Tuesday, August 29, 2006

MORE DETAILS ON NONSPOUSAL ROLLOVER OF INHERITED QUALIFIED PLANS

An important new provision in the Pension Protection Act of 2006 relates to rollovers of inherited qualified plan assets, such as assets from a 401(k) plan.

GENERAL BENEFITS OF DEFERRAL

When an individual dies owning assets in a qualified retirement plan, and a designated beneficiary is provided for under the plan, that beneficiary becomes the new owner of the decedent's plan assets. Such plan assets must be eventually distributed out of the plan to the beneficiary. When this happens, the recipient is generally taxable in the year of distribution.

Plan beneficiaries can benefit in two key ways by deferring such distributions as long as possible. First, since such distributions are taxable, from an economic perspective the longer one can defer paying such taxes the better off one usually is. Second, while such plan assets are still in the plan, any current earnings from those assets are not subject to immediate tax and are likewise deferred until ultimate distribution.

To avoid extensive deferral of taxes, the Internal Revenue Code contains provisions that require that distributions be made out of the plans within certain time periods.

MANDATORY TIME PERIODS FOR DISTRIBUTION

Prior to the Pension Protection Act of 2006, deferral opportunities existed for the recipients of inherited qualified plan assets. These provisions can be summarized as:

  • If the decedent/employee dies before he or she was obligated to start taking his or her own pension distributions, then distribution of the plan assets to the beneficiaries after death must be completed either (a) within five years of death, or (b) over the life expectancy of the beneficiary, beginning within one year of the employee's death.

  • If the decedent/employee was obligated to start taking his own pension distributions or had started taking them before he or she died, then his remaining interest must be distributed at least as rapidly as under the distribution method used by the decedent/employee as of the date of death.
Note, however, that beneficiaries who are spouses have additional deferral opportunities, since they can rollover the plan assets of their deceased spouse into THEIR OWN IRA. Once that is done, the surviving spouse must distribute the IRA assets in accordance with the rules that apply to his or her own IRA. Depending on the age of the surviving spouse, this will usually provide superior deferral opportunities than the above nonspousal rules.

WHY WERE CHANGES NEEDED?

If nonspousal beneficiaries already had the above deferral opportunities, why was a change in the law needed? Because while the law allows the above deferral opportunities, they apply only if the particular pension plan documents allow for one or more of them. Out in the real world, most company plans do not allow for them and require rapid payment of account balances to beneficiaries after the employee dies. Thus, most company plan beneficiaries cannot avail themselves of the deferral opportunities allowed under the law.

WHAT CHANGES WERE MADE?

The new law now allows for the plan assets to be rolled into an "inherited IRA." Once rolled into an "inherited IRA" the beneficiary can take advantage of all of the nonspousal deferral opportunities described above, even if the qualified plan mandated earlier distribution.

STILL NOT AS GOOD AS A SPOUSAL ROLLOVER

Some people now believe that a nonspouse beneficiary is treated the same as a spouse. However, this is not correct.

The new IRA is treated as an "inherited IRA" and gets to use the general deferral provisions listed above. This is not the same as the spousal option to transfer plan assets to his or her own IRA - that type of transfer allows for more enhanced deferral oportunities to the spouse.

MISC. OBSERVATIONS

  • A trust for designated beneficiaries can elect the same rollover as an individual beneficiary
  • The rules apply to distributions made AFTER December 31, 2006.
  • The new IRA must be titled in a manner that identifies it as an inherited IRA.
  • A direct trustee-to-trustee transfer is required.
  • The rollover can be made only by a beneficiary that qualifies as a "designated beneficiary" under the Internal Revenue Code rules. Thus, for example, a probate estate that is the beneficiary cannot do a rollover.
ACTION TO CONSIDER

Nonspousal beneficiaries who have inherited an interest in a plan should try to defer distributions from the plan until 2007 to take advantage of the rollover provision.
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