The Pension Protection Act of 2006 (PPA 2006) included a provision that would permit the non-spouse beneficiaries of company retirement plans to do direct transfers from the plans to properly titled inherited IRAs. This provision allows these beneficiaries to take stretch distributions over their lifetimes, instead of being subject to the harsh payout rules of most company plans. Originally the IRS said this provision, effective in 2007, was not mandatory for plans, but the agency has changed its position and made the provision mandatory beginning in 2008. This will help many of your non-spouse beneficiary clients who inherit a company plan.

Non-spouse beneficiaries are individuals (related or unrelated), since generally only individuals can be designated beneficiaries and can stretch distributions over their life expectancies. For this provision, however, a non-spouse beneficiary also includes qualifying trusts, but not estates or charities.

At Cross Purposes

The purpose of the PPA 2006 provision was to give non-spouse plan beneficiaries the same ability to stretch post-death distributions over their lifetime as if they inherited an IRA. But the provision lost its steam when the IRS stated last January that it was not mandatory for plans. (See "Unexpected Complications," March 2007.)

This controversial move was contrary to what Congress intended, so Congress has proposed a technical correction to the law stating that employer plans must allow a non-spouse direct rollover to an inherited IRA.

In light of the pending Congressional technical correction, the IRS reversed its earlier position. This change is especially helpful to beneficiaries of employees who are still working and have had no chance yet to do an IRA rollover. It will avoid a quick payout to their non-spouse beneficiaries, such as their kids or grandkids.

What to Look For

Although plans must now allow the transfer, there are still many details that can trip up clients and trigger immediate taxation if the transfer is done improperly. The current timing and transfer rules still apply. The transfer must be a direct transfer (a trustee-to-trustee transfer), and it must be done by the end of the year following the year of death.

In addition, the beneficiary must take his or her first required minimum distribution (RMD) from the inherited IRA by that same deadline. If the transfer isn't done in a timely manner, the beneficiary will still be able to do the transfer, but he or she will be stuck with the typically less favorable payout option of the plan (probably the five-year rule) instead of getting to stretch the payments over his or her lifetime.

The direct transfer must be to a properly titled inherited IRA, and 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 (January 28, 2008), 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 spouse beneficiary can do a rollover, but a non-spouse beneficiary cannot (even under this provision), so advisors must make sure that funds do not go from the 401(k) directly to the non-spouse beneficiary. If the inherited 401(k) funds are turned over to a non-spouse beneficiary, 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. In addition, the funds are no longer sheltered in an IRA, and potential decades of tax-deferred buildup can be lost.

Advisors also need to make sure that the inherited 401(k) funds do not mistakenly get transferred into the non-spouse beneficiary's own IRA. If this happens, the entire distribution is still taxable. Since a non-spouse beneficiary can't do a rollover, this error cannot be fixed; however, there will be no 10% early withdrawal penalty.

Trust Issues

To take advantage of the non-spouse transfer provision, a trust must qualify as a "see-through" or "look-through" trust under four IRS requirements:

• It must be valid under state law;
• It must be irrevocable after death;
• Its beneficiaries must be identifiable; and
• It or its documentation must be delivered to the plan administrator by October 31 of the year following the year of death.

Also, for this provision to work, all trust beneficiaries must be individuals. The stretch period would be over the age of the oldest trust beneficiary.

The delivery requirement is almost always neglected. If the trustee doesn't give the plan administrator a copy of the trust, the trust will be considered a non-designated beneficiary and will lose the ability to do a direct transfer of plan benefits to an inherited IRA.

Minimum Distributions

The entire plan balance can be transferred except for any RMDs, because RMDs are not eligible rollover distributions. If the plan participant dies before his or her required beginning date (RBD), then there is no RMD that must be taken for the year of death. If the plan participant dies on or after the RBD, which is generally April 1 of the year following the year he or she turns age 701/2, then there is a required distribution for the year of death. If the plan participant took that RMD, there is no problem. If he or she did not take that RMD, it must be taken by the beneficiary, and that amount cannot be transferred to the inherited IRA. Also, any RMD that the beneficiary must take cannot be transferred to the inherited IRA.

Advisors should be aware that this change in the IRS's position is certainly not a reason to leave money in an employer plan. The very last thing you want is for your new clients-the beneficiaries-to be at the mercy of some plan or IRS ruling that is subject to change. The absolute best move generally is still to do the IRA rollover when you can, unless one of the lump-sum distribution tax breaks, such as the net unrealized appreciation or 10-year averaging, might work out better for your client.