Pension Protection Act: Non-Spouse Beneficiaries May Transfer Plan Death Benefits to Inherited IRA

Client Advisory

November 15, 2006

The Internal Revenue Code of 1986, as amended (the “Code”), and accompanying regulations  provide complex rules for “minimum required distributions” (“MRDs”) and death benefits under employer-sponsored retirement plans, including 401(k) plans, and individual retirement accounts (“IRAs”).  The rules are intended to ensure that such plans are actually used as retirement arrangements rather than for estate planning purposes.  To this end, the Code requires that plan participants and beneficiaries of plan death benefits receive taxable distributions at specified times.  The Pension Protection Act of 2006 (the “Act”) revises the Code to enable beneficiaries to extend the payout period of death benefits from an employer-sponsored plan, a Code §403(b) annuity, or a Code §457 plan maintained by certain governmental entities.  The net effect of these revisions is to delay full taxation of the total death benefit for many years.

Review of Existing Requirements

MRDs must commence not later than the participant’s “required beginning date,” that is, April 1st following the year in which the participant attains age 70½ or retires, whichever occurs later.  (If the participant is a 5% owner of the plan sponsor, then his or her required beginning date is always the April 1st following the year the participant attains age 70½, whether or not the participant continues in employment.)

If a participant has attained the required beginning date and begins to receive MRDs from the plan, upon the participant’s death his or her beneficiary must continue to receive plan distributions at least as rapidly as the participant received them in life.  Regulations provide that this requirement is met by continuing to make payments over the beneficiary’s lifetime.

If the participant dies before attaining the required beginning date, his or her entire benefit must be paid to the beneficiary within five years of the participant’s death, unless the beneficiary starts installment payments of the death benefit over his or her life or life expectancy, beginning not later than one year after the participant’s death.  The rules give a participant’s spouse-beneficiary certain additional advantages not available to a non-spouse beneficiary: 

  • the spouse may postpone the commencement of death benefits until the participant would have attained age 70½; and
  • the spouse may roll over the death benefit to the spouse’s own IRA, distributions from which would begin when the spouse attains age 70½. 

Plans may provide any distribution arrangement that meets the foregoing requirements.  For the sake of administrative convenience, many plans do not allow beneficiaries the option of receiving death benefits in lifetime installment payments, and instead require them to take a lump sum distribution of the entire death benefit by the end of the year following the participant’s death.  In addition, plans designed for self-employed persons often provide for plan termination upon the death of the sole proprietor, with all death benefits becoming payable shortly after the proprietor’s death.  Such compulsory distributions disadvantage a non-spouse beneficiary (e.g., the participant’s domestic partner or child) who cannot roll over the distribution to an IRA and, who will, therefore, be taxed on the entire distribution in the year it is paid.

Effects of the Pension Protection Act

Beginning in 2007, the Act allows a non-spouse beneficiary to direct a trustee-to-trustee transfer of death benefits from a tax-qualified plan to an “inherited IRA” established by the beneficiary for this purpose.  Under an inherited IRA, the timing of the death benefit payments must still be made in accordance with the deadlines described above.  However, IRA sponsors are, for commercial reasons, very likely to make the installment form of payment available to a non-spouse beneficiary.  The beneficiary may not make further contributions to an inherited IRA or roll an inherited IRA over to any other IRA or tax qualified plan, but may name another beneficiary to continue to receive unpaid amounts upon his or her death for the remainder of the established installment schedule (e.g., the initial beneficiary’s life expectancy).

The effect of the new rule is to afford retirement plan beneficiaries similar advantages to those currently available to IRA beneficiaries.  Under current law, a non-spouse beneficiary of an IRA can have an “inherited IRA” established.  (This has given rise to what estate planners colloquially call a “stretch IRA,” which extends IRA payments over as long a period as possible through the strategy of naming young beneficiaries  to receive inherited IRA distributions.)  Because of the inability to do the same under retirement plans, estate planners often counseled plan participants to withdraw retirement benefits as soon as the benefits became available and roll the withdrawn amounts into an IRA, in order to make use of the stretch IRA strategy.  Failure to make the withdrawal prior to the participant’s death meant that the beneficiary’s distribution options were limited to the plan’s payment forms.  Under the Act, the beneficiary will be able to transfer a retirement plan death benefit directly to an inherited IRA himself and designate a beneficiary of that IRA.

In addition, the Act provides that if a trust is named as the beneficiary of a participant’s plan benefits, the trustee will be able to direct the transfer of the benefits to an inherited IRA, to the extent provided in future regulatory guidance from the Treasury Department.

Plan participants will want to take the new rules into consideration in estate planning.  The Act is especially helpful to participants who wish to provide for domestic partners, children, or other non-spouse beneficiaries.  Because the provisions of the Act apply to “distributions” after December 31, 2006, beneficiaries who are due death benefits from an employer-sponsored plan may wish to postpone receiving distributions, to the extent possible, until they consult with counsel to see if an inherited IRA will be available to them in 2007.

Sponsors of plans that offer lifetime installment payments to non-spouse beneficiaries might reconsider the plan design, inasmuch as all beneficiaries should now be able to obtain an inherited IRA that affords them an installment form of distribution.  Eliminating the installment form from a plan could streamline the plan’s administration and reduce costs.

EXAMPLE: The plan participant terminated employment in 2004 at age 65. His 401(k) plan permits him to leave his account balance in the plan until April 1st following his attainment of age 70½. The participant decides to postpone distribution until that time, but dies in 2007 before attaining age 70½. At his death, his plan account balance is $400,000. His beneficiary is his 35 year old son. The plan requires beneficiaries to take a lump sum distribution of the death benefit on or before the last day of the plan year following the year in which the participant dies.

Before the Act, the son would have had to take a distribution of the entire $400,000 on or before the end of 2008, paying ordinary income taxes on the full amount. Under the Act, however, the son may establish an “inherited IRA” to receive the distribution from the plan at the end of 2008 (or sooner). The IRA will begin annual installment payments to the son over his life expectancy of approximately 47 years, with the son paying taxes on only the annual payment made to him each year. He will have full power to manage the investments of his inherited IRA, but may not make additional contributions to it. If the son dies before receiving all distributions from the IRA, his designated beneficiary may continue to receive the installment payments for the remainder of the 47-year period.

Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2020 Carter Ledyard & Milburn LLP.
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