The Pension Protection Act expands the rights of non-spouse beneficiaries. Plan sponsors may choose to adopt these expanded rights by making minor modifications to existing plan rules.

The Pension Protection Act of 2006 (PPA), enacted into law on August 17, 2006, contains provisions that are beneficial to a countless number of employees who choose to name a beneficiary of their retirement plan to a person who is not deemed a spouse of the employee. The two main provisions of the PPA assisting such employees are Section 826 regarding hardship withdrawals and Section 829 regarding account balance rollovers for non-spouse beneficiaries.

Hardship Distributions

Employee benefit plans may allow a participant to receive a distribution from his or her plan account balance on account of certain financial hardship events (e.g.,medical, tuition and funeral expenses). Prior to enactment of the PPA, an employee benefit plan could only allow a participant to receive a hardship withdrawal due to a financial hardship affecting the participant, a spouse or dependent of the participant. Section 826 of the PPA expands this list for certain categories of financial hardship. As of August 17, 2006, an employee benefit plan may permit hardship distributions for expenses related to medical, tuition (educational) and funerals for a "primary beneficiary" under the plan.

A primary beneficiary is an individual who is named as beneficiary under the plan and has a right to all or a fraction of the participant’s account balance following the death of the participant. The employee benefit plan must follow all other relevant provisions regarding hardship withdrawals. Section 826 of the PPA applies to employee benefit plans under Sections 401(k), 403(b), 457(b) and 409A of the Internal Revenue Code. In effect, this provision enables a participant to withdraw funds from his account balance to pay for certain expenses of the participant’s non-spouse beneficiary, but only if the non-spouse beneficiary is the primary beneficiary under the plan.

This change is especially significant in the area of domestic partnership law because many, if not most, domestic partners do not meet the Internal Revenue Code definition of "dependent," and same-sex spouses do not qualify as "spouses" under federal law due to the federal Defense of Marriage Act. Section 826 of the PPA is permissive, not mandatory; a plan does not have to expand its definition of hardship to include events relating to the primary beneficiary.

Non-Spouse IRA Rollovers

Prior to the enactment of the PPA, only a surviving spouse could roll over the account balance of a deceased participant into his or her own Individual Retirement Account (IRA). All other beneficiaries (including dependents, siblings and all other non-spouse beneficiaries) were generally required to withdraw the account balance in a lump sum or over a period of time required by the plan and Section 401(a)(9) of the Internal Revenue Code. The enactment of the PPA now enables non-spouse beneficiaries to roll over the deceased participant’s account balance to an inherited IRA.

Limitations
There are two key limitations on the new non-spouse beneficiary rollover rights. First, the provision is optional for employers. Therefore, the non-spouse beneficiary rollover right only exists if the employer chooses to implement the provision and amends its plan accordingly. Second, a non-spouse beneficiary rollover must be a direct trustee-to-trustee rollover into an "inherited IRA."

An inherited IRA must be established for the purpose of receiving the deceased participant’s account balance in a manner that identifies it as an IRA with respect to a deceased individual (e.g., Jane Doe as beneficiary of John Doe). The minimum required distribution rules under Internal Revenue Code Section 401(a)(9) complicate this new rollover provision. Under this section, generally there are two rules that affect beneficiaries who inherit an account balance from a deceased participant: the five-year rule and the life expectancy rule. The five-year rule requires the beneficiary receiving an account balance from a deceased participant to receive the entire amount by the fifth calendar year following the year of the participant’s death. The life expectancy rule states that a minimum required distribution occurs each year based upon the life expectancy of the non-spouse beneficiary.

Prior to guidance released by the Internal Revenue Service (IRS), there was some confusion as to the application of the minimum required distribution rules of Internal Revenue Code Section 401(a)(9) to non-spouse beneficiaries in the event the participant dies prior to his or her "required beginning date" as defined in Section 401(a)(9). The confusion arose as a result of seemingly conflicting provisions of Q&As 17 and 19 of IRS Notice 2007-7. Q&A 19 provides that the rules for determining minimum required distributions applicable to a non-spouse beneficiary under the plan also apply to the IRA. Therefore, if the plan document uses the five-year rule, the IRA should use the five-year rule. However, Q&A 17 contains a special exception to the general rule whereby a non-spouse beneficiary can treat the plan as using the life expectancy rule so long as the rollover is made prior to the end of the year following the year of the participant’s death. However, in a special edition of Employee Plans News published by the IRS on February 13, 2007, the IRS clarified that the special rule of Q&A 17 trumps the general rule of Q&A 19. Therefore, as long as the rollover is made prior to the end of the year following the year of the participant’s death, a non-spouse beneficiary can elect to use the life expectancy rule for minimum required distributions from an IRA, even if the distributing benefit plan had a provision utilizing the five-year rule.

The following chart summarizes the minimum required distribution rules based upon the potential rollover scenarios (taking into account rules provided under Notice 2007-7 and the IRS interpretation in Employee Plans News). (See chart below.)

Despite the optional nature of the provisions under Sections 826 and 829 of the PPA, several companies have already implemented the rules under these Sections in order to stay competitive for purposes of recruiting and retaining quality employees. Future guidance from the IRS will, hopefully, clarify the provisions discussed in this article.

 

Completes Rollover in Year of Death of Participant

Completes Rollover in Calendar Year Following Year of Participant’s Death

Completes Rollover After End of Calendar Year Following Year of Participant’s Death but Before Fifth Year Following Date of Participant’s Death

Non-Spouse Beneficiary Inherits Account Balance Prior to Required Beginning Date

Entire account balance may be rolled over and life expectancy rule may be used (unless participant elects
to utilize five-year rule). Participant may elect to use life expectancy rule even if the plan utilizes five-year rule.

Minimum distribution for calendar year following year of participant’s death may not be rolled over, and remaining portion of account balance may be rolled over. Life expectancy rule may be used (unless participant elects to utilize five-year rule). Participant may elect to use life expectancy rule even if the plan utilizes five-year rule.

A rollover may occur; however, non-spouse beneficiary is required to take minimum distributions from the Individual Retirement Account and full balance must be distributed by end of fifth calendar year following date of death.*

Non-Spouse Beneficiary Inherits Account Balance After Required Beginning Date

Minimum required distribution during year of death is not eligible for rollover; remaining portion of account balance is eligible for rollover.

Minimum required distribution for calendar year following date of death and prior year are not eligible for rollover; remaining portion of account balance is eligible for rollover.

Minimum required distribution for year the death occurred and all subsequent years prior to the fifth year following the date of the participant’s death are not eligible for rollover; remaining portion of account balance is eligible for rollover.

*A rollover may not occur if the rollover is not completed by the end of the fifth calendar year following the year of the date of death of the participant.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.