Beneficiaries of qualified retirement plans know the value of stretching out distributions over life expectancy. Retirement plans may -- but don't have to -- offer stretch distributions to beneficiaries. Instead, many offer only a lump sum payout. And while surviving spouses have long been able to rollover qualified retirement plans to an individual retirement account (IRA) so as to stretch out distributions from the rollover IRA, nonspouse beneficiaries couldn't do this -- until the Pension Protection Act. Now, qualified plans are permitted to offer nonspouse beneficiaries the option of a direct rollover to an inherited IRA.
Unfortunately, the PPA did not make offering this option mandatory, so it remains to be seen how many plans will provide it. And a recent clarification from the Internal Revenue Service seems to have created an impediment to their doing so.
The IRS also issued guidance that managed to confuse practitioners about the relationship between the new direct rollover to an IRA and the so-called five-year rule. To clarify matters, the IRS issued a news release in a special February 13 edition of its publication Employee Plans News.
The five-year rule applies when a plan participant dies before reaching the required beginning date for distributions. It simply says that the retirement plan account must be liquidated within five years of the participant's death. The regulations interpret the deadline to mean December 31 of the year containing the fifth anniversary of the participant's death. There is no required minimum distribution (RMD) before the year when that deadline occurs, but the entire account balance becomes a RMD for that year.
Under a statutory exception to the five-year rule, distributions may be stretched out over a life expectancy. But certain conditions must be met: The plan must permit this; there must not have been an affirmative election to use the five-year rule; and the first RMD must be made by December 31 of the year following the year when the participant died.
In Employee Plan News, the IRS explains that once the transfer to an inherited IRA is made, the nonspouse beneficiary may treat the transferring qualified plan as if it permitted the life expectancy rule. This opens the door to life expectancy payouts. It also resolves the dilemma posed by Congress' apparent intention to allow the direct rollover as a way to get around many plans' lump-sum payouts and five-year rules versus the need for each and every qualified plan to follow strictly its own written terms.
The IRS news release cautions that the direct rollover to the inherited IRA must be completed by December 31 of the year following the participant's death. That means that nonspouse beneficiaries should act sooner rather than later, to allow time for the transfer to be completed by that date.
The IRS goes on to provide an example that is troubling in its interpretation of what the distributing plan must do when the direct rollover occurs during the year following the year of death. The example says that the distributing plan must make a distribution to the beneficiary of the first RMD based on the life expectancy rule. That amount cannot be transferred to the inherited IRA as part of the direct rollover.
Beneficiaries faced with either a lump sum distribution or a plan-mandated five-year rule should be able to make a direct rollover to an inherited IRA and have the choice after making the rollover whether to use the five-year rule or the life expectancy rule. The rollover itself should not preempt that decision by being treated as an election into the life expectancy rule, forcing the first RMD under that election.
To meet the terms and conditions of the distributing plan, the beneficiary may treat the plan as if it allows the life expectancy election, once the direct rollover to the inherited IRA is made. The only remaining condition is timely distribution of the first RMD. This condition may be met by the end of the year following the year of the participant's death, as with any inherited IRA. No life expectancy election has been made before that crucial first distribution is made, so there is no RMD at the time of the direct rollover from the distributing plan. Therefore, there is no need to impose upon the plan an RMD determination and distribution.
The example instead presupposes that the beneficiary has elected into life expectancy distributions by making the rollover, and so has created the first RMD before making the transfer. But this requires the plan to treat itself as though its terms permit the life expectancy exception when, in fact, that is not the case. Only the beneficiary is permitted this fiction, which is only possible after the direct transfer has occurred. Surely, any such fiction imposed on the plan administrator by reason of permitting the direct rollover will be unwelcome.
Prediction: imposing a requirement on plan administrators to determine an RMD that complicates the direct rollover and is contrary to the terms of the transferring plan's own governing instrument will discourage qualified plans from offering this valuable option to nonspouse beneficiaries. The IRS needs to drop this unnecessary requirement.
The IRS news release example also makes it clear that it is no longer possible to use a direct rollover to an inherited IRA to elect the life expectancy method, instead of the five-year method, if the plan participant died before the year 2006.
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