On Jan. 10, 2007, the IRS issued Notice 2007-7, which contains guidance for many provisions of the PPA 2006. It also provides new and unexpected interpretations of the rules for non-spousal direct rollovers from employer plans to inherited IRAs. While the topic is complex, advisors who don't take heed may make the wrong recommendations to clients.

THE ORIGINAL PROBLEM

Before PPA 2006, a non-spouse beneficiary, including a trust, was not able to move funds out of an employer plan other than by taking a taxable distribution. Many plans had so-called five-year plans.

Under a five-year plan, the entire plan balance had to be withdrawn by the end of the fifth year following the year of death. There were no required distributions in years one through four, but by the end of year five, the entire balance should have been distributed. This distribution would result in the loss of any extended payouts to the non-spouse beneficiary or trust beneficiary (the stretch).

If the employer plan allowed a life expectancy payout, then there was no problem and the beneficiary did not need the relief provision in PPA 2006. In that case, the beneficiary took lifetime distributions from the employer plan. There was also no problem for a spouse beneficiary, since a spouse can do a rollover and move the inherited plan funds to his or her own IRA.

THE SOLUTION

Effective for distributions in 2007, the new provision in the law gives a non-spouse beneficiary, including a qualifying trust, the ability to do a direct rollover (a trustee-to-trustee transfer) of inherited employer plan funds to an inherited IRA. The congressional intent of the new law was to give non-spouse beneficiaries the ability to stretch distributions over their own life expectancies after the funds were in the inherited IRA, just as if they had inherited an IRA rather than an employer plan.

IRS Notice 2007-7 makes it clear that this provision applies to 401(k)s, 403(b)s and Section 457 plans. In addition, the notice clarifies that the IRA receiving the inherited plan benefits must be a properly titled inherited IRA that keeps the name of the decedent in the account title. The example they use is, "Tom Smith as beneficiary of John Smith."

THE PROBLEMS

But then the Notice gets a bit confusing, and some of these rules may create a situation negating what Congress had intended. That would effectively put the non-spouse plan beneficiary right back in the same predicament that existed before the relief that PPA 2006 was supposed to provide.

Direct transfer. The notice says that a plan does not have to allow the non-spouse beneficiary a direct transfer option, which could diminish the intended impact. The notice doesn't say whether the plan must be amended to allow the direct transfer option. But if that turns out to be the case, that could be the death knell for this benefit. If a plan amendment is required, it is unlikely a plan will allow the direct rollover provision, which would undermine the main intent of the law. If the plan does offer the direct transfer option, it must do so on a nondiscriminatory basis.

Special rule. The IRS notice says that after the employer funds are moved to an inherited IRA, the distribution rules that applied under the plan will continue to apply to the inherited IRA, unless a special rule under Q & A-17(c)(2) of the notice applies. The special rule states that in order for the non-spouse plan beneficiary not to get stuck with the plan rules (assuming the plan does not allow life expectancy payout), the beneficiary must take the first required distribution based on the beneficiary's life expectancy by the end of the year following the year of the employee's death.

Every advisor must know about this special rule. If non-spouse beneficiaries don't want to get stuck with the five-year rule that most plans require, they must know to use this special rule.

The special rule allows non-spouse beneficiaries to stretch the IRA, but generally only going forward for plan participant deaths in 2006 and later. For a death in 2006 or later, the special rule requiring the non-spouse beneficiary to take the first required distribution by the end of the year following the year of death is not a problem, since there is still time to do that in 2007.

For a death in 2005 or earlier, however, it may be too late to employ this rule if the plan rules state that the five-year rule applies. Unfortunately, there is no retroactive relief. The result is a trap for any non-spouse plan beneficiary that inherited before 2006. If that non-spouse beneficiary didn't take a required distribution by the end of the year following the year of death, they will be stuck with the five-year payout rule, even though they couldn't possibly have known to take that distribution because the special rule didn't exist. They thought they were stuck with the five-year rule, so why take a distribution that wasn't necessary?

Custodian issues. Under these new rules, many inherited IRAs will be subject to the distribution rules of the plans the funds came from. Many IRA custodians are likely to refuse to take these rollover accounts, since each inherited IRA could have a different payout option from what is normally offered by the custodian for an inherited IRA. It would be nearly impossible for a custodian to keep track of which accounts came from inherited employer plans and what their distribution schedules should be.

The many rules and complications in this IRS Notice remind us of all the reasons to continue to advise clients with funds in company plans to roll those funds into IRAs when they have the opportunity to do so. This way, non-spouse beneficiaries, such as children, grandchildren, trust beneficiaries, partners or friends will be able to stretch distributions over their lifetimes from the inherited IRA without all the bumps in the road that can occur when funds are left in the plan. This law was supposed to make the road smoother for non-spouse plan beneficiaries, but that may not be the case. Rolling plan funds into IRAs and having beneficiaries inherit from the IRAs is still the best way to make sure beneficiaries get the stretch IRA.

Ed Slott, a CPA in Rockville Centre, N.Y., is a nationally recognized IRA distribution expert, professional speaker and author of several IRA books including the recent Your Complete Retirement Planning Road Map and Ed Slott's IRA Advisor, a monthly IRA newsletter. He has also created The IRA Leadership Program and Ed Slott's Elite IRA Advisor Group, developed to help financial advisors become recognized leaders in the IRA marketplace. Visit his website at www.irahelp.com.

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