In a move that generated considerable joy and surprise,1 the Internal Revenue Service announced in Notice 2008-30 that beginning this year, a decedent's qualified retirement account can be directly rolled over into a Roth individual retirement account (IRA) for a nonspouse beneficiary, such as a child, sibling or life partner. (See “And the Answer Is … ” p. 30.) Estate planners now have an additional tool using inherited retirement accounts that may provide estate planning and tax benefits for certain nonspouse beneficiaries.
The Roth IRA is treated as an inherited IRA rather than the beneficiary's own IRA.2 Thus, amounts must begin to be distributed to the beneficiary the year after the plan participant died, and the account generally must be liquidated over a beneficiary's remaining life expectancy, which is typically about ages 83, 84 or 85.3 By comparison, a person is never required to receive a distribution from his own Roth IRA during his lifetime.4 Note that a spouse always has had more flexibility with inherited retirement assets than a nonspouse, including the ability to roll over a deceased spouse's retirement assets into his own IRA.5
Given the IRS' go-ahead, non-spouse beneficiaries of a decedent's retirement account now should ask two questions: “Should I?” and “Can I?”
To answer the “Should I?” question, consider this: the direct rollover to a Roth IRA triggers a tax liability that is analogous to a Roth IRA conversion — it is taxable income as though the account had been distributed and then contributed to a Roth IRA, with no offsetting tax deduction.6 Distributions from the Roth IRA are generally exempt from tax. For many people, the tax cost of the direct Roth IRA rollover could exceed the tax benefits. Those taxpayers would instead benefit more under the general principles of income tax deferral by having the assets transferred tax-free to a regular IRA that would make taxable payments to them over their life expectancies.7
So who benefits from the “pay now, enjoy later” opportunity, especially when they must begin receiving distributions in the year following conversion? The best candidates are people who are in a low income tax bracket in the year of conversion, but who will be in higher income tax brackets in later years. Ideal candidates are graduate students who were named as beneficiaries of a decedent's retirement accounts or who could receive those amounts by way of a disclaimer by the primary beneficiary (that is, a primary child beneficiary disclaims to a contingent grandchild beneficiary). The Service will allow a primary beneficiary to disclaim most of an inherited IRA even if he received a mandatory distribution from the account in the year of the participant's death.8
Similarly, individuals could benefit if they are temporarily in a low income tax bracket due to employment changes or if they are beginning their careers. People in unusually low income tax brackets also are good candidates for a conventional Roth IRA conversion of their own IRAs, which will produce even better results since such Roth IRAs are not subject to a mandatory lifetime distribution requirement.9 Whether there is a conventional Roth IRA rollover or the direct rollover to an inherited Roth IRA, the greatest tax savings occur when the individual uses other resources to pay the income tax liability rather than using part of the rolled over retirement distribution.
Another opportunity exists when the decedent's estate was so large that it was subject to the federal estate tax. A beneficiary of retirement assets is entitled to claim an itemized deduction (known as “the Section 691(c) deduction”) for the 45 percent federal estate tax that was paid on the retirement assets. Although it's usually advantageous to defer income, it's also advantageous to accelerate tax deductions. By directly rolling over a retirement account into a Roth IRA, a beneficiary can immediately claim the entire Section 691(c) deduction in the year of the conversion, effectively cutting the income tax rate almost in half.10 There are other situations in which a conversion could be beneficial, such as prepaying the income tax to reduce an estate's size for a future estate tax liability.
To answer the “Can I?” question, consider: to take advantage of the direct Roth IRA rollover opportunity, there are at least three administrative and legal hurdles to overcome. First, the plan document must permit distributions from a decedent participant's account directly to an IRA. A plan is not required by law to make such trustee-to-trustee transfers of a decedent's account to either a regular IRA or a Roth IRA.11 The law merely offers this as an option. Second, the plan that holds the decedent's account must be an eligible retirement plan under Section 402(c)(11). Third, the beneficiary must meet the criteria for a conventional Roth IRA conversion. Often, the greatest challenge is the requirement that the beneficiary has adjusted gross income (AGI) below $100,000 in 2008 and 2009 (there is no AGI limit in 2010 or later years).12 If a retirement plan made a direct rollover to a Roth IRA for a person who is later determined to be ineligible for a Roth IRA conversion, the rollover can be recharacterized as a transfer to a regular IRA.13
Although the Internal Revenue Code permits a retirement plan to make a trustee-to-trustee transfer of a decedent's account to a regular IRA when a trust, rather than an individual, is named as the account's beneficiary,14 there's no guidance on how such a trust would qualify for the Roth IRA conversion. That is, does the $100,000 AGI threshold apply to the trust or to the trust's beneficiary? Further guidance is needed.15
What if a beneficiary misses the first distribution the year after the decedent's death? The Service offered a pleasant surprise in its answer in Private Letter Ruling 200811028 (issued Dec. 21, 2007). In this PLR, the IRS found that a beneficiary who failed to receive distributions for the first two years after her father's death still was eligible to receive distributions over her remaining life expectancy of 52 years. Until the release of this ruling, many had thought that the failure to receive a distribution in the year after the decedent's death foreclosed “stretch” payments and that the account would have to be liquidated in just five years (the father died at age 66, before his required beginning date).16 The beneficiary received all of the missed distributions in the third year after her father's death and paid a 50 percent penalty tax17 on the late distributions. The Service concluded that the beneficiary was thereby able to preserve stretch payouts over her remaining life expectancy.
