In the January issue (which went to press in early December), I said that the Internal Revenue Service had reversed its position, and was now requiring company retirement plans to allow non-spouse rollovers in 2008. Not so fast! On Dec. 29, 2007, President Bush signed The Tax Technical Corrections Act of 2007 into law (H.R. 4839) as expected. But mysteriously, it doesn't include the provision making the non-spouse rollover mandatory for 2008. Then in January 2008, the IRS released Publication 590 on IRAs, noting that the provision is effective, but there is no mention of whether it's mandatory or optional. It's enough to give a planner a headache.

So what's the rule on non-spouse rollovers from company plans under the Pension Protection Act (PPA) of 2006? Do company plans have to allow this or not? Who knows? It now appears that the non-spouse rollover provision will not be mandatory for 2008 until either the IRS or Congress issues official guidance otherwise. As a result, we must assume that the provision remains optional.

The Whole Story

The PPA included a provision that would permit non-spouse plan beneficiaries to make direct transfers from a company plan to a properly titled inherited IRA. The beneficiaries could then take stretch distributions over their lifetime instead of being subject to the harsh payout rules of most company plans. This provision became effective in 2007. But the provision lost its steam when the IRS released Notice 2007-7 in January 2007, which stated that the provision was not mandatory for plans.

This created confusion and was contrary to what Congress intended. Congress realized this and proposed a technical correction to the law that stated that employer plans must allow the non-spouse direct rollover to an inherited IRA. In light of the pending congressional technical correction, the IRS reversed its position and said that the non-spouse rollover provision would be mandatory beginning in 2008. There was no official announcement on this, other than a posting on the IRS website. In fact, as of January 2008, the posting is still there.

This provision, however, was not in the bill that was passed and signed by President Bush at the end of 2007, and it may not end up in the bill currently pending in Congress. A later posting on the IRS website is silent on the issue. It appears that the provision has gone away, like a bad dream. Barring any future changes, Notice 2007-7 is still the authority, meaning that the provision remains voluntary.

This is bad news for non-spouse beneficiaries such as children, grandchildren, friends and unmarried couples (even if they are legally married under state law). If a company plan doesn't allow a non-spouse direct rollover, these beneficiaries will most likely be forced to withdraw the inherited plan balances in five years or less after the owner's death. They won't be able to extend the tax deferral over their lifetime through a stretch IRA.

How To Do the Transfer

If a company does allow non-spousal transfers, the transfers must be direct (trustee to trustee), and they must be done by the end of the year following the year of death. In addition, beneficiaries must take the first required minimum distribution from the inherited IRA by that same deadline (the end of the year following the year of death). If a transfer doesn't meet these deadlines, the beneficiary will still be able to do the transfer, but will be stuck with the usually less favorable payout option of the plan (probably the five-year rule) instead of getting to stretch the payments over his or her lifetime.

When funds are turned over to a beneficiary (not as a direct transfer), the beneficiary cannot correct the error and transfer those funds to a properly titled inherited IRA. Instead, the entire amount of the distribution will be taxable, and that will be the end of the tax shelter.

The direct transfer must be to a properly titled inherited IRA. The name of the deceased plan participant must be in the title of the inherited IRA. One example of proper account titling for an inherited IRA would be Bob Jones, deceased (Nov. 28, 2007), IRA f/b/o Jane Jones where Bob Jones was the father and 401(k) participant, and Jane Jones his daughter, the beneficiary of his 401(k) plan.

A trust is a non-spouse beneficiary too. In order to take advantage of the non-spouse transfer provision, the trust must qualify as a "see-through" or "look-through" trust under IRS requirements. To qualify the trust must be valid under state law and irrevocable after death; the trust beneficiaries must be identifiable and must all be individuals; and the trust documentation or the trust itself must be delivered to the plan administrator by October 31 of the year following the year of death. A trust that does not qualify cannot do a direct transfer to an inherited IRA.

More Confusion

To add to the confusion, IRS Publication 590 (Individual Retirement Arrangements) and Publication 575 (Pension and Annuity Income) mention the non-spouse rollover provision, but don't say whether the provision is mandatory or optional. They even go one step further to state that the provision is not available to spouses. Congress put the non-spouse rollover provision in the law to add a benefit; the provision wasn't meant to take away options.

Individuals who inherit company plan balances from their spouses are already protected under IRS regulations. Section 1.408-8, A-7 states that if "the surviving spouse of an employee rolls over a distribution from a qualified plan, such surviving spouse may elect to treat the IRA as the spouse's own IRA... ." Since treating the IRA as the "spouse's own" is an election, it would follow that the election could come after the surviving spouse has rolled the company plan funds over to an inherited IRA in the name of the deceased plan participant with the spouse as beneficiary. The spouse, therefore, doesn't need to use the non-spouse rollover provision of the PPA.

Why would a spouse want to remain a beneficiary? Suppose the spouse is under age 591/2 and needs the money right away, he or she would be subject to the 10% early withdrawal penalty on distributions from his or her own IRA unless one of the exceptions applies. The better move would be for the young spouse to roll the plan funds over to an inherited IRA, since the 10% penalty never applies to distributions to beneficiaries. Then, when the spouse reaches age 591/2, he or she can always roll the funds to his or her own IRA, since there will be no more early withdrawal penalties on distributions. There is no deadline for a spousal rollover, so choosing to be a beneficiary upon inheriting has no effect on the spouse's ability to do a spousal rollover to his or her own IRA at any time in the future.

The Bottom Line

The best move is generally still for clients to do an IRA rollover when they can, unless one of the lump-sum distribution tax breaks like net unrealized appreciation or 10-year averaging might work out better. If the IRA rollover was right before, it's still the right move now. The last thing advisors want is for their new clients, the beneficiaries, to be at the mercy of some plan, the IRS or the congressional position of the moment. FP

Ed Slott, a CPA in Rockville Centre, N.Y., is a nationally recognized IRA distribution expert, professional speaker and author of several IRA books and Ed Slott's IRA Advisor, a monthly IRA newsletter. Visit www.irahelp.com for more.