IRS and DoL Address New Rules for Non-Spouse Beneficiaries

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March 14, 2007

The Pension Protection Act of 2006 (the "PPA") created a new rollover opportunity for non-spouse designated beneficiaries under qualified retirement plans (including 401(k) plans), 403(b) annuity plans and governmental 457 plans. The new provision allows a non-spouse designated beneficiary who receives a plan distribution after December 31, 2006 upon the death of the participant to roll over the distribution directly into an individual retirement account ("IRA"). The rollover IRA must be treated as an inherited IRA under the tax code.

This new rule was intended to provide non-spouse beneficiaries with a tax-deferral opportunity similar to that available to surviving spouses. By rolling over the distribution to an IRA, the nonspouse beneficiary presumably would be able to stretch out over his or her lifetime the payments (and the resulting income taxes) that might otherwise have been paid by the distributing plan in a lump sum. Both the Internal Revenue Service ("IRS") and the Department of Labor ("DoL") recently issued guidance relating to the changes brought about by the PPA's new rule for non-spouse beneficiaries.

IRS: Quelling the Confusion over Non-Spouse Rollovers

In January 2007, the IRS released Notice 2007-7 (the "Notice"), which, among other things, provided guidance on the application of the new non-spouse rollover rules. For more detailed information on Notice 2007-7, please see our January 22, 2007 article on this topic.

After the release of the Notice, the IRS became aware that certain of its provisions had created confusion among plan administrators and other benefits professionals. It appeared from the Notice that the IRA for a non-spouse beneficiary was required to apply the same required minimum distribution rules that otherwise applied under the distributing plan. That is, if the distributing plan followed the 5-year rule for non-spouse beneficiaries (which requires a full distribution of all benefits by the end of the fifth year following the participant's death), then the rollover IRA would also have to follow the 5-year rule. If this were the case, there would be little to no advantage to a non-spouse beneficiary in electing a rollover.

In a February 13, 2007 Special Edition of its Employee Plans News, the IRS explained that while the rule described above is indeed the general rule, a different provision of the Notice is intended to be an exception to the general rule. Under the exception, if the 5-year rule applies to a non-spouse designated beneficiary under a plan, the beneficiary may nonetheless elect to have the rollover IRA apply the life expectancy rule (which permits periodic payments over the lifetime of the beneficiary), as long as the rollover is completed by the end of the year following the year of the participant's death.

DoL: Dealing With Missing Non-Spouse Beneficiaries

On February 15, 2007, the DoL published interim final regulations, effective March 19, 2007, addressing distributions from terminating defined contribution plans to non-spouse designated beneficiaries. Existing DoL regulations provide a fiduciary "safe harbor" for plan fiduciaries and "qualified termination administrators" who follow certain procedures to terminate a plan and make distributions to participants who cannot be located or who do not timely return their distribution election forms (referred to as "missing participants").

Under existing regulations, distributions from a terminating plan may be made in a tax-free distribution to an IRA on behalf of a missing participant or surviving spouse. However, because distributions to non-spouse beneficiaries were not previously eligible for rollover, the regulations currently require that a distribution to a missing non-spouse beneficiary from a terminating plan be made in a taxable distribution to an account that is not an IRA. For more detailed information on these regulations, please see our June 5, 2006 article on this topic.

As a result of the PPA changes, the DoL modified its existing regulations to allow terminating plans to make tax-free distributions to inherited IRAs on behalf of missing non-spouse beneficiaries. The DoL also published a proposed amendment to Prohibited Transaction Exemption 2006-6, which currently allows a qualified termination administrator to select itself as an IRA provider for a terminating abandoned plan. The DoL proposes to amend PTE 2006-6 to clarify that a qualified termination administrator may designate itself as the provider of an inherited IRA to accept a distribution on behalf of a missing non-spouse designated beneficiary.

For more information, please contact:

Robyn S. T. Carlson
[email protected] 

Larry R. Goldstein
[email protected]

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