before the end of 2008. Ditto for participants dying in 2008 if they complete the rollover by end 2008 or take the 2009 life expectancy RMD and transfer the remaining funds by the end of 2009, and so on.

Unfortunately, Notice 2007-7 doesn’t provide any transitional rules. If the participant died before 2006 and the plan required the five-year rule, the beneficiary is apparently out of luck—the five-year rule will apply to the IRA. Thus, for participants dying in 2003, 2004, or 2005, the entire balance will have be distributed by the end of 2008, 2009, or 2010, respectively.

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The decision as to whether to roll over an inherited retirement account to an IRA when allowed by the plan is really a no-brainer decision, as there is no downside to doing so. At best, the client may earn thousands of dollars on the taxes deferred from taking minimum distributions over his lifetime. At worst, the client can change his mind, pull everything out of the IRA, and end up back at square one. The only mistake as we see it is not doing the trustee-to-trustee rollover for starters. Why? Because once the client receives the cash, the deal is done—no rollover is possible. For the rollover to be tax free, the beneficiary should:

Arrange for a trustee-to-trustee rollover of amounts exceeding the year’s RMD from the plan directly to a new IRA established for this purpose. The beneficiary cannot receive the cash and then roll it over. (A check, payable to the new inherited IRA trustee that could then be given by the beneficiary to this trustee may work. However, why take a chance? It’s better for the funds to go straight from trustee-to-trustee if possible.) Also, the funds should not be transferred to an existing IRA, nor should any additional contributions be made to this new IRA.

Withdraw at least the RMD from the inherited IRA every year until the money is gone. More can be taken if needed or desired.

You’ll also want to make sure that the beneficiary doesn’t get stuck with the five-year rule. If the participant died before the required beginning date, the beneficiary should be instructed to:

Complete the transfer to the IRA in the year of death if at all possible and in no case later the end of the year following the year of the participant’s death.

Take at least the RMD calculated under the life expectancy rule from the IRA beginning the year after the participant’s death and continuing each successive year until the funds are gone. However, if the transfer completed in the year after the year of death, that year’s RMD should be taken from the plan before (or at the time) the transfer is made.

The new provision, for plans that allow it, can be a significant benefit for nonspouse heirs who want to save for their own retirement (or who simply want to delay the tax as long as possible). Because the rollover can only be a trustee-to-trustee transfer and it may need to be completed by the end of the year following the year of the participant’s death to maximize the possible tax deferral period, it’s important for clients who want to take advantage of the option to know the rules.

Only the amount is excess of the rollover year’s RMD can be transferred to an IRA. We’ll discuss the RMD rules for the year of death next.

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