IRS Disappoints With Guidance for Rollovers of Inherited Company Plans

About six months ago we informed you about one of the most important provisions of the Retirement Protection Act of 2006 (“the Act”) — the ability of a non-spouse beneficiary to “roll-over” assets from a 401-K Plan or other qualified plan of the deceased employee to an inherited IRA for the non-spouse beneficiary. This is a significant development because most 401-K and other qualified plans have default provisions that require that where the beneficiary is other than a spouse, the account must be distributed in a lump sum, often within one to five years after the death of the employee. Guidance from the IRS was needed to clarify how certain portions of the Act would be implemented. That guidance was recently issued in IRS Notice 2007-7 (“the Notice”). You can get a copy of Notice 2007-7 at the following internet link:

http://www.irs.gov/pub/irs-drop/n-07-07.pdf

Unfortunately, the guidance the IRS has issued clarifies only a few issues, raises many new questions and appears not to comply with the intent of Congress in passing the Act.

First, the Notice states that a plan will not be required to offer a direct rollover for non-spouse beneficiaries. This provision, in and of itself, will likely kill the anticipated benefits of the Act, as it is unlikely that most employers will make available a benefit that they don’t have to, especially if it is a benefit that does not directly benefit their employees. For those employers that do offer non-spousal rollovers, it is also not clear from the Notice whether the Employer’s plans will have to be amended.

The Service provides at Q &A-11 and Q&A-13 of the Notice that a non-spousal rollover must be accomplished as a direct trustee-to-trustee transfer in order to qualify, and that any distribution received by a non-spousal beneficiary will be treated as a distribution and not eligible for rollover.

The IRS requires that the transfer must be to a properly titled inherited IRA, meaning that the title would include the name of the deceased individual as well as that of the beneficiary. An example would be: John Doe (deceased) IRA fbo Mary Doe. The beneficiary could also be a trust, as long as the trust qualifies as a designated beneficiary trust under Treasury Reg. § 1.401(a)(9)-4, Q&A-5 and Q&A-6.

The Notice indicates that any amount that is not a required distribution may be eligible for a trustee-to-trustee transfer (direct rollover) to an inherited IRA. How the required minimum distribution (“RMD”) is calculated varies upon whether the employee died before or after his or her required beginning date (“RBD”).

If the employee dies before RBD, the beneficiary’s RMD options are the five year rule or taking distributions over the beneficiary’s life expectancy. Under Treas. Reg. 1.401(a)(9)-3 Q&A-4(b), the custodian has the option of specifying in the plan document that the default rule is the five year rule. In this case the IRS indicates that the non-spouse beneficiary may take a distribution consistent with the life expectancy method, if a distribution is taken in the year after the year of death of the employee.

If the employee dies after RBD, a RMD is required in the year the employee died. This RMD is based on the life expectancy of the employee. It must be distributed to the non-spouse beneficiary – it is not eligible for direct rollover. RMD options that may be available to the beneficiary are: (1) the five year rule, (2) the deceased employee’s life expectancy based on his or her age at date of death, or (3) the life expectancy of the non-spouse beneficiary as of the year after death. Unfortunately, here the IRS departs from what was clearly the intent of Congress. The IRS states that once transferred to the Inherited IRA, the RMDs to be taken must be a continuation of whatever rule was in effect under the employee plan. If the plan required the five year rule, the non-spousal beneficiary must take distributions over the remainder of the five year period. This is especially devastating news to many non-spouse beneficiaries who deferred taking distributions last year under the five year rule in the hope they could transfer the retirement funds to an inherited IRA in 2007 and begin taking distributions using the life expectancy method. It is even more devastating news for non-spousal beneficiaries where the employee died in 2005 or earlier. In these cases, the beneficiary would be required to take any RMDs that would have been required under the plan before transferring the retirement assets to the inherited IRA. If the plan required a five year payout and the employee died in 2003, the beneficiary would be required to distribute one-fifth of the plan balance for 2004, one-fifth for 2005, and one-fifth for 2006, for a total of three-fifths of the plan balance before he or she could transferring the remaining funds to the inherited IRA. The balance in the inherited IRA would then have to be distributed as required under plan – meaning the total funds would have to be distributed in the next two years. Under this interpretation, the non-spousal beneficiary will in many circumstances get none of the benefits promised by Congress in the Pension Protection Act.

Hopefully, the IRS will make corrections to Notice 2007-7 to bring it into conformity with what was intended by Congress in the Pension Protection Act. Many individuals and organizations have already expressed their displeasure to Congress and the IRS. For those non-spouse beneficiaries who are provided with no relief based on the IRS’ guidance in the Notice, we recommend you sit tight for another few months to see what develops as the result of these communications. You may want to lend your voice to this cause and also contact your Congressman and the IRS and let them know the guidance offered by the IRS in Notice 2007-7 does not conform with the intent of Congress.

For those non-spouse beneficiaries who will benefit from the guidance as it is currently given, we recommend you use the following checklist in order to avoid any costly mistakes:

1. Verify with the custodian whether the plan will allow direct rollovers by a non-spouse beneficiary.
2. In the event the deceased employee had not taken all of his or her RMD for the year of death, distribute this RMD to the beneficiary before engaging in any trustee-to-trustee transfers.
3. In the year following date of death, distribute the applicable RMD, as described above, to the non-spouse beneficiary. This should be done before engaging in the trustee-to-trustee transfer.
4. Transfer the remaining retirement assets, via trustee-to-trustee (do not take personal possession of any of these funds) to an inherited IRA you have established. Make sure that the inherited IRA is properly titled using the deceased employee’s name, and not the name of the non-spouse beneficiary.
5. In order to remain in compliance with Treas. Reg. 1.401(a)(9)-4, in the event the non-spouse beneficiary is a trust, be certain to provide a copy of the trust document to the IRA custodian by no later than October 31st of the year after the death of the employee.

Estate planning and income tax planning for retirement assets is not easy. The rules are often arcane and the consequences of a mis-step can be VERY expensive. Please contact us to schedule an appointment with one of our attorneys about this very important matter.