By: Investor Solutions, Inc.
Leave it to the Feds to rain on our parade. A few months ago, I excitedly wrote about how the 2006 Pension Reform Act had liberated the retirement plan distribution rules for non-spouse beneficiaries. The celebration, it seems, is short lived.
Previous to recent legislation, only spouses had the ability to rollover retirement plan assets (i.e. 401k, profit sharing, 403b, etc) into their own IRA or an Inherited IRA. Surviving children or domestic partners were left out of the tax deferral deal; instead distributions in many cases were limited to lump sum distributions or distributions over five years. This, of course, had potentially huge tax ramifications for the non-spouse beneficiaries and the ability to “stretch” the money was non-existent.
Passed late summer 2006, The Pension Reform Act created an allowance for a child or other non-spouse beneficiary to roll funds directly from the company retirement plan to an Inherited IRA, giving that beneficiary the ability to stretch the distributions (thereby extending the taxation) over their lifetime. Congress then instructed the IRS to issue rules of guidance under which a trust “for the benefit of” designated beneficiaries could initiate these rollovers after the participant’s death.
The Birth of IRS Interference
January 7th, 2007 rolled around with the unveiling of the IRS rules under Notice 2007-7, including provisions for “look through trusts”. There are certain technical requirements for the “look through” provision to be valid:
- Trust must be valid under state law
- Copy of trust must be given to trustee
- Trust must become irrevocable at your death
- All beneficiaries must be identifiable
- The beneficiaries are individuals (not organizations)
The notice confirmed the IRS position that the rules for look-through-trusts would also apply to the new distribution allowance, thereby qualifying a trust named as beneficiary for the Inherited IRA. This is good.
Now here’s the bad. Within the same notice, the IRS also stated that the non-spouse beneficiary must use the “Special Rule” to get the stretch IRA, but ONLY if:
- the plan allows it (the plan does not have to), and
- the direct rollover occurs by the end of the year following the year of death, and
- the first required distribution is taken by the beneficiary by the end of the year following the year of death.
So, although the intent of the Congressional legislation was to extend life expectancy payouts for non spouse heirs, the IRS had made it clear that this will not automatically take place. If the employer (plan sponsor) chooses to disallow such a transfer, it can-regardless of what the law allows. Quite frankly, if corporations have the ability to trump federal law, I wonder why Congress even bothered with it?
The second piece of bad news stemming from this Notice has to do with the “Special Rule”. If the plan does allow for distributions to a non-spouse, but the distribution does not take place by the end of the year following the decedent’s death, then the beneficiary loses the ability to stretch that IRA over his life.
If you are stuck in an employer plan that does not offer the special distribution provision, there’s not much you can do about it, short of igniting a revolution at work. If the employer does not currently allow for non-spouse death distributions, it’s certainly worth asking if they would consider amending their documents to allow for this. Honestly, many employers and HR divisions may not even be aware that this option exists. So ask
What I would advise, however, is for anyone who has already retired or has otherwise terminated employment to consider rolling over their retirement assets to a rollover IRA. Leaving your assets with an employer plan may severely limit your ability to make decisions within that account, especially as they pertain to investment choices and beneficiary distributions. As a final reminder, these rules are only available to persons who die after 12/31/06.