For those of us interested in retirement benefits — and who isn't? — there was a lot of change in 2006, including the enactment of the Tax Increase Prevention and Reconciliation Act (TIPRA) and the Pension Protection Act (PPA); the issuance of a key revenue ruling; and several private letter rulings of note. All in all, the legislative changes greatly enhance retirement savings accounts, both for those who accumulate savings and for their heirs.

Other 2006 developments affect such areas as qualified terminable interest property (QTIP) elections, nonspousal beneficiaries, beneficiary designations and Roth individual retirement account (IRA) conversions and rollovers.

QTIP ELECTIONS

One hot area involves QTIPs. QTIP planning is considered by advisors for nearly every significant marital estate. A vast majority of working and retired Americans have IRAs and defined contribution retirement plans. The combination of the two creates unique problems. On the one hand, the QTIP trust named as beneficiary of the IRA must satisfy QTIP requirements such as having to pay all income to the surviving spouse for life. On the other hand, withdrawals from an IRA during the lifetime of the surviving spouse (and beyond) are subject to required minimum distributions (RMDs).

When an IRA or defined contribution retirement plan names a trust as beneficiary, Revenue Ruling 2006-26, 2006-22 I.R.B. 1 (issued May 30, 2006) clarifies that it's possible to cause QTIP qualification failure under Internal Revenue Code Section 2056(b)(7) merely by failing to override a default provision found in many state principal and income laws.1 That provision2 arbitrarily allocates 10 percent of distributions to trust income from an IRA or other retirement plan account. The other 90 percent is allocated to principal. The ruling holds that application of the 90/10 rule fails the QTIP requirement that all income be payable to the surviving spouse for life. Furthermore, the Service specifically said state law marital deduction savings provisions that are along the lines of Uniform Principal and Income Act (UPIA) Section 409(d) won't work.

In states that have adopted the 90/10 rule, all QTIP trusts intending to receive retirement plan death benefits must contain provisions that override the 90/10 rule.

The stakes are extraordinarily high. For example, assume a $100,000 IRA names a QTIP trust as beneficiary, and that the QTIP trust has $1 million in other, non-IRA assets. If the QTIP trust does not contain a provision that overrides the 90/10 rule, the entire $1.1 million value of the trust fails the QTIP requirements.

Outlined in the ruling are definitions of qualified income. They include the annual right of the surviving spouse to demand income earned within the retirement plan account using:

  • the traditional method for determining income, including traditional income that the trustee adjusts under a state statute similar to UPIA Section 104(a), or

  • under unitrust provisions contained in state statutes, using a unitrust percentage of between three percent and five percent.

To obtain the marital deduction, the QTIP election must be made over both the retirement plan account and the trust. Therefore, the ruling holds that it is necessary to list both the IRA (or other retirement plan) and the trust named as beneficiary on the estate tax return marital deduction schedule.

NONSPOUSE BENEFICIARIES

A groundbreaking legislative change opens new vistas for IRA and qualified retirement plan beneficiaries who are not surviving spouses. Many qualified retirement plans and some IRAs won't stretch out distributions for nonspouse beneficiaries, even though tax law provisions have always allowed them to do this.3 In such cases, the tax law permits distributions over the life expectancy of the beneficiary, but the controlling plan document overrides the tax law, instead mandating a lump-sum payout to the beneficiary.

Beginning on Jan. 1, 2007, nonspouse beneficiaries have a new option under the PPA.4 They can transfer the benefits to an inherited IRA. Before this change, nonspouse beneficiaries were not permitted to transfer death benefits to an IRA.

Rollovers are not permitted. Instead, a direct transfer must be made. In other words, if a check is issued to the qualified retirement plan beneficiary, the beneficiary is not able to put those funds in an IRA. This can be extremely problematic, because the Service has not been granted authority to remedy these mistakes. For example, although in some instances the Service may waive the 60-day rollover requirement, that authority does not apply to a transfer by a nonspouse beneficiary, since transfers are not rollovers.

