In August, 2006 Congress passed the Pension Protection Act, included in which is a potentially very beneficial, but little known, section that permits “nonspouse” beneficiaries (NSB) of retirement plan participants who die after 2006 to roll over the retirement plan death benefit to a special Inherited Individual Retirement Account (IIRA). The NSB is any beneficiary other than the deceased participants spouse – such as minor children, elderly parents or significant others. The significance of the new law is enormous. For the first time the law permits retirement plan death benefits to be distributed income tax free to an IRA established for the non-spouse in the participant’s name. Even better, for the first time the benefits must be paid out over the NSB’s own life expectancy. For minor children, this means very small distributions while they are young, and permits the rest of the account to accumulate tax-free. The IIRA can be designed to permit more to be withdrawn at college time or for emergencies. The new law covers all qualified retirement plans; 401(k), 403(b), 457 (government plans), pension and profit sharing plans.
What should retirement plan participants do now to get their tax break? First, contact the plan administrator and fill out a beneficiary designation form that names the NSB and directs distribution to an IRA. Expect resistance because it is likely the retirement plan has not yet been amended to permit the direct rollover for the NSB. Next, if the participant has control over the retirement plan, such as small business owners or persons able to influence decisions, they should cause it to be amended. Others should press the company to amend the plan promptly.
If the participant works for a large company, a government entity, or is covered by a union plan, the news from around the country is not good. The new law is unknown and these types of plans are difficult to amend. Some companies are refusing to amend their plans at all. Furthermore, the IRS in a recent publication stated employers do not have to permit NSB direct rollovers and cannot do so unless the plan expressly permits it. Nevertheless, all participants should change their beneficiary designations to provide for the direct rollover to the NSB when and if it is eventually permitted. Even if the plan is never amended, a new law could require the plan to make the NSB direct rollover anyway.
The rules for the tax-free distribution are tricky. Failure to follow them will result in full taxation of the death benefit. The entire benefit must be rolled over by the end of the year following death. If the benefit is rolled over in the year of death, the first minimum required distribution (MRD) must be paid from the IRA. If the rollover occurs the year after death, then the entire benefit must be distributed by the fifth anniversary of the death and is fully taxable.
The IIRA is different from a regular IRA. It cannot be owned by the beneficiary; the required distributions cannot be postponed; and its assets cannot be rolled over to another IRA tax free. But with correct planning, it can be made a “Stretch IRA” whereby the NSB can cause the remaining benefits to be paid to designated beneficiaries, such as children, over the NSB’s remaining life expectancy.
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