Spring 2009 Newsletter
Transitioning Inherited Retirement Assets: A Classic Catch-22
By: Helen Modly, CFP
Understanding and complying with the new rules for transferring assets from inherited IRAs and other retirement plan accounts is a challenging proposition. Once you’ve mastered the rules, you still have to fight the bureaucratic snafus created by the financial institutions whose restrictions often overrule current tax law. Throw in a little bad advice, and it’s no wonder you and your clients feel like you are up against the classic Catch-22.
I. MEET VIRGINIA
Virginia and her two sisters were listed, by name, as the only beneficiaries of their father’s IRA. When he died at the age of 82 in late December, 2007, the IRA account was worth almost $2.5 million and was held by a bank. Virginia, serving as executrix, consulted with a young attorney for help in distributing the account. What should have been a simple task of splitting the account into separate, equal, inherited IRA accounts for each sister, took over five months and a mountain of correspondence.
A. When a Trust is Not a Trust
According to the beneficiary form on file at the bank, the three sisters were clearly Designated Beneficiaries and allowed under current law to create inherited IRA accounts and have the money transferred via a direct trustee-to-trustee transfer process to their respective accounts.
Unfortunately, the bank sent Virginia a letter referring to the IRA account as “John Doe, Rollover IRA Trust”, along with a standard beneficiary distribution form and a notice that the bank intended to make a required minimum distribution based upon the father’s age for the year of death (2007). Virginia’s attorney made the assumption that the IRA was actually owned by a trust, and that the trust was the beneficiary and the sisters were actually beneficiaries of the trust. The confusion was one of terminology, and arose because the bank relied on a model IRS form 5305 to establish IRA accounts with the bank as trustee. Other firms, such as broker-dealers often use a similar form substituting the word, custodian, for trustee.
Virginia’s attorney advised the sisters to take a distribution to satisfy calendar year 2007 and then direct the bank to establish one account in the name of the trust, for the benefit of the sisters, and continue annual distributions based upon the father’s age at death.
The bank’s beneficiary distribution form gave Virginia two choices under the option of Death occurring on or after RBD (Required Beginning Date):
• Total Distribution: I elect to receive the entire balance in a single sum.
• Continue Distributions: I elect to continue to receive the required minimum distribution under the applicable distribution period.
Since Virginia and her sisters were non-spouse beneficiaries, the bank’s form excluded the option to rollover, or transfer, the balance into their own IRAs. There was no mention or explanation of inherited IRAs, or any definition of applicable distribution period.
B. When a Rollover is Not a Rollover
This one word, rollover, is responsible for most of the headache involving the movement of retirement funds. A true rollover occurs when retirement funds are distributed outright to the participant who then has 60 days to redeposit them into another retirement account. In years past, the definition of rollover has expanded to informally include any movement of funds from one retirement account to another.
In the case of moving funds from an employer’s retirement plan to an individual IRA, which is actually a distribution that is then rolled over to the IRA, the term rollover is often used to describe the entire process. In a true rollover from an employer’s plan, the participant takes a distribution less the mandatory 20% that the employer must withhold in taxes. The participant must then either make up the 20% when depositing the funds within 60 days to the new account, or recognize the 20% withheld as a taxable distribution. To avoid the need for this mandatory tax withholding, the trustee-to-trustee direct transfer process became popular. No funds are distributed to the participant, therefore no tax liability and no mandatory withholding. Since only the participant or their spouse had the ability to move retirement funds prior to the PPA-2006, calling this process a rollover didn’t cause many problems.
Then the PPA-2006 gave non-spouse beneficiaries the right, if not the ability, to move funds from the deceased’s account to an inherited IRA account, but only if the process occurs directly between the two custodians, since non-spouse beneficiaries are not allowed to do a true 60-day rollover. Now, when we really need to make a clear distinction between these two forms of transferring qualified assets, we have this murkiness instead. To make matters worse, many institutions and employers still use the word, rollover for any movement of retirement assets.