The transfer must be to an IRA held in the decedent's name for the benefit of the beneficiary of the transferring qualified retirement plan account or IRA.

The new rule also relieves tension about whether to name a trust as beneficiary. Before the change, the specter of a lump-sum payout to a trust had to be weighed against naming a spouse directly as beneficiary, because the spouse could roll over the lump-sum payout to an IRA and continue deferring income taxes. The new rule will permit a trust to make a transfer of the lump-sum payout to a inherited IRA.

IRA

Starting in 2010, a Roth IRA conversion will be permitted if adjusted gross income exceeds $100,000. This dollar limit was repealed by TIPRA.5 And here's a bonus if the Roth IRA conversion is made during 2010: The income from the conversion will be recognized ratably over 2010 and 2011, unless the taxpayer elects to recognize all of it in 2010.

Also, beginning in 2008, Roth IRA conversions of eligible retirement plans other than IRAs may be made directly, without having to transfer the assets first into a traditional IRA.6 “Eligible retirement plans” now include IRAs, Section 401 qualified retirement plans (including the ever-popular 401(k) plans), Section 403(b) tax-deferred annuities, and Section 457 retirement plans of a state, political subdivision of a state, and any agency or instrumentality of a state or political subdivision of a state.

  • Old rule example — Allen has a 401(k) account with his former employer. He's retired and wants to convert his account to a Roth IRA during a tax year in which he satisfies all requirements for a Roth IRA conversion. Before he makes the conversion, he must first transfer or roll over his 401(k) account to a traditional IRA. Only after he has transferred or rolled his 401(k) account to a traditional IRA account may Allen convert the traditional IRA to a Roth IRA.

  • New rule example — Beginning in 2008, Allen may convert his 401(k) account directly to a Roth IRA. He does not need to first transfer or roll it over to a traditional IRA.

New legislation also affects charitable transfers. A qualifying transfer from an IRA to a qualifying charity will bypass taxable income.7 As the transfer is not taxable, there is no further charitable deduction.

There is an annual limit of $100,000 per year that applies separately to each taxpayer. Spouses can each contribute $100,000. Such charitable transfers are permitted only in 2006 or 2007. This is an opportunity to redirect up to $100,000 of RMDs to charity. No contributions may be made to a private (that is to say, grant-making) foundation, a donor-advised fund (DAF), or an IRC Section 509(a)(3) supporting organization (SO). Age checks are critical. It is not enough that the transfer occurs during the year in which the IRA owner turns 701/2. To qualify, the transfer must occur on or after the date when the IRA owner actually does attain age 701/2.

For example, Sidney was 70 on Aug. 4, 2006. He will be 701/2 on Feb. 4, 2007. He may not make a charitable IRA transfer before Feb. 4, 2007.

To make a charitable IRA transfer, the IRA owner directs the IRA trustee or custodian to issue a check from the IRA made payable to charity. The charitable transfer does not qualify if the custodian makes the mistake of putting IRA money in a non-IRA account as an intermediate step.

Be sure to obtain an acknowledgment letter from the charity.

RELIEF

The IRS deserves high marks for promptly providing a method for SOs to request reclassification to qualify for IRA charitable contributions in Announcement 2006-93, IRB 2006-38 (November 27, 2006). It is truly praiseworthy that 70 such reclassifications were made by early December 2006.

Additional, significant legal developments in the retirement benefits arena include:

  • Tax refunds — Beginning in 2007, taxpayers may direct tax refunds to their IRAs.8 The IRS has already announced its new Form 8888 to be used for this purpose.

