Thursday, February 1, 2007

Rollover of Inherited 401(k) or 403(b) Plans -Spousal versus Non-Spousal

If your spouse dies you can roll your inherited 401(k) plan to an IRA in your name. It essentially becomes your own IRA. Non-Spousal IRAs have always been handled differently.

Until recently, employer plans required non-spousal inheritors to take a lump sum distribuiton or the five year distribution causing a big income tax liability. You were not allowed to roll the plan assets into an IRA and stretch out the payments. You had to take the distribution and pay the tax.

The pension protection law passed in late 2006 was suppose to fix this problem. The law was intended to give non-spousal inheritors the ability to stretch the payments out.

The rules were very specific and required a direct rollover. The direct transfer would go to a properly titled inherited IRA, which means that the inherited IRA must be maintained in the name of the deceased plan participant: “Dad IRA (deceased, Feb. 10, 2007) FBO, daughter.” If the inheritor accepted a check in their name and not in the name of the inherited IRA then the distribution would be fully taxable. If the rollover went into a normal IRA with the inheritors name then the distribution would be taxable. The rules were very specific.

Apparently the IRS didn't get the message and in a special Guidance Notice they are not giving non-spousal inheritors of 401(k) plans a break. In other words, you should roll your previous employer 401(k) balances over to an IRA and avoid this whole mess for your inheritors.

Below is the press release from Ed Slott's website that spells out this complication in greater detail.

What a bust!
The Financial Pragmatist
Libby Mihalka


January 16, 2007
Update on Non-Spouse Beneficiary Transfers from Employer Plans
IRS Issues Guidance in Notice 2007-7
On January 10, 2007 the IRS issued Notice 2007-7 which contained some unexpected surprises.
IRS has issued notice 2007-7 which answers some questions on non-spouse rollovers from employer plans to inherited IRAs but leaves many more.

Previously a non-spouse beneficiary was not able to move funds out of an employer plan other than by taking a taxable distribution. Many employer plans did not offer a life expectancy distribution option to non-spouse beneficiaries. Distributions in many cases were limited to lump sum distributions or distributions over 5 years.

The new provision in the law gives a non-spouse beneficiary the ability to do a direct rollover of inherited employer plan funds to an inherited IRA. The Congressional intent of the new law was to give the non-spouse beneficiary the ability to stretch distributions over their own life expectancies after the funds were in the inherited IRA.

Well, it looks like IRS did not get the message. Notice 2007-7 does not give the beneficiary any breaks. First of all, it says that a plan does not have to allow the non-spouse beneficiary a direct transfer option.

Then, the Notice goes on to say that after the employer funds are moved to an inherited IRA, the distribution rules that applied under the plan will continue to apply to the inherited IRA. A-19. says “Thus, if the employee dies before his or her required beginning date and the 5-year rule in § 401(a)(9)(B)(ii) applied to the non-spouse designated beneficiary under the plan making the direct rollover, the 5-year rule applies for purposes of determining required minimum distributions under the IRA. If the life expectancy rule applied to the non-spouse designated beneficiary under the plan, the required minimum distribution under the IRA must be determined using the same applicable distribution period as would have been used under the plan if the direct rollover had not occurred. Similarly, if the employee dies on or after his or her required beginning date, the required minimum distribution under the IRA for any year after the year of death must be determined using the same applicable distribution period as would have been used under the plan if the direct rollover had not occurred.” (emphasis added)

There are no transitional rules since none are needed. There is nothing to transition. The distributions to the non-spouse beneficiary will be exactly as they would have been made under the plan, except they are coming from an IRA. This interpretation by IRS completely nullifies the intent of Congress in the new law. In other words, the non-spouse rollover provision in the Pension Protection Act of 2006 doesn’t work. The problem still exists. This is yet another reason to roll funds from your company 401(k) or other plan to an IRA when you get the chance, so that your non-spouse beneficiaries, such as your children and grandchildren will be able to stretch distributions over their lifetimes. This law was supposed to make that happen even if they inherited from your company plan, but that is not the case based on the latest official ruling.

What were they thinking?

This will need to be corrected by IRS, but until then, that is the official IRS position.

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Look for more details in “Ed Slott’s IRA Advisor”
By Ed Slott © 2007
Ed Slott’s IRA Advisor

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