C. Saved by the 1099-R
A distribution from an employer retirement plan directly to the individual will generate a 1099-R from the administrator showing that the amount distributed is fully taxable. If the funds are sent directly to an IRA or another plan and do not pass through the individual, the 1099-R will reflect this by showing that 0% of the distribution is taxable and that no tax has been withheld. When a distribution is taken from an IRA and goes directly to an individual, a 1099-R is generated that reflects the distribution as being taxable. (Tax withholding is not required for IRA distributions). When funds transfer from one traditional (tax-deferred) IRA to another IRA account (including an inherited IRA account) via the direct transfer process, no 1099-R is generated since no distribution has occurred. Take a look at the sample 1099-R form below:
Box 1 will hold the amount of the distribution from the retirement plan or IRA. Box 2 will be $0 if the entire distribution is rolled over to another plan. Box 4 will show if any tax was withheld. Box 7 will describe the type of distribution. There are numerous codes for Box 7, but remember Death code 4. A number 4 in this box means the distribution was due to death.
D. Virginia's Dilemma
Not only did these options appear vastly dissimilar to Virginia, neither made much sense for designated beneficiaries. Remember that an IRA account for a living, breathing person can never be owned by a trust. To transfer IRA assets into a trust while the account holder is still alive would be treated as an immediate, fully taxable distribution. Virginia’s investment advisors requested a copy of this “trust” from the bank. When the IRS form 5305 arrived, the trust as owner issue was set aside.
Writing to the bank, Virginia requested these three next steps:
• Confirmation that her father had indeed already taken his required minimum distribution for 2007, thus no distribution was due until December 31, 2008. This was done by producing a copy of the 1099-R sent by the bank to her father for the 2007 tax year.
• Liquidate all positions in the IRA account and transfer the proceeds to the newly established inherited IRA accounts for each sister at a different institution, via the trustee-to-trustee direct transfer process, and only via that process.
• Confirm that this transfer would be treated as a non-reportable (no 1099-R) transaction.
The bank reversed their insistence on a distribution for 2007. They agreed to the liquidation of assets, but “No,” they would not rollover IRA funds to a non-spouse beneficiary’s inherited IRA account at a different institution.
E. Aye, There's the Rub
Remember that the PPA gives non-spouse beneficiaries the right to establish and fund inherited IRAs via this direct process, it did not require the IRA custodians (or plan trustees) to comply with the process. (The Worker, Retiree, and Employer recovery act of 2008 does require this as of January 2009).
Going back to the actual IRA disclosure document (the bank’s model form 5305), Virginia’s advisors reviewed the section discussing what actions they would allow beneficiaries to do. Among them was the wording …“ and anything else requested by the beneficiary that was not prohibited by bank policy or by law.” They were provided with a summary of the Pension Protection Act (PPA) of 2006 and the new rules effective for 2007 regarding non-spouse beneficiaries, and another request to initiate a direct transfer of the funds to the new institutions.
In a moment of enlightenment, the bank agreed to the transfer, but not before it made each sister’s required distribution that was not actually due until December 31, 2008. Not only was this distribution made months before it needed to be, the bank erroneously used the father’s age for calculation rather than each sister’s own age, making the distribution a good bit larger than it needed to be. By this time, the sisters were so thoroughly frustrated, they let it go.
F. Not Done Yet
Now they faced a problem from one of the receiving institutions regarding how they were going to treat the transferred funds. Normally, a direct transfer of assets from one IRA to another (including an inherited IRA) is not a reportable transaction. However, one of the new institutions informed Virginia that they were going to “code” the transfer-in of assets as a rollover contribution, since they had no proof the bank was not going to issue a 1099-R next April. The issue here was that a 1099-R would have caused this transfer to be treated as a rollover, and non-spouse beneficiaries cannot do rollovers, so a taxable distribution would have occurred by default. Virginia requested and obtained a letter on bank letterhead confirming that these transfers to the sisters were non-reportable and that no 1099-R would be issued. With letter in hand, Virginia was able to get the receiving institutions to properly account for the transfers into the inherited IRA accounts.
II. INHERITING FROM EMPLOYER PLANS
The Employer, Worker, and Retiree Recovery Act-2008 mandated employer plans to comply with non-spouse beneficiary requests for a trustee-to-trustee distribution of inherited plan balances. It also waived any required minimum distribution for 2009 for both participants and beneficiaries. That doesn’t mean all the transfer problems have disappeared. Even when beneficiaries receive competent advice, it doesn’t necessarily mean that the plan trustees are on the same page.