  • EGTRRA — The Economic Growth and Tax Relief Reconciliation Act of 2001 contained a provision that repeals itself after Dec. 31, 2010. But the PPA repealed EGTRRA sunset provisions only relating to EGTRRA pension and individual retirement arrangement provisions. This means, for example, that hardship relief from the 60-day rollover requirement survives beyond 2010.9

  • After-tax rollovers — Beginning in 2007, the after-tax portion of annuity contracts may be rolled over to an IRC Section 403(b) contract.10

PENALTY EXCEPTIONS

Under the PPA, retroactive to Sept. 11, 2001, a new exception to the 10 percent penalty for pre-age 59½ retirement plan withdrawals applies for individuals called to active military duty for at least 179 days. The distribution must be a “qualified reservist distribution.” The penalty relief applies to distributions made during the active duty period. The statute of limitations is suspended for retroactive refund claims available under this provision.11 The distributions may be repaid to the retirement plan within the two-year period beginning the day after the end of the active duty period, regardless of contribution limits. However, no income tax deduction will be allowed for the repayment.

Effective Aug. 17, 2006, the PPA loosened the exception to the 10 percent penalty on pre-age 70½ distributions made to an employee after separation from service. The age when the penalty exception applies has been lowered from age 55 to 50, but only for qualified public safety employees receiving distributions from a defined benefit plan sponsored by a governmental agency.12

SPECIAL NEEDS TRUST

Under PLR 200620025, grantor trust rules were applied to avoid treatment of an IRA benefits transfer as an income taxable transfer or sale of income in respect of a decedent. One of the IRA owner's four sons qualified for Medicaid benefits. All four were named IRA beneficiaries. A state court established a special needs trust (SNT) for the disabled son. His share of the IRA was set up in a separate inherited IRA for which he was the only trust beneficiary during the grantor's lifetime. The trust reimburses the state upon his death, and the remainder passes to the son's heirs at law. The disabled son's mother disclaimed her intestacy rights in the son's trust.

IRA ALLOCATION

In PLR 200617020, an IRA named the decedent's estate as beneficiary. The will provided for a charitable bequest of a share of the residue, and granted the personal representative the power to pick and choose property to satisfy bequests. The personal representative proposed to assign the right to the IRA in partial satisfaction of the charitable bequest. The Service held that this was not a sale of the IRA, income in respect of decedent (IRD) was not recognized by the estate, and the IRA presumably passed free of income taxes to the charity.

In PLR 200633009, an IRA was payable to the estate of the IRA owner. The IRA owner died testate. His will directed that a share of his estate pass to charity. The will granted his executor the power to make distributions in cash, in-kind, or partly in each, either pro rata or otherwise.

The personal representative of the estate proposed to assign, in-kind, some or all of the IRA to the charitable beneficiary as satisfaction of the charitable bequest under the will.

The IRS held that the estate would not realize IRD as a consequence of the allocation to charitable beneficiary. So, with no income tax consequence to the estate, the IRA passed to the charity, income tax-free.

My advice would be, though, to go direct. Name the charity as the IRA beneficiary. Still, an alternative should be provided, in the trust instrument, that the trustee is required to use the IRA to satisfy the charitable bequest.

WAIVER DENIED

The taxpayer was less fortunate in CCM 200644020. A trust was named as beneficiary of an IRA. The trust provided a pecuniary (dollar amount) bequest to charity. The trustee made an in-kind transfer of the right to receive a portion of the decedent's IRA to the charity. The Service said that satisfaction of the pecuniary charitable bequest with the IRA must be treated as a taxable sale of the IRA, triggering recognition of the IRD. Worse, the trust was not entitled to a charitable income tax deduction. This CCM stands in stark contrast to several PLRs where a trust satisfied a pecuniary marital bequest with an IRA.13 In those rulings, the Service held there was no recognition of IRD and that the surviving spouse, who received the IRA under the marital bequest, could roll over the IRA to an IRA of the surviving spouse. Evidently, there are conflicting theories about the topic of pecuniary bequests and IRAs within the Service that need to be resolved, or else the Service changes its ruling position.

In PLRs 200634017 through 200634022, the IRS denied requests to waive the 60-day rollover rule. Several employee-participants in an employer-sponsored qualified plan were misled by a summary plan description and by an individual who met and dispensed misleading advice to these employees. The misleading advice was that partial distributions from the plan account of employer stock would qualify for treatment as net unrealized appreciation (NUA).