- See Bob Keebler, “Notice 2008 30 — Guidance on Conversions to Roth IRAs,” LISI Employee Benefits and Retirement Planning Newsletter #446 (March 6, 2008); Mike Jones, “Mike Jones on Roth IRA Rollovers by Non Spouse Beneficiaries,” LISI Employee Benefits and Retirement Planning Newsletter #447 (March 10, 2008): Natalie Choate, “IRS Notice 2008 30 Part II: Natalie Choate Asks: So What?” LISI Employee Benefits and Retirement Planning Newsletter #448 (March 10, 2008).
- Internal Revenue Code Section 402(c)(11)(A)(ii).
- IRC Sections 408(a)(6) (regular individual retirement account (IRA)); 408A(a) (Roth IRA); and 401(a)(9)(A)(ii) and 401(a)(9)(B)(i) (“stretch” payments over life expectancy). The regulations use the life expectancy tables contained in Table A-1 of Treasury Regulations Section 1.401(a)(9)-9, as required by Treas. Regs. Section 1.401(a)(9)-5, Q&A 5(a) and 5(c) and Q&A 6.
- IRC Section 408A(c)(5).
- IRC Section 402(c)(9).
- A person who converts a regular IRA into a Roth IRA reports the converted amount as a taxable distribution from the IRA (though there is no 10 percent penalty for doing this before age 59 1/2) and receives no offsetting deduction for the deposit into the Roth IRA. IRC Section 408A(d)(3)(A). The benefit is that after five years and after age 59 1/2, all distributions from the Roth IRA are exempt from the income tax. IRC Section 408A(d). An important additional benefit is that there are no required minimum distributions (RMDs) from a person's own Roth IRA after age 70 1/2, as is the case for all other types of qualified retirement plans. IRC Section 408A(c)(5). After a person's death, though, the RMD from an inherited Roth IRA are subject to the same RMD requirements as an inherited regular IRA.
- Natalie Choate made this point in her commentary, “IRS Notice 2008 30 Part II: Natalie Choate Asks: So What?” supra at note 1.
- Revenue Ruling 2005-36, 2005-26 I.R.B. 1368. Usually the acceptance of benefits of inherited property will disqualify a disclaimer. IRC Section 2518.
- See ibid. and IRC Section 408A(c)(5).
- For planning strategies concerning the IRC Section 691(c) deduction, see Christopher R. Hoyt, “Inherited IRAs: When Deferring Distributions Doesn't Make Sense,” Trusts and Estates, at pp. 52-64 (June 1998).
- Notice 2008-30, Q&A 7, 2008-12 I.R.B. 638, 639.
- IRC Section 408A(c)(3)(B), as amended by P.L. 109-222 for tax years after 2009.
- IRC Section 402(c)(11)(B).
- See the analysis in “Mike Jones on Roth IRA Rollovers by Non Spouse Beneficiaries,” supra at note 1.
- IRC Section 401(a)(9)(B)(ii).
- IRC Section 4974.
Christopher R. Hoyt is a professor of law at the University of Missouri-Kansas City School of Law in Kansas City, Mo.
And the Answer Is …
Yes! Nonspouse beneficiaries can make qualified rollover contributions to Roth IRAs
In Notice 2008-30, 2008-12 I.R.B. 638, 639, the Internal Revenue Service put to rest the issue of whether beneficiaries can make qualified rollover contributions to Roth IRAs. Here's the text of Q&A-7 from the notice:
Q 7. CAN BENEFICIARIES MAKE QUALIFIED ROLLOVER CONTRIBUTIONS TO A ROTH IRA?
A-7. Yes. In the case of a distribution from an eligible retirement plan other than a Roth IRA, the MAGI and filing status of the beneficiary are used to determine eligibility to make a qualified rollover contribution to a Roth IRA. Pursuant to section 402(c)(11), a plan may but is not required to permit rollovers by nonspouse beneficiaries and a rollover by a nonspouse beneficiary must be made by a direct trustee-to-trustee transfer. A nonspouse beneficiary that is ineligible to make a qualified rollover contribution to a Roth IRA may recharacterize the contribution pursuant to section 408A(d)(6). A surviving spouse who makes a rollover to a Roth IRA may elect either to treat the Roth IRA as his or her own or to establish the Roth IRA in the name of the decedent with the surviving spouse as the beneficiary. (See Notice 2007-7, Q&A-13, for a rule on how to title a beneficiary IRA.) A nonspouse beneficiary cannot elect to treat the Roth IRA as his or her own. (See Notice 2007-7, Part V.)
In the case of a rollover where the beneficiary does not treat the Roth IRA as his or her own, required minimum distributions from the Roth IRA are determined in accordance with Notice 2007-7, Q&As - 17, -18 and -19.
— Christopher R. Hoyt