Nonspouse Beneficiary Rollover Rules
Rev. 07/09/09; E-mail Alert 2009-10, Updated 02/17/10

The purpose of this article is to provide the rules on nonspouse beneficiary rollovers. To start, we provide a list of the guidance on this subject incorporated into this article.

Law and Guidance
Initially, Section 829 of the Pension Protection Act of 2006 (PPA) created  the ability of a nonspouse beneficiary of a participant in a qualified plan, §403(b) arrangement, or governmental §457(b) plan to make a direct rollover of the deceased participant’s plan balance to an inherited IRA (effective for distributions that occur after December 31, 2006).

The IRS issued Notice 2007-7 in Q&A format to provide guidance on how this transaction would actually operate. The IRS subsequently published a special edition of its online newsletter, Employee Plan News, to provide further clarification of Notice 2007-7.

MHC Comment: Although individuals in nontraditional relationships may establish inherited IRAs, the federal Defense of Marriage Act denies a same-sex partner spousal status for federal tax purposes, even if applicable state law recognizes same-sex marriages or civil unions.

Inherited IRA Title
The IRA must be identified explicitly as an IRA with respect to a decedent. Thus, the names of the decedent and the beneficiary must be included in its title. For example, an appropriate title would be, “Mary Smith as beneficiary of John Smith.”

"Direct Rollover" Requirements
A direct rollover is the exclusive means of moving funds from a qualified plan to an inherited IRA. Therefore, a rollover to the beneficiary’s own IRA is not permitted, and a nonspouse beneficiary may not take a cash distribution and then complete a rollover within 60 days. We assume the rationale for this is to prevent mistakes or abuse and to avoid invalidation of the rollover.

Nonspousal direct rollovers are exempt from the standard direct rollover requirements prior to 2010, such as mandatory 20% withholding on amounts not directly rolled over and the requirement to provide the 402(f) rollover notice. Nonetheless, the IRS recommends providing a 402(f) notice. As of 2010, the 20% mandatory withholding applies to eligible rollover distributions paid to a nonspouse beneficiary.

Originally an Optional Plan Provision (according to Notice 2007-7)
In Notice 2007-7, a plan was not required to offer a direct rollover of a distribution to a nonspouse beneficiary and if the plan did, the plan had to pass benefits. rights and features testing. However, this has been changed, first by the IRS and then by the Workers, Retirees and Employees Recovery Act of 2008, so that the direct rollover by a nonspouse beneficiary is a required plan provision and not an employer option. (See the plan amendment rules at the end of this article for a timeline of this provision).

Under the Original Notice 2007-7 Rules Terminating Plans Had to Offer Nonspouse Beneficiary Direct Rollovers
A terminating defined contribution plan must offer direct rollovers to nonspouse beneficiaries regardless of existing plan terms. The DOL recently issued separate guidance on this and on the use of nonspouse inherited IRAs by orphan plans.

Trust as Beneficiary
A plan may make a direct rollover to an IRA established on behalf of a beneficiary of a trust provided the beneficiary is a designated beneficiary within the meaning of the required minimum distribution rules of §401(a)(9)(E). In this situation, the IRA must be established with the trust identified as the beneficiary and distributions made based on the life expectancy(ies) of the beneficiary(ies) of the trust.

Rollover No Later Than 4th Year after Death
If the five-year rule (versus a life expectancy payout) applies, a direct rollover must be completed within the first four years of the five-year period but not in the fifth year. Because RMDs are calculated based on the preceding December 31balance, and receiving organizations don’t track rollovers for distribution calculation purposes until a December 31st has passed, this is a logical requirement. For example, if the funds were rolled over in the fifth year, they would not be included in an RMD calculation program because they were not in the account on the preceding December 31.

Inherited IRA To Follow Plan Distribution Rules
Generally, the inherited IRA must follow the distribution rules of the plan. Thus, if the plan only offers life expectancy payments, then the inherited IRA must make life expectancy payments (though nothing would prohibit a beneficiary from accelerating the payment's). Conversely, if the plan requires distribution within five years of the death of a participant who dies before the required beginning date, then the inherited IRA must follow the five-year rule. However, Notice 2007-7 adds a “special rule” for such situations.

