IRS Causes Non Spousal Rollover Confusion

The Internal Revenue Service (“IRS”) is at it again regarding causing confusion over a new benefit that is very favorable to individuals that are owners of qualified retirement plans.  The IRS recently issued a notice discussed, below, that clarified who can be a beneficiary of a non spousal rollover.  Unfortunately, it also has caused confusion over the payout of the rollover.

Prior to the Pension Protection of 2006, if you are married and wish your spouse to be the beneficiary of the plan, the lump sum form of benefit does not present a problem. That's because, if your spouse survives, he or she can roll the lump sum over to her own IRA.   But if you are not married, or do not wish your spouse to be the direct beneficiary, the beneficiary has no choice but to take the lump sum. The result is an acceleration of the tax on all the income in the plan. 

Section 402(c)(11), enacted as part of the Pension Protection of 2006, was intended to put non-spousal beneficiaries of qualified retirement plans on a level playing field with beneficiaries of IRAs with respect to distribution options.  A provision of this kind, dubbed by some the "universal rollover," had been sought by the estate planning community for some time and its enactment came as a welcome surprise.  Now, however, the IRS in Notice 2007-7 appears to have construed the section in a way which would negate the very purpose it was intended to serve.

THE PAYOUT PROBLEM: The situation addressed by Code section 402(c)(11) has become a familiar one:  You are a participant in a 401(k) plan or other form of profit sharing plan. The plan has restricted payout options for the death benefit. As is the case with many such plans, the only form of death benefit offered is a lump sum payment.   The fact that, under applicable law (Code section 401(a)(9)), the beneficiary could take out payment over his or her life expectancy is of no help because there is no way to get the benefit from the plan to an IRA, from which payout over life expectancy could be made.

CHANGES MADE BY CODE SECTION 402(c) (11): Section 402(c)(11) changes that it provides that a non-spouse beneficiary of a qualified retirement plan, including governmental 457 plans and sec. 403(b) arrangements, may make a "direct trustee-to-trustee transfer" (also known as a direct rollover) of the death benefit to an IRA "established for the purpose of receiving the distribution on behalf of an individual who is a designated beneficiary." 

The transfer will not be treated as a taxable distribution, so immediate realization of income is avoided.  The transferee IRA will be treated as an inherited IRA, subject to the distribution rules applicable to beneficiaries (sec. 401(a)(9)(B)). 

 In this respect, therefore, the result differs from the spousal rollover, under which the spouse, at his or her option, may elect to treat the IRA as his or her own and thus take out over the rules applicable to IRA owners (sec. 401(a)(9)(A)).   This places the beneficiary in the same position he or she would have been in had the benefit originally been in an IRA rather than in a qualified plan.

EFFECTIVE DATE:  Section 402(c)(11) is effective "for distributions after 12/31/2006," regardless of the date of death of the plan participant.  Hence, it could be used for plan distributions with respect to participants who died prior to the 12/31/06 effective date.

DESIGNATED BENEFICIARY REQUIRED:  If the beneficiary of the plan is such as not to give rise to a designated beneficiary (for instance the participant's estate or a trust without a designated beneficiary is named) the direct rollover to an IRA will not be available!  This is because, by its terms, Section 402(c)(11) requires a "designated" beneficiary. 

TRUST NAMED AS BENEFICIARY:  The Notice contains -  in Q&A-16 -  the requisite "rule" that a trust named as beneficiary may make a direct rollover  "provided the beneficiaries of the trust meet the requirements to be designated beneficiaries within the meaning of sec. 401(a)(9)(E)." 

IF PLAN OFFERS DIRECT ROLLOVERS FOR NON-SPOUSE BENEFICIARIES, IT MUST DO SO IN NON-DISCRIMINATORY MANNER:  The Notice also states that a plan is not required to offer a direct rollover for non-spouse beneficiaries. But it provides that if the plan offers this option to less than all participants, it must do so on a nondiscriminatory basis.  Q&A-14. 

The question of whether a plan amendment is required is not addressed.

THE NEW PAYOUT PROBLEMS:  Q&A-17 and -18 of the Notice deal with the determination of the required minimum distribution ("RMD") for the plan prior to the direct rollover, which the Notice assumes cannot be the subject of a direct rollover.

The statute itself is not clear on this, and with a plan which pays out only in a lump sum, it would be a great deal easier if any RMD for the year of the direct rollover could be taken after the rollover rather than before. (Of course, the point is moot if the direct rollover occurs in the year of the participant's death, except for the need to pay out any RMD not taken by the participant in that year.) 

Be that as it may, the Notice takes the contrary position, which in and of itself is not unreasonable.  However, it is at this point that one first realizes that something is badly wrong.

What one would expect to see is that the RMD is what it would have been if the benefit had been held initially in an IRA and a life expectancy form of payout was being used.  If previously the beneficiary had been taking out over the five-year rule (presumably because it was the only option offered by the plan), one could say that RMDs for all years for which distributions had not been taken (because until the fifth year there is no RMD) would have to be taken prior to the rollover, and some position would have to be taken as to the applicability of the 50% underdistribution penalty to any such distributions. 

If a life expectancy rule was being used, whether the participant died before or after the required beginning date, the result is what one would expect – one determines the RMD from the plan in accordance with the applicable life expectancy.  (Of course, if the life expectancy form of payout was available under the plan, in the usual case there would be no particular reason to do a direct rollover.)   If the five year rule was being used, however, A-17(b) states that the entire balance in the plan may be rolled over through the fourth year "(but, as described in Q&A-19 of this notice, the 5-year rule must also apply to the IRA to which the rollover contribution is made)."

IRS NEEDS TO TRY AGAIN - SOON!  The IRS needs to make it clear that the non-spouse beneficiary of a plan which offers only a lump sum form of payout, the very beneficiary for whom the statute was intended, may make a direct rollover and take a life expectancy form of payout from the transferee IRA.