Non-spouse rollover muddle lingers

If you’re looking for a muddle, consider the status of the rule on non-spouse direct rollovers from company plans under the Pension Protection Act of 2006.

Here’s the background: The PPA included a provision that would permit non-spouse plan beneficiaries to do direct transfers from a qualified plan to a properly titled inherited IRA and take stretch distributions over the beneficiaries’ lifetimes instead of being subject to the harsh payout rules of most company plans. The provision became effective in 2007, but the confusion began when the Internal Revenue Service re-leased Notice 2007-7 in January 2007 stating that the provision was not mandatory.

Do company plans have to allow this or not? Is the provision mandatory or voluntary? It’s hard to tell.

Apparently, the non-spouse rollover provision will not be mandatory for 2008 until either the IRS or Congress issues official guidance otherwise. Last year, Congress realized it had to do something 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 would be mandatory, beginning in 2008. But there was no official announcement on this, other than a posting on the IRS website, which is still there.

Unfortunately, the corrected provision was not in the Technical Corrections Act of 2007, the bill that was passed and signed by the president, and it may not end up in the bill currently pending in Congress. A later posting on the IRS website is silent on the issue. It appears that the provision has gone away, like a bad dream. Barring any future changes, IRS Notice 2007-7 is still the authority, meaning that the provision remains voluntary, even though we know this was not the intent of Congress.

This is bad news for non-spouse beneficiaries such as children, grandchildren, friends and unmarried partners. If the plan does not allow the non-spouse the direct rollover, these beneficiaries most likely will be forced to withdraw the inherited plan balances in five years or less after death and will lose the ability to extend the tax deferral over their lifetimes through a stretch IRA.

For those non-spouses that can use the provision (where the plan allows it), the transfer must be a direct, trustee-to-trustee transfer that must be done by the end of the year following the year of death.

In addition, the beneficiary must take his or her first required minimum distribution from the inherited IRA by that same deadline — the end of the year following the year of death. If the transfer is not done within the time limits, the beneficiary still will be able to do the transfer, but under the plan’s usually less favorable payout option (probably five years), not stretched over the beneficiary’s lifetime.

Caution: When funds are turned over to a beneficiary and not handled through a trustee-to-trustee transfer, the beneficiary cannot correct the error by transferring the funds to a properly titled inherited IRA. Instead, the entire amount of the distribution will be taxable, ending 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. An example of proper account titling for an inherited IRA would be Bob Jones, deceased (Nov. 28, 2007), IRA f/b/o Jane Jones, where Bob Jones was the dad and 401(k) participant and Jane Jones is his daughter, the beneficiary of his 401(k) plan.

As you can see, these provisions can change and it is clear that the plans have a better lobby in Congress than the people. The plans obviously do not want this provision to be made mandatory. This tells you that beneficiaries will not do well if company plan funds are left in the plan. What was originally intended to be expanded protection for those who need the money most — the children of plan participants — has now been taken away, again!

The best move for your clients is still generally for them to do the IRA rollover when they can, unless one of the lump-sum distribution tax breaks like net unrealized appreciation or 10-year averaging might work out better. If the IRA rollover was right before, 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 or the IRS or Congress.

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.

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