The Pension Protection Act of 2006 included a provision, applicable to distributions after Dec. 31, 2006, permitting the rollover of plan assets of a deceased participant in a qualified plan to an IRA for a non-spousal beneficiary. Previously, the law had permitted such rollovers only if done by a participant during their lifetime or, if after death, only to a spousal IRA. Unfortunately, certain restrictions under the new law that are out of a taxpayer/participant's hands may actually prove to be the reason why rollovers by non-spousal beneficiaries will never catch on as a viable tax strategy.The non-spousal rollover provisions may be the latest example of a good rule that provides no incentive for change by those who control the infrastructure - in this case, the plan sponsors and administrators. Some practitioners are hoping for a technical or substantive correction eventually to fix the problem.
Retirement plans often pay out distributions to non-spousal beneficiaries in a lump sum soon after a plan participant's death, even though the minimum distribution rules would permit a longer payout period. According to a Senate Finance Committee report from an earlier version of the legislation, this law change was designed to give non-spousal beneficiaries more flexibility to extend the payout period, in accordance with the minimum distribution rules.
Many commentators were hailing this change as giving non-spousal beneficiaries a lot more discretion to elect payouts over their own life expectancy, rather than being forced to take a lump-sum payout or a payout within five years. The Internal Revenue Service has now released Notice 2007-7, focused on interpreting the new distribution rules under the PPA.
The IRS interpretation of the distribution rules applicable to rollovers by non-spousal beneficiaries has put a considerable damper on the initial euphoria associated with this law change.
THE PENSION PROTECTION ACT
The PPA allows assets of a deceased participant of an eligible retirement plan, including 401(k) plans, 403(b) plans and 457(b) plans, to be rolled over to an inherited IRA by a non-spousal beneficiary. Provided that the rollover was made in a direct trustee-to-trustee transfer to an inherited IRA - i.e., the IRA was still in the name of the deceased participant - the new law provides that:
* The transfer is treated as an eligible rollover distribution;
* The transferee IRA is treated as an inherited account; and,
* The required minimum distribution rules applicable where the participant dies before the entire interest is distributed apply to the transferee IRA (with the exception that the special rules for surviving spouse beneficiaries do not apply).
The legislation also provides that a trust that is maintained for the benefit of one or more designated beneficiaries must be treated as a trust-designated beneficiary for purposes of the rollover available to non-spousal beneficiaries, unless the IRS expressly provides otherwise. The IRS has not done so yet.
PLAN OPERATION
Qualified plans have not permitted rollovers to IRAs for non-spousal beneficiaries of deceased participants because the prior law did not permit them. Planners sometimes had the foresight to have the participant roll over plan assets to an IRA for the benefit of non-spousal beneficiaries before death. However, if this was not done before death, the law did not permit such rollovers.
Although plans could permit distributions from qualified plans to non-spousal beneficiaries in a variety of formats - lump sum, over a five-year period, or over a life expectancy - typically plans have been drafted to favor more rapid distribution of those assets. This has meant that most non-spousal beneficiaries of pre-death rolled-over accounts have found that the distributions were made to them within five years of death. There is no reason now to expect post-death rollovers by the non-spousal beneficiaries to fare much better simply now that the law allows plans to do so.
NOTICE 2007-7
Notice 2007-7 clarifies that the rollover IRA must be titled in a manner that reflects its inherited IRA status, such as "Tom Smith as beneficiary of John Smith." The notice also states that plans are not required to offer a direct rollover of a distribution to a non-spousal beneficiary. Therefore, since plans do not currently offer that option, plan amendments would have to be made to permit these rollovers. Plan administrators will therefore have to perceive some benefit to be derived from permitting these rollovers.
Notice 2007-7 also provides, however, that if the participant dies before their required beginning date for distributions, the required minimum distribution rules that would apply to the rollover, if the plan permits a rollover, would be the five-year rule or the life expectancy rule. Under the life expectancy rule, the distribution would be made over the longer of:
* The remaining life expectancy of the employee's designated beneficiary; or,
* The remaining life expectancy of the employee.
The required minimum distribution rules under the plan must still be applied to the distributions from the IRA. Thus, if the five-year rule would have applied to a plan distribution, the five-year rule applies for purposes of determining the required minimum distributions under the IRA. If the life expectancy rule applied to the non-spousal designated beneficiary under the plan, the required minimum distribution under the IRA again must be determined using the same applicable distribution period as would have been used under the plan if the direct rollover has not occurred.
The net result of this interpretation is that, even though a plan can now permit a direct rollover to an inherited IRA, the non-spousal beneficiary does not get any greater discretion as to the distribution period from the IRA than would have been permitted under the qualified plan under the terms existing at the date of death.
Plans that had no great incentive to permit distributions under the life expectancy rule might, if the plans are modified to permit direct rollovers to non-spousal IRAs, be more likely to permit distributions under the life expectancy rule, under the theory that the burden for the longer distributions would be borne by the IRA and not the plan. However, without any assurance that the assets will be rolled over into an IRA, plans may still be reluctant to make these changes and risk being exposed to the additional distribution burden if the rollover is not made.
In short, non-spousal beneficiaries may end up gaining very little from this law change if plans are not modified to permit the rollovers and are not also modified to permit distributions under the life expectancy rule. As was the case before the new law allowed post-death non-spousal rollovers, plans may continue to have little incentive to make these changes, thereby continuing to bar in practice what the new law has tried to encourage on paper.
PLANNING
Plan administrators will want to at least look at the possible merits of making plan modifications to take advantage of the new law. Practitioners who had hoped that the new law would open up additional planning opportunities will want to monitor plan amendments.
However, if amendments are not made in this area, practitioners will have to continue to focus on prior planning techniques, i.e., pre-death IRA rollovers. Practitioners will also want to continue to monitor further legislative developments in the area should Congress decide that Notice 2007-7 was not in accordance with legislative intent and try to correct the problem.
George G. Jones, JD, LL.M, is managing editor, and Mark A Luscombe, JD, LL.M, CPA, is principal analyst, at CCH, a Wolters Kluwer business.
