Unexpected trouble on direct non-spouse rollovers

Transfers to non-spouse company retirement plan beneficiaries under the Pension Protection Act of 2006 are effective for 2007 (InvestmentNews, Jan. 29), but it turns out there may be problems and challenges in obtaining the intended benefits. Internal Revenue Service Notice 2007-7, issued Jan. 10, contains guidance for many provisions of the Pension Protection Act of 2006 and provides new and unexpected interpretations of the rules for non-spouse direct rollovers from employer plans to inherited IRAs. On Feb. 13, the IRS released a clarification of Notice 2007-7 regarding the rules for non-spouse company plan beneficiaries. Prior to the act, a non-spouse beneficiary, including a trust, was not able to move funds out of an employer plan other than by taking a taxable distribution — which would result in the loss of any extended payouts to the non-spouse plan beneficiary or trust beneficiary. If the plan allows a life expectancy payout, then there is no problem, and the beneficiary would not need the relief provision in the act. In that case, the beneficiary could take lifetime distributions from the employer plan. There also was no problem for a spouse beneficiary since a spouse can do a rollover and move the inherited plan funds to their own IRA. A non-spouse beneficiary could not do a rollover to an inherited IRA since that option was not available under prior law. Effective for distributions in 2007, the act provision gives a non-spouse beneficiary, including a qualifying trust, the ability to do a direct rollover (a trustee-to-trustee transfer) of inherited employer plan funds to an inherited IRA. The congressional intent of the new law was to give non-spouse beneficiaries the ability to stretch distributions over their own life expectancies after the funds were in the inherited IRA — the same as if they inherited an IRA rather than an employer plan. IRS Notice 2007-7 makes it clear that this provision applies to 401(k)s, 403(b)s and Section 457 plans. In addition, it clarifies that the IRA receiving the inherited plan benefits must be a properly titled inherited IRA that keeps the name of the decedent in the account title. The example it uses is: “Tom Smith as beneficiary of John Smith.” But then the notice gets a bit dizzying, and some of these rules may create a situation that would negate what Congress had intended. The notice says that a plan does not have to allow the non-spouse beneficiary a direct-transfer option — and that could diminish the intended effect. It does not say whether or not the plan must be amended to allow the direct- transfer option. If the plan does offer the direct-transfer option, it must do so on a non-discriminatory basis. The Feb. 13 clarification stated that the “special rule” introduced in IRS Notice 2007-7, Q & A, 17 (c)(2) is the exception to the general rule and trumps it. The general rule is that, even if the company plan funds are transferred directly from the company plan (assuming the plan allows it) to an inherited IRA, the plan distribution rules still apply to the IRA. The transfer to the inherited IRA does not break you free of the more restrictive plan rules. The special rule states that if the first-year required distribution is taken by the end of the year following the year of the plan participant’s death, then the general rule does not apply and the non-spouse plan beneficiary can stretch distributions over his own life expectancy. However, the IRS clarification also stated that in order for the special rule to allow the non-spouse beneficiary to break free of the plan rules, the plan funds must be directly transferred from the plan to the inherited IRA by the end of the year following the year of death. Every adviser must know this special rule, because it is the key to taking advantage of this provision. This rollover deadline means that the provision will not work for a pre-2006 death if the plan requires the five-year rule. This provision was not effective until 2007, so the first year a direct rollover to the inherited IRA could have possibly been done is 2007. And the direct rollover must be done by the end of the year following the year of death in order to break free of the plan rules. So the provision works only for plan participants dying in 2006 and later. The bottom line, then, is to have your clients do the IRA rollover rather than rely on the company retirement plan. Even if the plan says that it will allow the rollover, it always can change its policy in the future, so there still is no guarantee. 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.