4/25/07

Carlene Ballieu Consultant, IRAs/HSAs, Wolters Kluwer Financial Services

The Pension Protection Act (PPA) of 2006 included a number of significant changes to IRAs. From an IRA perspective, the most significant change is a new rule that could affect nonspouse beneficiaries of deceased employer-sponsored retirement plan participants. The new rule may provide a tax savings opportunity for these nonspouse beneficiaries, but also provides a new opportunity for IRA custodians/trustees to grow deposits.

This article will discuss the new direct rollover rule, as well as the opportunities it could provide to both individuals and financial organizations.

The Nonspouse Beneficiary Tax Savings Benefit

Prior to PPA, a nonspouse beneficiary who inherited employer plan assets was subject to plan rules, which could mean an immediate distribution or distribution within a shorter period than allowed by law or regulation. The disadvantage was that a nonspouse beneficiary not only lost the ability to accumulate tax-deferred earnings on the account, but had to pay taxes on the amount distributed.

The new rule may allow a nonspouse beneficiary to escape the more stringent employer plan rules and limited investment options by directly rolling the inherited plan assets to a traditional "Beneficiary IRA". The beneficiary could possibly take distributions over his/her life expectancy. As a result, a nonspouse beneficiary could take advantage of the ability to accumulate tax-deferred earnings and spread the tax liability over a longer period of time.

IRS Rules and Restrictions

The new legislation did not appear to restrict this benefit based on the age of the deceased, timing of his/her death, or any other circumstances. The new legislation appeared to provide nonspouse beneficiaries of employer plans with rights and options similar to those of nonspouse beneficiaries of IRAs, which closely mirror the maximum flexibility allowed by law and regulations. However, recent IRS guidance does restrict when a beneficiary may use the direct rollover option and can potentially eliminate the benefit altogether. IRS Notice 2007-7 provides the following rules and restrictions:

• An employer plan is not required to offer this option to a nonspouse beneficiary unless the plan is terminated
  
  
• If allowed by the employer plan, the plan must use the direct rollover method to move the assets to a Beneficiary IRA; a distribution made directly to a nonspouse beneficiary is not eligible for rollover to a Beneficiary IRA
  
  
• The Beneficiary IRA must be properly identified as such (e.g., Tom Smith, beneficiary of John Smith)
  
  
• Participant and beneficiary required minimum distributions (RMDs) are not eligible for direct rollover to a Beneficiary IRA

Employer Plan Rules and Restrictions

When an employer plan offers the direct rollover to Beneficiary IRA option:

• The employer plan's distribution rules may also apply to the Beneficiary IRA assets
  
  
• If the plan participant died after his required beginning date, once directly rolled over, the RMD for subsequent years from the Beneficiary IRA will be based on the distribution period as would have been determined under the employer plan
  
  
• If an employer plan requires distribution within five years (which can only occur if the participant died before his/her required beginning date or the beneficiary elected this option), this option must also apply to the inherited assets even when directly rolled to a Beneficiary IRA
  
  Exception:  A nonspouse beneficiary may take life expectancy distributions if the assets are directly rolled to a Beneficiary IRA by December 31 of the year after death and he/she does not roll over any RMDs, determined under the life expectancy method, to the Beneficiary IRA. For direct rollovers in 2007, this exception is not available if the plan participant died prior to 2006.

Example

John, age 68, died in 2007 and left his 401(k) plan assets to his niece, Jane. The 401(k) plan document requires Jane to take distribution of all assets under the five-year rule, meaning all assets must be distributed by December 31, 2012. The amended employer plan document allows direct rollovers of inherited employer plan assets to a Beneficiary IRA.

If Jane elects a direct rollover to a Beneficiary IRA in 2007, all of the inherited IRA assets are eligible for the direct rollover; Jane could elect to take death distributions from the Beneficiary IRA based on her own single life expectancy beginning in 2008.

If Jane elects a direct rollover to a Beneficiary IRA in 2008, she must first take the 2008 beneficiary RMD from the 401(k) plan based on her own single life expectancy; the remaining amount is eligible for direct rollover to a Beneficiary IRA. Although unclear from the guidance, it appears that if she does not take, or the plan administrator fails to distribute, her 2008 RMD before the direct rollover, she may be subject to the five-year rule, and would have to withdraw all assets from the Beneficiary IRA by December 31, 2012.

Jane may elect a direct rollover to a Beneficiary IRA in 2009, 2010, or 2011, but must take distribution of all remaining employer plan or IRA assets by December 31, 2012.

Jane may not elect a direct rollover to a Beneficiary IRA after 2011, as all assets remaining in the 401(k) plan in 2012 are considered to be the RMD for 2012 and would not be eligible for rollover.

Example

Continuing with the previous example, Jane inherited $100,000 from her uncle John's 401(k) plan, and elected a direct rollover to a Beneficiary IRA in 2007. Because Jane timely elected a direct rollover in 2007, the RMD rules allow her to take distribution of the assets from the Beneficiary IRA under the five-year rule or over her own life expectancy.

