Last year's passage of the Pension Protection Act (PPA) allowed, under Section 829, for non-spouse beneficiaries to complete rollovers of inherited employer retirement plans into inherited IRAs to maximize tax deferral.
Unfortunately, though, the IRS' interpretation of the newly created IRC Section 402(c)(11) early this year in IRS Notice 2007-7, declared that such rollovers would only be optional, at the discretion of the employer to allow them or not. Fortunately, though, in the face of a pending Technical Corrections bill in Congress to reverse this undesirable interpretation, the IRS has acquiesced to simply making the treatment mandatory for all employers.
Non-Spousal Rollovers From A 401(k) To An Inherited IRA Under PPA
Why does all this non-spouse rollover stuff matter? An example can best illustrate:
John Smith, age 50, dies with a 401(k) plan, with his daughter Jenny, age 28, as beneficiary. Since Jenny is a non-spouse beneficiary (i.e., a beneficiary who is not a spouse), the 401(k) plan may require her to liquidate the entire account by the end of the 5th year after death (and most plans did apply this rule, to minimize their own retirement plan costs over time). On the other hand, if John Smith had completed an IRA rollover and died with the same account balance in his IRA, Jenny would have the option to stretch withdrawals after John's death over her life expectancy (the so-called "stretch IRA" technique), affording her decades of additional tax deferral.
Unfortunately, though, if John didn't realize this and failed to rollover his account to an IRA before he died (or perhaps wasn't even eligible to roll over since he still worked for his company), Jenny would be forced to follow the 401(k) plan's potentially much less favorable treatment. In some cases, John might have wanted to keep his 401(k) for asset protection purposes under ERISA, and would thus have been forced to choose between asset protection during life or the opportunity for better tax deferral for Jenny after his death!
The Pension Protection Act (PPA) resolved this dilemma by allowing Jenny to complete a direct rollover to an inherited IRA after John's death (as long as it is completed by December 31 of the year after John's death), and subsequently stretch post-death distributions out over her life expectancy. However, as mentioned above, the IRS significantly diminished the value of Congress's act by declaring that plans are not required to allow such rollovers, under Q&A-14 of IRS Notice 2007-7.
IRS Reverses IRS Notice 2007-7
The IRS has reversed its position, as recently announced in its IRS Interim and Discretionary Amendments release. Specifically, the Service stated:
§ 402(c)(11) [Discretionary]: PPA ’06 § 829(a)(1) added § 402(c)(11) to allow nonspouse beneficiaries to roll over distributions from a qualified plan to an individual retirement plan. Nonspouse beneficiary rollovers are an optional plan provision for 2007. See, Notice 2007-7. Pursuant to an impending technical correction, nonspouse beneficiary rollovers will be required for plan years beginning on or after January 1, 2008. See, section 9(e) of S. 1974, the Pension Protection Technical Corrections Act of 2007, as introduced in the Senate on August 2, 2007 and section 9(e) of H.R. 3361, the Pension Protection Technical Corrections Act of 2007, as introduced in the House of Representatives on August 3, 2007.
So the good news is that for any client who dies in 2007 or later, the new mandatory rules will ensure non-spouse beneficiaries the ability to complete post-death inherited IRA rollovers and preserve their ability for a tax-deferred "stretch IRA." This can be a boon to any non-spouse beneficiary, ranging from a child, sibling, or other family member, to a same-sex partner or unmarried significant other. It's also relevant in situations where a trust is being used as the beneficiary of a retirement account. However, the news isn't quite as good for any beneficiary of a 2006 decedent who was hoping to take advantage of these rules and found themselves subject to a plan that had chosen not to allow the non-spouse inherited IRA rollovers.
Because the new rules take effect as of January 1, 2008, and the IRS has provided no further interim guidance, it appears that for some beneficiaries of 2006 decedents a restrictive plan may still force money out under the 5-year rule without allowing for a rollover. And of course, pre-2005 decedents are entirely out of luck to convert from the 5-year rule to the life expectancy rule, because their rollovers had to be completed by December 31, 2006. Nonetheless, the IRS' relief in this area - even if prompted by Congress' Technical Corrections Act - is still a tremendous improvement in flexibility for post-death retirement account planning!