Retirement Planning and Non-Spousal Beneficiaries

Retirement distribution planning can shield heirs from large amounts of tax exposure. Now a recent law change extends relief to non-spousal beneficiaries.

September 20, 2007
Sponsored by BNA Software

by Nancy Faussett, CPA

Retirement distribution planning, if done well, can shield your heirs from large amounts of tax exposure. While wills control probate assets and trusts control trust assets, IRAs and qualified retirement plans are controlled either by the designation of a beneficiary or the default provisions of the contract. Planning for the distribution of an IRA or qualified retirement plan is of utmost importance as such funds often constitute the largest asset of an estate. The focus of this article is when the designated beneficiary of an IRA or qualified retirement plan is a non-spouse.

The recent passage of the Pension Protection Act of 2006, with its wide-ranging reform of the pension laws, significantly affected qualified retirement plans, including a change in the treatment of non-spousal beneficiaries. Previously, only a surviving spouse could transfer an inherited retirement plan (such as a 401(k) plan) into their own IRA, thus deferring any tax. If the beneficiary was other than the spouse of the deceased, the person inheriting the funds was forced to take a lump sum distribution, incurring an immediate (and often quite large) tax liability. The reasoning behind this was that the employer didn’t want to have to bear the administrative cost of having a non-employee on its plan.

However, with the passage of the Pension Protection Act, non-spousal beneficiaries, who receive a distribution of a qualified retirement plan after 2006, are now allowed to direct the plan’s trustee to transfer the money directly into an IRA account, thereby entitling them to receive payments over their lifetime. Since IRAs are not taxed until distributed, this is a noteworthy improvement to the earlier rules.

A “non-spouse” may be a domestic partner, a relative or anyone else named as the beneficiary. Realize, of course, that the retirement plan may restrict who constitutes an allowable beneficiary. The Act does not legislate that the terms of a pension plan have to allow such beneficiaries and, in fact, IRS Notice 2007–7 confirms this.

The IRA to which the inherited funds are distributed must be established by the non-spouse beneficiary specifically for this purpose and be identified with both the decedent’s and beneficiary’s names, such as “John Smith, a beneficiary of Robert Jones.” It is also important that the check for the inherited funds be made payable directly to the IRA, and not made out to the individual. It will then be treated as an inherited IRA and the minimum distribution rules apply.

In order to prevent unlimited deferrals, a qualified retirement plan or IRA must provide that the entire interest of the participant be distributed or start to be distributed on or before the required beginning date (RBD). Generally, for years beginning after December 31, 1996, distributions from a qualified retirement plan are required to begin by April 1 of the calendar year following the later of: (1) the calendar year in which the employee attains age 70½; or (2) the calendar year in which the employee retires. In the case of an IRA or a five percent owner of the employer, distributions are required to begin no later than the April 1 of the calendar year following the year in which the IRA owner or five percent owner attains age 70½.

Once the RBD is reached, required minimum distributions (RMD) must begin. The RMD is calculated by dividing the prior year-end account balance by the life expectancy factor.

However, whereas a spousal beneficiary can wait until age 70½ to receive distributions, the rules are different for a non-spousal beneficiary even though the non-spousal beneficiary has been allowed to roll over the funds into an IRA. A non-spousal beneficiary has two options if the participant dies before his or her RBD:

  1. Take regular installment payments of equal amounts over the remaining life expectancy of the beneficiary or over a period of time not extending beyond the life expectancy of the beneficiary. Such payments must start prior to the end of the year following the participant’s death. The advantage of this option is that it greatly decreases the amount required to be withdrawn each year, while allowing the account balance to continue to grow tax-free.
  2. Take a lump sum payment no later than the end of the fifth year following the participant’s death (a.k.a., the “five-year rule”). The beneficiary can directly roll over the beneficiary's entire benefit until the end of the fourth year. However, on or after January 1 of the fifth year following the year in which the participant died, no amount payable to the beneficiary is eligible for a rollover.

Under either of the above scenarios, there is no required minimum distribution for the year in which the participant dies.

If, however, the decedent dies after starting distributions, the non-spouse beneficiary has the following two options:

  1. Same as the first option above, with the distributions starting in the year after death, based on beneficiary's life expectancy.
  2. Take a lump sum payment and include the entire amount in income in the year after death (i.e., the five-year rule does not apply).

Example: A plan participant, Miss Careful, dies in 2007 before her required beginning date. The plan uses the five-year rule and allows for direct rollovers by non-spouse beneficiaries. The non-spouse beneficiary may roll over (via direct trustee-to-trustee transfer) the deceased participant's account balance into an "Inherited IRA" in 2007 and take required minimum distributions from the IRA beginning in 2008, using the life expectancy of the beneficiary. If Miss Careful’s account balance is rolled over in 2008, the amount eligible for rollover is reduced by the amount of the required minimum distribution for 2008, determined using the life expectancy rule. After 2008, the non-spouse beneficiary still could roll over funds from the plan, but would have to take required minimum distributions from the IRA under the five-year rule. No amount can be rolled over after 2011.

In summary, the Pension Protection Act has certainly improved the inheritance rules for non-spousal beneficiaries of qualified retirement plans. While these newest rules differ from those applicable to a spousal beneficiary, the fact that a non-spousal beneficiary can establish an IRA for the inherited funds is a big improvement over requiring an immediate lump sum withdrawal. Calculating what the minimum distributions should be, however, can be quite complex and you will want to be sure you do it correctly to avoid the assessment of any needless penalties. Good tax planning software can greatly assist you if it has the capability of calculating what the minimum distribution should be. In fact, providing a minimum distribution calculator should be a must-have requirement for any software you are considering purchasing.

For more information, visit BNA Software.