Guest Article

(From the March 5, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Clarifies Guidance on Direct Rollovers to IRAs of Nonspouse Beneficiaries

The IRS on February 13, 2007 issued a Special Edition of "employee plan news" to clarify an issue relating to new rules permitting 401(k) and other tax-qualified retirement plans to make direct rollovers of a deceased participant's accrued benefit to an IRA established by the deceased participant's nonspouse designated beneficiary. The Special Edition also reiterates that plans may offer this direct rollover option, but are not required to do so. The new rules, which were enacted as part of the Pension Protection Act (PPA) of 2006 (P.L. 109-280), are effective for distributions made after December 31, 2006.

Background

The PPA (§ 829) established new IRC § 402(c)(11), which permits tax-qualified plans (including 403(a) and 403(b) annuity plans and governmental 457(b) plans) to make non-taxable direct trustee-to-trustee transfers to an IRA that has been set up by a deceased participant's designated nonspouse beneficiary for the purpose of receiving the distribution. The amount transferred must satisfy all the requirements for eligible rollover distributions, except for the requirement that the distribution be made to the participant or the participant's spouse.

Any part of the distribution that is a required minimum distribution pursuant to IRC § 401(a)(9) is not an eligible rollover distribution. As a result, this portion of the distribution may not be transferred to the nonspouse designated beneficiary's IRA. IRS Notice 2007-7, 2007-5 I.R.B. 395 ("Notice"), provides guidance on determining the extent to which the distribution is a required minimum distribution, as well as on applying the required minimum distribution rules to the nonspouse designated beneficiary's IRA.

If the employee died before his or her required beginning date, Notice 2007-7 Q/A 17 specifies either the "five-year" method of IRC § 401(a)(9)(B)(ii) or the "life expectancy" method of IRC § 401(a)(9)(B)(iii) is used to determine the extent to which the distribution is a required minimum distribution. Plans can specify which method will be used in specific circumstances, or give beneficiaries the option to elect either method. In the absence of a specific plan provision, the life expectancy method must be used in cases where the deceased employee has a designated beneficiary. See Treas. Reg. § 1.401(a)(9)-3, Q/A 4.

There is no required minimum distribution for the year of the employee's death under either method. However, under the life expectancy method there is a required minimum distribution for each year following the year of death. By comparison, under the five year method there is no required minimum distribution for the first four years after the year the employee dies. But on or after January 1 of the fifth year after the employee died the required minimum distribution is the deceased employee's total accrued benefit.

The general rule, according to Notice 2007-7 Q/A 19, is that the same method used to determine the extent to which the distribution is a required minimum distribution also must be used when applying the required minimum distribution rules to the nonspouse beneficiary's IRA. For example, if the five year method is used to determine the amount of the distribution that is a required minimum distribution, it also must be used to determine required minimum distributions from the nonspouse beneficiary's IRA. Thus, the total distribution is an eligible rollover distribution as long as it occurs in the year of the employee's death or in any of the next four years; however, the entire amount must be distributed from the nonspouse beneficiary's IRA -- and taxed -- in the fifth year following the employee's death.

If the nonspouse beneficiary's life expectancy is more than five years, he or she should prefer using the life expectancy method to determine required minimum distributions from the IRA. But the general rules outlined in Q/A 17 and 19 indicate that if the distributing plan requires nonspouse beneficiaries to use the five year method for purposes of determining the extent to which the distribution is a required minimum distribution, then that is the method that also must be used to apply the required minimum distribution rules to the IRA. However, Notice 2007-7 Q/A 17(c) establishes a special rule permitting the nonspouse beneficiary to use the life expectancy method for both purposes even if the plan requires the five year method. In order to take advantage of this special rule, the rollover distribution must be made before the end of the year following the year of the employee's death.

The Question (and the IRS's Answer)

After the IRS released Notice 2007-7, some plan administrators and benefits practitioners raised questions about whether the general rule in Q/A 19 overrides the special rule in Q/A 17(c). The IRS issued the February 13, 2007 Special Edition of "employee plan news" to clarify that it does not. The Special Edition illustrates the interaction of these two rules with the following example:

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Laura Morrison 202.879-5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.