Rollover Confusion: Uncertainty Over Nonspouse Rollovers From Retirement Plans
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June 1, 2008
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Rollover confusion: Uncertainty over nonspouse rollovers from retirement plans
Ed Slott
It's now back up in the air whether employers must allow nonspouse rollovers from company retirement plans in 2008.
On Dec. 29, 2007, President Bush signed The Tax Technical Corrections Act of 2007 into law. But, mysteriously, it doesn't include the provision making the nonspouse rollover mandatory for 2008.
In January 2008, the IRS released Publication 590 on IRAs, noting that the provision is effective, with no mention of whether it's mandatory or optional. It's enough to give an HR pro a headache.
So what's the rule on nonspouse rollovers from company plans under the Pension Protection Act of 2006? Do company plans have to allow this or not? It now appears that the nonspouse rollover provision will not be mandatory for 2008 until the IRS or Congress issues guidance otherwise. As a result, we must assume that the provision remains optional.
The PPA included a provision that would permit nonspouse plan beneficiaries to make direct transfers from a company plan to a properly titled, inherited IRA. The beneficiaries could then take stretch distributions over their lifetime, instead of being subject to the harsh payout rules of most company plans. This provision became effective in 2007. But the provision lost its steam when the IRS released a notice in January 2007, which stated that the provision was not mandatory for retirement plans.
This created confusion and was contrary to what Congress intended. Congress proposed a technical correction to the law that stated that employer plans must allow the nonspouse direct rollover to an inherited IRA. The IRS reversed its position and said the nonspouse rollover provision would be mandatory beginning in 2008. This provision, however, was not in the bill that was passed and signed by President Bush at the end of 2007, and it may not end up in the bill currently pending in Congress. A later posting on the IRS Web site is silent on the issue. It appears that the provision has gone away, like a bad dream. Barring any future changes, the provision remains voluntary.
This is bad news for nonspouse beneficiaries, such as children, grandchildren, friends and unmarried couples . If a company retirement plan doesn't allow a direct rollover, these beneficiaries will most likely be forced to withdraw the inherited plan balances in five years or less after the owner's death. They won't be able to extend the tax deferral over their lifetime through a stretch IRA. If a company does allow nonspouse transfers, the transfers must be direct (trustee to trustee) and must be done by the end of the year following the year of death. In addition, beneficiaries must take the first required minimum distribution from the inherited IRA by that same deadline (the end of the year following the year of death).
If a transfer doesn't meet these deadlines, the beneficiary will still be able to do the transfer, but will be stuck with the usually less favorable payout option of the plan (probably the five-year rule), instead of getting to stretch the payments over his or her lifetime.
When funds are turned over to a beneficiary (not as a direct transfer), the beneficiary cannot correct the error and transfer those funds to a properly titled inherited IRA. Instead, the distribution will be taxable, and that will be the end of 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.
A trust is a nonspouse beneficiary, too. In order to take advantage of the nonspouse transfer provision, the trust must qualify as a "see-through" or "look-through" trust under IRS requirements. To qualify, the trust must be valid under state law and irrevocable after death; the trust beneficiaries must be identifiable and must all be individuals, and the trust documentation or the trust itself must be delivered to the plan administrator by Oct. 31 of the year following the year of the death. A trust that does not qualify cannot do a direct transfer to an inherited IRA.
To add to the confusion, IRS Publication 590 and Publication 575 mention the nonspouse rollover provision, but don't say whether it's mandatory or optional.
Individuals who inherit company plan balances from their spouses are already protected under IRS regulations. The spouse doesn't need to use the nonspouse rollover provision of the PPA. Why would a spouse want to remain a beneficiary? Suppose the spouse is under age 59 1/2 and needs the money right away. He or she would be subject to the 10% early-withdrawal penalty on distributions from his or her own IRA, unless an exception applies.
The better move would be for the young spouse to roll the plan funds over to an inherited IRA, since the 10% penalty never applies to distributions to beneficiaries. Then, when the spouse reaches age 59 1/2, he or she can always roll the funds to his or her own IRA, since there will be no more early-withdrawal penalties on distributions. There is no deadline for a spousal rollover, so choosing to be a beneficiary upon inheriting has no effect on the spouse's ability to do a spousal rollover to his or her own IRA in the future. The best move is generally still for individuals to do an IRA rollover when they can, unless one of the lump-sum distribution tax breaks, such as net unrealized appreciation or 10-year averaging, might work out better. If the IRA rollover was right before, it's still the right move now.
Ed Slott, a CPA in Rockville Centre, N.Y., is an author of several IRA books and Ed Slott's IRA Advisor. This article originally appeared in Financial Planning, a sister publication to EBN.
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