Click here for an illustration of how Jane can turn her $100,000 inheritance into over $500,000 by electing the life expectancy option. Using a hypothetical 8 percent average return, the illustration indicates that Jane's benefit is $158,687 if she takes a full distribution in year five or $553,269 if she takes life expectancy distributions each year until she depletes the Beneficiary IRA. Although Jane may maximize her tax benefits by taking only the RMD each year, she may take more than her RMD at any time without penalty.

IRA Custodian/Trustee Opportunity

According to Investment Company Institute (www.ici.org), retirement assets reached a record $14.5 trillion in 2005. Nearly two-thirds of these assets are held in employer-sponsored retirement plans—much of which nonspouse beneficiaries could inherit. Since the rules have never before allowed a nonspouse beneficiary to roll these assets to a Beneficiary IRA, this is a brand new source of IRA deposits. IRA custodians/trustees are in the right place at the right time to receive these deposits—but does your financial organization have the knowledge and the right tools to properly administer Beneficiary IRAs?

The Knowledge—Beneficiary IRA Administration

Understanding that the establishment of a "Beneficiary IRA" is inherently different from that of the usual IRA for an IRA owner is fundamental to administering Beneficiary IRAs. When an individual establishes a Beneficiary IRA, it is not his/her own IRA. Although he/she has control of the assets, he/she cannot make regular contributions to the IRA and he cannot combine the Beneficiary IRA assets with his/her own IRA assets. These Beneficiary IRA administration differences result in a number of compliance and documentation concerns.

The Tools—Beneficiary Specific IRA Documents

Having the right tools to address these compliance and documentation concerns is also key to administering Beneficiary IRAs. In response to these concerns, Wolters Kluwer Financial Services developed a "Beneficiary IRA" line of documents. Although the IRS does not require use of these forms, they are specifically designed to support and address many of the compliance and documentation concerns in establishing and administering a Beneficiary IRA. The Beneficiary IRA line of documents includes an establishment document as well as ancillary documents for additional transactions. Let's take a look at the available Beneficiary IRA forms.

The Traditional Beneficiary IRA [IRAB-T-ORG-C (custodial), IRAB-T-ORG-T (trust)] is an establishment document for a traditional Beneficiary IRA. This Beneficiary IRA Organizer includes an application, Form 5305, Disclosure Statement, and a financial disclosure designed specifically for a beneficiary. A financial organization's policy may require the use of a Beneficiary IRA after the death of an IRA owner, preceding beneficiary, or employer plan participant. This document allows a financial organization to:

• Document nonspouse direct rollovers of inherited employer plan assets
  
  
• Document transfers of Beneficiary IRA assets from a decedent's IRA internally or from other financial organizations
  
  
• Obtain a beneficiary's signature certifying that he has provided true and accurate information, and the beneficiary’s agreement to be bound by the Beneficiary IRA's terms
  
  
• Document appropriate information regarding the original deceased IRA owner or plan participant
  
  
• Document the beneficiary's receipt of Beneficiary IRA disclosures
  
  
• If not prohibited by state law, specify its policy on naming successor beneficiaries and if allowed, provides space for such designations; a spousal consent area is available, if applicable
  
  
• Administer the Beneficiary IRA according to the rules of the document and its own policies
  
  
• Help the custodian/trustee ensure the beneficiary does not make regular contributions to the Beneficiary IRA

The Request for Transfer or Direct Rollover to a Traditional Beneficiary IRA (IRAB-T-REQ) documents a beneficiary’s request for transfer of inherited IRA assets from an employer plan or another IRA custodian/trustee.

The Traditional Beneficiary IRA Contribution Instructions (IRAB-T-CONT) documents a beneficiary's transfer of inherited IRA assets or direct rollovers of inherited employer plan assets. A beneficiary may combine assets only from the same decedent. Further issues with respect to combining assets from different account sources are beyond the scope of this article.

The Traditional Beneficiary IRA Election of Payment by Beneficiary (IRAB-T-ELECT) documents a beneficiary's election of the method to be used to determine his/her RMDs.

The Traditional Beneficiary IRA Distribution Form (IRAB-T-DIS) documents a beneficiary's distribution amount, payment method, withholding election, and/or information required for IRS reporting, including the distribution reason.

The IRA Designation or Change of Successor Beneficiary Form (IRA-SUC-BENE) documents a beneficiary's initial selection or change of a successor beneficiary. Watch for a follow-up article addressing successor beneficiary issues and options.

Conclusion

The new nonspouse beneficiary direct rollover rule provides an excellent opportunity for IRA custodians/trustees to grow deposits. Wolters Kluwer Financial Services offers a variety of products to assist you in learning more about Beneficiary IRAs, including tour and tailored seminars, web casts, and our IRA Library. For pricing information on training and/or forms, please call 1-800-552-9410.