Big News for Non-Spouse Beneficiaries

Attention: Daughters, Sons, Cousins, Uncles, Aunts, Siblings, Neighbors, Bosom Buddies, Unmarried Partners, et al!

Did Cousin Ned name you the numero uno recipient of his 401(k) when he died? Has Aunt Beatrice bestowed upon you the title of “beneficiary” of the 403(b) plan she had through her former school district?

Or, to come at this in reverse, have you designated your daughter, brother, or household partner as the beneficiary of your company-sponsored retirement plan?

For obvious reasons, all of the above individuals fall into the category of “non-spouse.” And, unlike a wife or husband who inherited a spouse’s retirement plan, non-spouse beneficiaries have not been allowed to roll those assets into an IRA Instead, they generally have been forced to empty the account and pay the income tax due within 5 years after the plan owner died.

The Pension Protection Act (PPA), which was passed last year, was supposed to change that – but the IRS had a different interpretation of the wording Congress used. Early this year it issued two notices (1) taking the position that a non-spouse beneficiary who inherits a retirement plan can only roll it into an IRA if the sponsor of the retirement plan can accommodate this.

In other words, if Dad’s 401(k) plan didn’t recognize non-spouse rollovers, his son Larry would be out of luck. Even if Larry followed the rules to the letter, he couldn’t roll over the money in Dad’s account.

It was absurd: Congress clearly wanted to give people the option of conserving this money; instead, the IRS put the power in the hands of each company sponsoring a retirement plan!

The financial planning and retirement communities have been up in arms ever since the IRS issued its interpretation of this provision. Thankfully, Congress heard about it, too, and decided to set the record straight in follow-up legislation.

As a result, the IRS now says that starting Jan. 1st, every retirement plan sponsor must allow a non-spouse beneficiary to roll over an inherited account.

Hallelujah!

According to Boston attorney Natalie Choate, a nationally recognized expert on retirement plans, “Apparently when the IRS saw Congress’ technical corrections, these made it clear enough that even the IRS could understand this is required effective 2008.” For this year, accommodating a non-spouse rollover is optional for a plan.

Other than being able to postpone paying income tax on the lump sum that’s inherited, why is this a big deal? Because when the assets are moved into an IRA, the potential gains they generate can continue to grow for decades on a tax-deferred basis. Depending upon the amount of time and how the money is invested, compounding can turn a modest inheritance into one worth more than a million bucks.

For instance, say grandma dies and leaves her granddaughter, Milly, as beneficiary of her $30,000 IRA.  Milly’s age in the year after grandma’s death is 6. According to the IRS tables, Milly has a life expectancy of 82 additional years. Thus, to calculate her first required withdrawal Milly will divide the value of the IRA by 82. The next year she’ll divide by 81, the next she’ll divide by 80, continuing to reduce her life expectancy by one year.

Now, let’s assume the investments in the IRA earn 8% per year and that Milly only takes out the minimum amount required each year. Thanks to the effects of compounding and tax-deferral, by the time she is age 88, Milly will have received more than $2,000,000 from grandma’s $30,000 IRA!

But getting the retirement plan to roll over the assets is just the beginning. There are very specific requirements that must be met in order to qualify:

1) Don’t let Uncle Ned’s plan make out the check to you! It’s critical that the assets in Uncle Ned’s account be moved into what’s called a “direct transfer,” that is, from the retirement plan to the IRA custodian.

The safest way to do this is to have the retirement plan wire the money electronically to the IRA custodian. If the plan insists upon sending you a check, make sure it’s made out to the IRA custodian. If it’s made out to you, you lose the ability to stretch out the withdrawals over your life expectancy.

2) Don’t roll the money into your own IRA! It has to go into what’s known as a “beneficiary” IRA, which means Uncle Ned’s name must still be on the account. The title should be along the lines of “Ned Smith’s IRA for the benefit of Suzy Jones” or “Suzy Jones, beneficiary of Ned Smith’s IRA.”

2a) Don’t comingle the money! By law, Uncle Ned’s 401(k) account must go into its very own, new IRA. Don’t roll the money into an existing “beneficiary” IRA, such as the IRA that was left to you by your grandfather!

3) As a non-spouse beneficiary, you must start withdrawing a minimum amount of money from this inherited IRA by December 31st of the year after Uncle Ned died. If Uncle Ned’s year of death is 2007, you must take your first “required minimum distribution” (RMD) by December 31, 2008.

The amount you have to withdraw is based on your own life expectancy. The younger you are, the smaller the RMD, which means more money remains in the IRA, where its gains remain sheltered from taxes. (See example above.)

Since a retirement plan is not required to accommodate a direct transfer on behalf of a non-spouse beneficiary until 2008, if the plan refuses your request and the account owner died in 2006, you’re probably out of luck in terms of stretching out the withdrawals. (The money would have to be in the inherited IRA this year so you can take your first RMD by Dec. 31st.)

However, anyone who inherits a retirement account this year or later is guaranteed the option of having the money rolled into an IRA.

Here’s another little twist. If the inherited account is rolled over to an IRA the same year the owner died, then 100% of the balance can be moved. The following year (i.e. the “year after death”) you must take your first required withdrawal from the IRA by Dec. 31st.

However, if the rollover doesn’t occur until the year after death, you’re supposed to take the first year’s required distribution from the account and then roll the balance into the IRA.

Choate, author of Life and Death Planning for Retirement Benefits, says in the case of a year-after-death rollover the burden falls on the retirement plan. “To maintain its qualification, the plan must pay out the RMD before making the rollover.”

This sounds complicated, but it really isn’t. All you have to remember is that if you inherit a company-sponsored retirement account from someone who you are not married to, you have an opportunity to roll over the money to an IRA and turn it into a windfall.

Hope this helps,
Gail

(1) Notice 2007-7, which came out in January, was so convoluted it was followed by a clarification the next month!

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.