This week, Gail explains the IRS' spin on (what was first thought of as) "the most exciting provision" of the Pension Protection Act.

Dear Friends-

As I wrote shortly after passage of the Pension Protection Act (PPA) in August, one of the most exciting provisions was that non-spouse beneficiaries – children, siblings, domestic partners, grandkids, etc.— would finally be able to roll an inherited retirement plan to an IRA and allow the money to continue to grow on a tax-deferred basis — or so we thought.

Including this provision in the law was Congress’ way of stressing the importance of saving —instead of spending — this money. By rolling it over instead of cashing it out, as required by many company retirement plans, it would potentially be available to help finance the beneficiary’s own retirement.

A spouse has always been able to do this. If a wife inherits her husband’s company retirement plan, she can roll that over into an IRA in her own name.

But anyone else has been prohibited from doing this.

For instance, say Hazel dies with $200,000 in her 401(k) account. According to the terms of the 401(k), when the account owner dies, the beneficiary has to withdraw the balance in 5 years or less.

No problem if the beneficiary is Hazel’s husband, Fernando. He can simply roll the money into an IRA and name himself as the new owner.

But if her beneficiary is her niece, Esmerelda, she was out of luck. At most, she could leave the money in the 401(k) for five years. At that point, she had to close out the account by withdrawing the balance.

Bingo! Income taxes were due that year. Worse, the money no longer had the benefit of being in a tax-sheltered account.

PPA, as it was commonly understood, would radically alter this.

Instead of having to cash out the 401(k) account and pay taxes on the lump sum, starting this year Esmerelda would be able to roll Aunt Hazel’s retirement account into an “inherited” IRA. Unlike a spouse rollover, the IRA would not be in the beneficiary’s name. Instead, it would be titled “Hazel Smith’s IRA for the benefit of her niece, ”Esmerelda Jones.”

The important thing is, once in the IRA, Esmerelda could “stretch out” the required annual withdrawals over her own life expectancy by just taking out a minimum amount each year. This would not only spread out the tax consequences, it would also give the investments additional time to appreciate and potentially become a significant source of income to her later in life.

For some reason, the IRS has interpreted the law Congress wrote very differently and has decided certain non-spouse beneficiaries cannot stretch inherited retirement accounts, after all.

Boston attorney Natalie Choate, a nationally-recognized expert on retirement plan distributions, expresses the frustration of many financial and tax professionals: “After 20 years of lobbying so that people who inherit a ‘lump sum only’ plan could stretch it out over their own life expectancy, now we have the IRS reversing the results.”

How is it possible that the IRS can change what Congress wrote? John W. Roth, a senior analyst for CCH, a major provider of tax information, says it’s simple: Congress didn’t do a very good job of spelling out exactly what it intended.

“It boils down to sloppy draftsmanship on the part of Congress,” which was in a hurry to get the bill passed last summer so that members could get back to their home districts and continue campaigning for the fall elections.

Last month the IRS issued a major announcement explaining how it interprets this section of the law. Yes, non-spouse beneficiaries can roll an inherited retirement plan to an IRA titled in the name of the deceased person. But if the decedent was under age 70½, the IRS says the rules of the retirement plan will continue to dictate how fast the money has to be withdrawn.

In other words, even if Esmerelda rolls Aunt Hazel’s 401(k) to an IRA, she will still have to withdraw the money in 5 years or less because that’s the time limit of the 401(k). Income tax will be due at that time.

In Choate’s words, “Congress was obviously trying to encourage people to use life-time payouts.” However, the IRS has decided “if the plan is forcing the 5-year rule, we are going to carry that over to the IRA.”

“This defeats what everyone thought was the intent of the Pension Protection Act,” says Roth.

To confuse things more, in the twisted (il)logic of the IRS, a different rule applies if, at death, the owner of the retirement plan is over age 70½ (the age at which the account owner must start taking withdrawals from a 40(k) or similar plan).

In this case, a non-spouse beneficiary can stretch the withdrawals over his/her own life expectancy!

Invariably, when Congress enacts legislation this significant (900+ pages) and complex, it has to pass another bill that corrects inadvertent mistakes and clarifies its intent. Both Choate and Roth are fairly confident this issue will be resolved this year.

But what if it isn’t? What should you do if your dad died last year and you were the beneficiary of his 403(B) account? If the plan requires you to close the account within 2 years, should you wait and withdraw the money at that time or roll it to an inherited IRA?

Choate’s recommendation is to “do the transfer to the IRA. We’ll assume the IRS will fix this. If they don’t you’re no worse off.”

That is, at worst, you’ll have to take the money out as fast as the 403(b) plan requires. That’s the same outcome as leaving the money in the 403(b). However, if Congress passes legislation spelling out the right of a beneficiary to stretch the distributions, you’ve already got the money in an IRA, making it easier to meet the deadline* for taking your first withdrawal.

Hope this helps,
Gail

*December 31, of the year after the year the account owner died.

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.