IRS Switcheroo: Non-Spouse Beneficiaries CAN Do Rollover if ...

This week, Gail discusses the continued complexity about a simple concept.

Dear Friends:

In an embarrassing turn of events for the Treasury Department, based on a barrage of negative reaction from financial professionals, it has just issued a new notice aimed at clarifying what it said in a previous notice!

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The question concerns how the IRS interpreted a specific section of the Pension Protection Act (PPA) enacted last year. The issue happens to be one of those things that doesn’t get your attention until you’re affected by it, so this hasn’t received a lot of general media exposure. However, folks in legal, accounting and financial planning circles are going ballistic.

As I explained a few weeks ago, for the first time, non-spouses who inherit someone’s company retirement plan (401(k), 403(b), profit-sharing, etc.) are supposed to have the opportunity to roll that money into an IRA instead of being forced to cash it out. This is a privilege that — up to now — has been available only to a spouse.

There are significant advantages to this, including the ability to: 1) avoid a huge tax bill on the lump sum, and 2) withdraw just a minimum amount each year, thereby leaving much of the money in the IRA where it can continue to compound on a tax-sheltered basis.

The younger the beneficiary, the more significant the result. For instance, say grandpa died in 1999, leaving the $50,000 balance in his 401(k) account to his 10-year-old grandchild, Suzy. Since most company retirement plans require the account to be closed within 5 years after the employee dies, at most, Suzy could wait until the end of 2004 until she cashed it out.

If the account earned 8 percent per-year over that period, she’d walk away with about $73,000, minus income tax. End of story.

PPA was heralded as finally extending to non-spouse beneficiaries (almost) the same benefit that has been available only with married couples — or so we thought.

Change the date of grandpa’s death to 2007. Assume that Suzy (more accurately, her guardian acting on her behalf) rolls the 401(k) into an IRA. As a 10-year old, Suzy has a 73-year life expectancy. Each year she just withdraws the minimum amount required by law.

If the investments in the IRA earn 8 percent per-year, Suzy’s inheritance turns into more than $2.7 million!

Trouble is, the IRS has chosen to interpret what Congress wrote in a very conservative fashion. And unless the Suzies of the world handle this inherited account absolutely perfectly, they’re going to miss this opportunity.

In the words of Brooklyn, New York CPA Barry Picker, in its latest notice “the IRS basically confirmed everything bad that we thought they meant and where we thought there might be a chance to interpret [the new law] in a way that was good, they confirmed that it’s not good.”

First, even though the law now allows rollovers by non-spouse beneficiaries, the IRS has taken the position that if mom’s retirement plan doesn’t provide for this type of rollover, you’re out of luck!

In addition, according to Picker, you’ve got to be sure to start your required minimum distributions (RMDs) by December 31st in the year following the year mom died. Even if you rolled the money to an IRA, if you miss this deadline, you’re again forced to empty the assets in 5 years.

Another disappointment is that the opportunity to “stretch” withdrawals over the beneficiary’s life expectancy only applies to retirement accounts inherited in 2006 or later. For instance, imagine you inherited your mom’s profit-sharing plan in 2005. Rolling over wasn’t an option back then and since you wanted to postpone paying taxes as long as possible, you decided to leave the money in her account for the 5 years allowed.

Some professionals thought that under the new law, provided you brought your withdrawals current by taking out the minimum amount you should have withdrawn last year (and paying the penalty for missing it), you’d be able to “stretch” future withdrawals over your own life expectancy.

This flexibility is allowed with inherited IRAs. But apparently there is no chance to “catch up” when it comes to inherited retirement plans.

According to CPA Bob Keebler of Green Bay, Wisconsin, “In the case of a qualified plan, it appears one must begin distributions in the year following the year of death or forego the life expectancy option.”

Or, as Picker puts it, if the owner of the retirement account “died before 2006, the beneficiary is stuck with the 5-year withdrawal rule if the plan mandates this.”

No stretch.

What’s more, you have to be very careful about the timing of your rollover and which account you take your first year’s withdrawal from.

Take the example of an employee who dies in 2007, leaving his 401(k) to his domestic partner. If this non-spouse beneficiary waits until 2008 to rollover the 401(k) to an IRA and then takes his first required distribution, the IRS says he loses the ability to stretch the withdrawals over his own life expectancy. He should have taken the withdrawal from the 401(k) first and then rolled over the rest!

Do you see why financial professionals are shaking their heads?

“They took something that had a very good purpose and was fairly simple,” says Picker, “and made it extremely complicated and less than what it was supposed to be.”

The only way to fix this is for Congress to pass new legislation that specifically lays out how they want this to work.

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To avoid complications about the timing of your first withdrawal and your rollover, Picker’s firm is advising that clients rollover an inherited retirement plan in the same year the owner dies. “If you get the money out of the plan in the year of death, the entire balance goes into the IRA. The following year, you can take your required distribution from the IRA” without a problem.

Stay tuned.


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