By Denise Appleby, JM, CISP, CRC, CRPS, CRSP, APA
Beneficiaries could be saddled with the high cost of account owners’ failure to name beneficiaries for their retirement accounts. This can be avoided by properly completing beneficiary designation forms, and making updates when necessary.
Recently issued private letter ruling (PLR) 201821008 is yet another case of a failure to properly designate a beneficiary of a retirement account. In this case, the IRS remedied the issue by approving the surviving spouse’s rollover of a Governmental 457(b) account to her own traditional IRA, even though the decedent’s estate was the beneficiary of the 457(b) account. The IRS considered the spouse’s rights and control over the estate, in responding to the PLR request.
Before we discuss the facts of the PLR, let’s take a high-level look at the applicable rules and regulations.
Rollover Permissibility and Rules
Designated beneficiaries are permitted to roll over amounts they inherit under employer sponsored retirement plans* to IRAs, as long as the amounts are eligible for rollover (IRC § 402(c)(11). This option is not available to nondesignated beneficiaries.
*For this purpose, an employer sponsored retirement plan is a qualified retirement plan (pension, profit sharing, 401(k) etc.), a 403(b) plan, a thrift savings plan, and a governmental 457(b) plan.
It is important here to understand the difference between a designated beneficiary and a nondesignated beneficiary. While both are ‘beneficiaries, only a designated beneficiary is permitted to roll over a distribution from an employer sponsored retirement plan.
A designated beneficiary is a person – such as a spouse or nonspouse, or a qualified trust as defined under Treas. Reg. 1.401(a)(9)-4, Q&A 5.
A nondesignated beneficiary is a nonperson, such as an estate, charity, or nonqualified trust.
Such rollovers must be completed within 60 days of receipt, unless an exception applies.
Generally, amounts that are not eligible for rollover- such as distributions to nondesignated beneficiaries- must be included in the income of the recipient beneficiary, for the year in which the distribution occurs.Whereas, amounts that are properly rolled over to a traditional IRA continue to be tax-deferred.
Amounts that are eligible to be rolled over and are paid to a beneficiary, is subject to a mandatory 20% federal tax withholding on taxable amounts. If the amount is not eligible for rollover, then withholding is optional, allowing the beneficiary to elect to withhold at least 10% for federal taxes.
Identifying the Beneficiary
The beneficiary of a retirement account is the person or entity named on the governing beneficiary form at the time of the participant’s death, providing that beneficiary survives the participant.
If there is no such (named) beneficiary, then the beneficiary is determined under the terms of the governing plan document.
Facts of the PLR
The following is a summary of the relevant facts as presented in PLR 201821008:
- At the time of the participant’s death, there was no named beneficiary for his 457(b) account. As a result, the beneficiary was determined under the default terms of the 457(b) plan.
- Under the default terms of the 457(b) plan, his estate was his beneficiary.
- After his death, the plan distributed the balance of his account to his estate.
- Federal income tax was withheld from the distribution amount.
- His surviving spouse was the sole executor and sole beneficiary of his estate.
- His spouse, in her role as executor and beneficiary of the estate, promptly distributed the amount from the estate to herself, and subsequently rolled over the amount to her IRA by the 60-day deadline. This included the amount that was withheld for income tax, which she made-up out of pocket.
The following rulings were requested:
- That the surviving spouse is treated as receiving the distribution directly from the plan, and not from the estate.
- That she is considered eligible to roll over the distribution to her own non-inherited IRA. And,
- As a result of the rollover, the distribution from the 457(b) plan would not be included in her income.
The IRS’s Ruling
The IRS approved all three ruling requests based on the facts and circumstances, on condition that the information and documentation submitted are subject to verification upon examination. The IRS noted that the ruling could be revoked if there are any misstatements or omission of facts that could change the outcome.
This ruling does not come as a surprise. The IRS has traditionally allowed rollovers for surviving spouses, where the estate is the beneficiary, and the spouse is the sole executor and sole beneficiary of the estate. See PLRs 200644031 and 200637033.
The IRS will be notified of both the distribution- which must be reported on IRS Form 1099-R and the rollover- which must be reported on Form 5498. Since these transactions are required to be reported on the affected parties’ tax returns, a copy of the PLR must be attached to such tax returns. The PLR helps to make the case of why the distribution is nontaxable.
For electronically filed tax returns, an attached statement that includes the date and control number of the letter ruling would suffice.
Costly Lesson and How to Avoid It
The cost to the beneficiary includes the IRS’sfee of $10,000 for handling the PLR request, plus any fees paid to professionals who aid with the process. These fees, and operational requirements that then become necessary, would have been avoided had the participant ensured that his spouse was named as the beneficiary for his 457(b) account.
As an advisor, you can help your clients by performing a beneficiary check-up for all their accounts, at least once per year and when there is a life-event that could affect the beneficiary designation. The check-up should include reviewing the governing plan document to determine whether the default provisions are consistent with your clients’ estate planning goals.
Reminder: A PLR may not be used or cited as precedent. IRC Section 6110(k)(3)