Non-Spouse IRA Rollover Confusion

Congress has created more confusion on this already confusing area of IRA Rollovers.

In the past, a non-spouse beneficiary who inherited a retirement plan such as a 401(k) had very few options. Usually the plan was simply cashed out making the entire distribution taxable to the beneficiary in the one year. This action would end the tax deferred status of the account and eliminate the opportunity to stretch the distributions over the beneficiary's lifetime. Why did this happen? Most often this was the only option.

Situations like these are all too common. The reason this is a problem is that a non-spouse cannot do a rollover. A rollover is when there is a distribution from a retirement plan and the funds are put back into the same or similar plan such as an IRA within 60 days. As long as the funds are "rolled over" into an IRA or other plan, then the funds will continue with the tax deferral. A spouse inheriting a plan has the option to roll it over and treat the account as his/her own, or has the option to roll it over to a properly titled inherited IRA. There are advantages and disadvantages of both options. However if you are a non-spouse beneficiary, you cannot do a rollover.

A non-spouse beneficiary can do what is called a "trustee-to-trustee" transfer, aka a "Direct Transfer," or a "Direct Rollover." This is very different from a standard rollover because the funds are never withdrawn from the account, they are transferred from one custodian to another. In this case, the beneficiary never takes "constructive receipt" and therefore the funds are not taxable. The problem is that many plans did not allow a non-spouse to do a Trustee-to-trustee transfer. However help was on the way, or so we thought.

Congress passed the Pension Protection Act of 2006 which included a provision that would allow a non-spouse beneficiary to do a Direct Transfers from a plan to a properly titled inherited IRA and take distributions over thier lifetimes instead of being subject to the harsh payout rules of most plans. This became effective in 2007. The idea was to allow non-spouse beneficiaries the same ability to take lifetime distributions as if the funds were inherited from an IRA. The only problem was that the IRS released Notice 2007-7 in January of 2007 stating the the provision was not mandatory for plans.

So what is the rule now? Do company plans have to allow this or not? Is the provision mandatory or voluntary? The intent of the law was to allow non-spouse beneficiaries of plans to have the same ability as if they inherited an IRA. In August of 2007, the IRS posted a notice on its website stating that this provision will be mandatory in 2008, referencing a technical correction to be put into law requiring plans to allow this provision in 2008. Again, help was on the way, or so we thought.

When President Bush signed the Tax Technical Corrections Act of 2007 on December 29, 2007, this provision was mysteriously not included. So where we are now is that this provision is still optional for plans. There is no official guidance stating that this provision is mandatory even though it is clear that this was the intent of congress. Why did this happen? One can only assume that beneficiaries will not do as will if company plans are left in the plan. Without this provision, the inherited funds would be fully taxable when taken from the plan and more taxes to go in government coffers.

It is clear from this one issue that these provisions can and do frequently change. This is another reason why in most cases doing the rollover to an IRA when leaving a plan is the best move to protect your beneficiaries. This is of course unless one of the lump-sum distribution tax breaks like net unrealized appreciate  or 10-year averaging might work out better. These issues depend on each individuals circumstances. These decisions should not be made without consulting an advisor who is properly trained in these and many other technical IRA issues such as an Ed Slott Elite IRA Advisor.