The NUA rule, which only applies in the case of a qualifying lump-sum distribution, taxes the plan trustee's basis as ordinary income and defers taxation of the NUA until an actual sale of the employer's stock occurs. At that time, NUA is taxed at long-term capital gains rates.

Because the distributions of employer stock were partial distributions, the employees who applied for the rulings were required to pay income taxes on the entire fair market value (FMV) of stock distributed to them from the plan at ordinary income tax rates.

The employees learned that the advice they received was in error, but that was after the 60-day rollover period had expired. They applied for relief under IRC Section 402(c)(3)(B).

The Service declined to waive the rollover requirement, noting that, while the taxpayers were misinformed about the tax effect of the distributions of employer stock that they requested and received, they had no intention to make rollovers when the distribution of employer stock occurred. Instead, they intended to pay income taxes at favorable rates and keep the after-tax proceeds outside of an IRA. It's tragic that reliance on a summary plan description and an ill-qualified advisor led to irreversible disaster.

SPOUSAL ROLLOVERS

PLR 200615032 is yet another instance in which the IRS will permit a surviving spouse to execute a rollover to her IRA, even though the IRA of the deceased spouse named a trust as beneficiary. The key to this and other similar rulings is that the surviving spouse held rights that added up to an unrestricted right to withdraw the IRA. In this case, the spouse, acting as trustee, could allocate the IRA to herself, as beneficiary of the trust.

Obtaining PLRs is costly. The lengthy process (often one year or more) causes delay in estate-and-trust administration. And there are overwhelming numbers of similar rulings. Therefore, authoritative guidance would be helpful, particularly if it addresses circumstances in which the surviving spouse is regarded as the “true” beneficiary for tax purposes, even though an estate or trust is the named beneficiary of an IRA or other retirement plan.

The IRS broke new ground in PLRs 200616030, 200616040 and 200616041 by recognizing a court order that reformed an IRA beneficiary form. These three rulings relate to the same situation.

Through failure to execute written instructions, a new IRA set up to receive the funds in an old IRA did not list the IRA owner's daughters as contingent beneficiaries. The IRA owner's wife was the primary beneficiary. The IRA owner died, making his wife the beneficiary. The wife died shortly thereafter, and the wife's estate became the IRA beneficiary. The daughters sought a court order reforming the IRA beneficiary form to conform to the IRA owner's intentions, as evidenced by his written instructions. The employee of the IRA custodian, who received those instructions and failed to execute them in full, provided a statement owning up to the mistake. The court issued its order nunc pro tunc, so that the reformation was effective as though the IRA beneficiary form had been filled out correctly.

One of the daughters, in her capacity as executor of the wife's estate, exec uted a qualified disclaimer of the wife's interest. As the daughters were the alternate beneficiaries under the reformed IRA beneficiary form, the effect of the disclaimer was to make them the only beneficiaries.

The IRS permitted the daughters to transfer the IRA to two new IRAs, and stretch out the IRA distributions over the life expectancy of the oldest daughter.

Note that each daughter might have been able to use her own life expectancy, but apparently neither asked the IRS that question. They only asked whether they could use the life expectancy of the oldest daughter to pay RMDs. The IRS answered in the affirmative.

Endnotes

  1. Revenue Ruling 2000-2, 2000-1 C.B. 305 was modified and superseded.
  2. See Uniform Principal and Income Act (UPIA), Section 409.
  3. See Internal Revenue Code Section 401(a)(9) and related regulations.
  4. Pension Protection Act of 2006 (PPA), P.L. 109-280, Aug. 17, 2006, Section 829.
  5. Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), pp. 109-222, May 19, 2006, Section 512.
  6. PPA Section 824.
  7. Ibid., Section 1201.
  8. Ibid., Section 830.
  9. Ibid., Section 811.
  10. Ibid., Section 822.
  11. Ibid., Section 827.
  12. Ibid., Section 828.
  13. See PLR 9808043, 9524020, 9608036 and 9623056.