Tax Law and Business Organization Strategy

Qualified Plan Rollover Rules Liberalized for Non-Spouse Beneficiaries *

In August 2006, Congress passed the Pension Protection Act of 2006 (the “Act”), a massive tax bill that contains liberalized retirement account payout and rollover rules. Following is a summary of one of the key tax changes in this important new legislation—non-spousal rollovers for beneficiaries who inherit a qualified plan (such as a 401(k)), governmental Section 457 plan, or tax-sheltered annuity.  

Pre-Act law had harsh income tax consequences for non-spouse beneficiaries who inherited any of the above plans.  Non-spouse beneficiaries were generally forced to collect the entire balance within 5 years following the owner's death, and some employer plans required that the payout be made within 1 year or as a lump sum. Either way, the result was a huge income tax burden on the recipient because the inherited amounts that could not be rolled into an IRA were taxable income in the year they were distributed.  The payout was added to the beneficiary's other income, often pushing them into a higher tax bracket. In contrast, payouts to the decedent's spouse from a 401(k) could be—and still can be—rolled over into the surviving spouse's IRA or stretched over the spouse's lifetime, thus stretching out the income tax burden.

Beginning in 2007, the Act allows non-spouse designated beneficiaries to make rollovers of inherited amounts in any of the above plans to either (i) an IRA or (ii) an individual retirement annuity, established for the purpose of receiving the distribution on behalf of the employee's designated beneficiary. This allows beneficiaries to spread the distributions and the taxable income over several years, and, better yet, the inheritance, less required distributions, continues to appreciate income tax-deferred. The transferee plan is treated as an inherited IRA under which benefits must be distributed in accordance with the RMD rules that apply to inherited IRAs of non-spouse beneficiaries.

Cautions: (1) In order for the non-spouse transfer to take place, the plan must allow it.  Check with your Plan Administrator to make sure the plan allows a direct transfer to an inherited IRA for a non-spouse beneficiary.  (2) The law stipulates that the funds must be moved in a trustee-to-trustee transfer.  This means that the beneficiary cannot receive a check and then deposit the check into an inherited IRA.  Rather, the plan must make the check payable to the trustee or custodian of the inherited IRA, making it a qualifying transfer. (3) The rules described above apply to distributions from qualified plans, but also apply to distributions from some other plans. If you are in the process of inheriting an employee’s retirement plan, seek professional tax advice as to the new options that may be available.

 * Taken in part from RIA's "Complete Analysis of the Pension Protection Act of 2006"

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