A reversal of policy on rollovers

The Pension Protection Act of 2006 included a provision that would permit non-spouse plan beneficiaries to transfer assets directly from the plan to a properly titled inherited individual retirement account. Also permitted was the ability of non-spouse beneficiaries to take stretch distributions over their lifetimes instead of being subject to the harsh payout rules of most company plans. This provision became effective in 2007.

The purpose of the provision was to allow non-spouse plan beneficiaries the same ability to stretch post-death distributions over their lifetimes as if they inherited from IRAs. That was the plan, but the provision lost its steam when the Internal Revenue Service released Notice 2007-7 in January stating that the provision was not mandatory for plans.

This created confusion and controversy, and was contrary to what Congress intended. Congress realized this and proposed a technical correction to the law stating that employer plans must allow the non-spouse direct rollover to an inherited IRA.

In light of the pending Congressional technical correction, the IRS reversed its position and said that the non-spouse rollover provision will be mandatory beginning in 2008. There has been no official announcement on this yet, other than a posting on the IRS website (see irs.gov/retirement/article/0,,id=173372,00.html).

This change in the IRS position is especially helpful to employees who are still working and who have had no chance to do an IRA rollover. It will avoid a quick payout to their non-spouse beneficiaries such as their children or grandchildren.

It is also a big benefit to unmarried partners who inherit qualified plans and cannot be treated as spouse beneficiaries under the tax law. Without this change, an unmarried partner who inherited from their partner would not be able to do a spousal rollover, even though they might be legally married under state law. For tax purposes, they are non-spouses.

In dealing with non-spouse rollovers, the current timing and transfer rules still apply. The transfer must be a direct transfer (a trustee-to-trustee transfer), and it must be done by the end of the year following the year of death. In addition, the beneficiary must take their first required minimum distribution from the inherited IRA by that same deadline (by the end of the year following the year of death). If the transfer is not done within the time guidelines, the beneficiary will still be able to do the transfer but will be stuck with the usually less favorable payout option of the plan (probably the five-year rule) instead of getting to stretch the payments over their lifetime.

If funds are turned over to a beneficiary (that is, not handled as a direct transfer), the beneficiary cannot correct the error and transfer those funds to a properly titled inherited IRA. Instead, the entire amount of the distribution will be taxable — bringing an end to the tax shelter.

The direct transfer must be to a properly titled inherited IRA. The name of the deceased plan participant must be in the title of the inherited IRA. One example of proper account titling for an inherited IRA is “Bob Jones, deceased (Nov. 28, 2007), IRA f/b/o Jane Jones,” where the dad was the 401(k) participant, and his daughter is the beneficiary of his plan.

A trust can be a non-spouse beneficiary, too. In order to take advantage of this non-spouse transfer provision, the trust must qualify as a “see through” or “look through” trust under the IRS requirements. The trust also must be valid under state law, it must be irrevocable after death, the trust beneficiaries must be identifiable, and the trust documentation or the trust itself must be delivered to the plan administrator by Oct. 31 of the year following the year of death — plus all trust beneficiaries must be individuals. A trust that does not qualify cannot do a direct transfer to an inherited IRA.

This change in IRS position is not a reason to leave money in an employer plan. If an IRA rollover was the right move before this policy change, it is still the right move now. The last thing you want is for your new clients, the beneficiaries, to be at the mercy of some plan. As you can see, plan provisions can change.

Most times, the best move is still to do the IRA rollover when possible, unless one of the lump-sum- distribution tax breaks such as net unrealized appreciation or 10-year averaging might work out better for your client.

Ed Slott, a certified public accountant in Rockville Centre, N.Y., has created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.