The Special Rule
Under the special rule, a nonspouse designated beneficiary may elect to use the life expectancy method instead of applying the five-year rule; however, the account must be directly rolled before the end of the year following the year of death for this to apply. In addition, the RMDs under the newly established inherited IRA in this situation must be determined using the life expectancy of the same designated beneficiary.

Life Expectancy Rule
If the life expectancy rule applies, the RMD paid by the IRA must be determined using the same applicable distribution period as would have been used by the plan had the direct rollover not occurred.

Similarly, if the participant dies on or after the required beginning date, the RMD paid by the IRA for any year after the year of death must be determined using the same applicable distribution period as would have been used had the direct rollover not occurred.

Nonspouse Beneficiary of a Participant Who Died Prior to 2006
A high ranking IRS representative clarified that the special rule, which permits a beneficiary in a plan with only the five-year rule to nonetheless choose the life expectancy method of distribution once the funds are directly rolled into the inherited IRA [Notice 2007-7 Q&A 17(c)], is not available for beneficiaries of participants who died before 2006.

This option was not made available because the deadline for a beneficiary to choose the life expectancy method is the end of the year after the participant’s death; thus, the deadline to choose the life expectancy method for a participant who died before 2006 has already passed.

However, it was confirmed that a beneficiary who is taking life expectancy payments for a participant who died prior to 2006 may still directly roll  the remaining amount, less the RMD for the year of the direct rollover, to an inherited IRA. (This is possible only if the plan permits direct rollovers by non-spouse beneficiaries to inherited IRAs.)

Further, it was confirmed that a beneficiary of a participant who died in 2004, 2005, or 2006 in a plan with the five-year rule, may directly roll  the remaining amount to an inherited IRA and continue the five-year rule (assuming the plan permits direct rollovers by nonspouse beneficiaries to inherited IRAs and the rollover is completed within the first four years after the participant’s death).

Plan Amendment
In Notice 2007-7, the IRS provided guidance on the operation of these rules including that the employer plan did not have to incorporate the provision for the nonspouse beneficiary rollover as this was an optional plan provision. Later in 2007, the IRS indicated on its web page that the nonspouse beneficiary rollover would be a required plan provision effective for plan years starting in 2008 but that for 2007 it was an optional provision. The reason cited for this change was the pending Technical Corrections Act was known to have a provision to make this a required plan provision. The WRERA included the PPA Technical Corrections and made the nonspouse beneficiary direct rollover distribution a required plan provision, however, the nonspouse beneficiary rollover effective date from WRERA is for plan years starting after December 31, 2009.

Note that WRERA has changed the nonspouse beneficiary rollover into an eligible rollover distribution for plan years beginning after December 31, 2009. Thus, as with any eligible rollover distribution, the 20% mandatory withholding and the 402(f) notice are required.

For plans that have already incorporated this provision as part of a PPA amendment or a board resolution, obviously the plan provision is already in place. For those that did not, the provision may be incorporated simultaneously with this year's PPA amendment (which includes this provision in accordance with the IRS web site representation), or it may be added next year in accordance with WRERA.

2008 Publication 590 Information On Nonspouse Beneficiary Rollovers:
Page 26
"Rollover by nonspouse beneficiary. A direct transfer from a deceased employee’s qualified pension, profit-sharing or stock bonus plan, annuity plan, tax-sheltered annuity (section 403(b)) plan, or governmental deferred compensation (section 457) plan to an IRA set up to receive the distribution on your behalf can be treated as an eligible rollover distribution if you are the designated beneficiary of the plan and not the employee’s spouse. The IRA is treated as an inherited IRA. For more information about inherited IRAs, see What if You Inherit an IRA, earlier."

Page 20
"IRA Inherited from someone other than spouse. If you inherit a traditional IRA from anyone other than your deceased spouse, you cannot treat the inherited IRA as your own. This means that you cannot make any contributions to the IRA. It also means you cannot roll over any amounts into or out of the inherited IRA. However, you can make a trustee-to-trustee transfer as long as the IRA into which amounts are being moved is set up and maintained in the name of the deceased IRA owner for the benefit of you as beneficiary.

Like the original owner, you generally will not owe tax on the assets in the IRA until you receive distributions from it. You must begin receiving distributions from the IRA under the rules for distributions that apply to beneficiaries."