Are distributions to nonspouse beneficiaries subject to 20% mandatory withholding?
Rev. 08/07/09; E-mail Alert 2009-12

Starting in 2010, yes. 

Under the Pension Protection Act of 2006, a nonspouse beneficiary was permitted to rollover a deceased qualified plan participant’s assets into an IRA. In Notice 2007-7 the IRS issued guidance on how this transaction was to be handled.

Procedure from 2007 to end of 2009
The guidance in Notice 2007-7 is in effect from 2007 through the end of 2009. The guidance issued in Notice 2007-7 is as follows:

• An inherited IRA may only be established by a direct rollover.
• If an amount distributed from a plan is received directly by a nonspouse beneficiary, the distribution is not eligible for rollover.
• The nonspouse distribution of an inherited benefit is not subject to the direct rollover requirements of §401(a)(31), the notice requirements of §402(f), or the mandatory withholding requirements.
• A plan is not required to offer a direct rollover of a distribution to a nonspouse beneficiary. However, the opportunity to make a direct rollover is a benefit, right, or feature subject to §401(a)(4). For example, if a plan in any way limits which nonspouse beneficiaries may make direct rollovers, such program must be administered on a nondiscriminatory basis.
• A terminating defined contribution plan must offer direct rollovers to nonspouse beneficiaries regardless of existing plan terms.

Procedure Starting in 2010
The Worker, Retiree and Employer Recovery Act of 2008 (WRERA) changed these rules by making this transaction an eligible rollover distribution as of 2010. As an eligible rollover distribution under Code section 401(a)(31), all qualified plans must permit nonspouse beneficiary rollovers for plan years beginning after December 31, 2009.  Thus, once this is effective, all nonspouse beneficiary distributions will be subject to the normal rules for eligible rollover distributions, including the 402(f) notice and including the 20% mandatory withholding when the funds are paid to the nonspouse beneficiary, instead of being directly rolled to an inherited IRA. Nonetheless, a nonspouse beneficiary may only use a direct rollover to move to an inherited IRA as per Notice 2007-7.