A. The Cobbler's Children
The mother worked for a small CPA firm and died in late 2008 in her early 40s, leaving an orphaned minor with a 401k plan balance. The plan is self-administered in-house by the CPAs themselves with counsel. Fortunately, the mother had established a valid trust to be the beneficiary of her retirement plan and her son is the beneficiary of this trust. The CPA firm has a correct beneficiary designation on file naming this trust as the beneficiary of the 401k account.
In early 2009, the trustee notifies the employer/401k administrator that the trust meets the requirements to be a valid designated beneficiary and provides a full copy of the trust. Then the trustee notifies that plan that the trust/beneficiary wants to waive the beneficiary’s 2009 required minimum distribution and requests that the plan transfer the entire plan balance (via the direct trustee-to-trustee process) to an inherited IRA in the name of the trust for the benefit of the son. The trustee also notified the plan that the beneficiary’s first required minimum distribution, now not due until 12/31/2010, would be taken from the inherited IRA. This is possible because the plan administrator must issue a form 5498 for the decedent showing the plan balance as of the date of death. The inherited IRA custodian will issue a form 5498 for the beneficiary with the account value as of 12/31/09 which will be the value used to calculate the first distribution to be taken in 2010.
B. Let the Emails Begin
Counsel for the CPA firm responded to the trustee’s request by asking counsel for the trustee to provide a legal opinion certifying that the trust was valid as a designated beneficiary for the son. Fortunately, for the client, an email sufficed. Next, Counsel for the CPA firm insisted that the beneficiary’s required minimum distribution must be paid out before any rollovers could be made and demanded all of the birth dates for the contingent beneficiaries of the trust in order to calculate this amount. He relied on the fact that any amounts considered to be a required distribution were not eligible for rollover or transfer to an inherited IRA. The Worker, Retiree, and Employer Recovery Act of 2008 confirms this, but it also allows for a plan to elect to treat any portion of a 2009 distribution that would have been a MRD (without the waiver), as an eligible rollover (transfer) distribution for the direct rollover requirements. The plan administrator is permitted, but not required to offer a direct rollover of that amount. Also, the waived 2009 distribution is not subject to the 20% income tax withholding requirement (IRS Pub 590).
The trustee’s counsel literally resorted to sending CPA’s counsel the IRS publication 590 in lieu of his request for another legal opinion regarding the“unsettled issue” of whether the waiver of the 2009 required minimum distribution applied to both participants and beneficiaries. Since the mother died in 2008, the first required distribution would be due on 12/31/2009 and thus was eligible to be waived.
C. Decisions, Decisions
CPA’s counsel responded that the plan could not waive the distribution for 2009 without a plan amendment. Actually, while the waiver is not automatic, each plan is able to decide whether it will waive 2009 required minimum distributions for all its participants. If so, an amendment would be required, although it would not need to be adopted until late 2011. If the plan does decide to waive the 2009 distributions, it must be operated in compliance with the waiver for this year. So, this plan must make a decision sometime prior to making any required minimum distributions for 2009. Since the plan must make this decision any way this year, the trustee was simply asking them to do it sooner rather than later. Granted, this all was occurring during tax time, but one can always hope.
The outcome for this client is not settled yet, the prognosis for a full plan transfer is not hopeful. The trustee will probably have to settle for either leaving the funds with the plan until (and if) the plan makes their decision on this issue later this year, or accept the 2009 distribution for the beneficiary and transfer the balance of the plan assets to the inherited IRA. There is a planning tip in here. For plan participants who die on or after their required beginning date, rollover the assets to the inherited IRA account the year the death occurs. Beneficiaries should then be able to avoid the additional complications of having to coordinate with the 401(k) administrator the required first distribution before the account can be rolled over to the custodian for the inherited IRA.
These two real scenarios confirm how difficult it is for clients to actually obtain the benefits intended by these laws. Not only does it feel like chipping away at a rock pile, it’s enough to make you crazy.
Helen Modly, CFP is Executive VP of Focus Wealth Management, Ltd., in Middleburg, Va. She has written frequently on retirement income distribution planning and is quoted regularly by industry publications such as the Wall Street Journal, Forbes, and Money Magazine, etc. She welcomes your comments via her website, www.Focus-Wealth.com.