When an employee who participates in an employer-sponsored retirement plan dies, a notice must be sent advising each death beneficiary about options to make a rollover to an IRA.1 A payment that qualifies for one of those options is an “eligible rollover distribution.”
The notice must be sent before any distributions are made.
The types of retirement plan trusts that must provide such a notice include: employer-sponsored plans qualifying under Internal Revenue Code Section 401, annuities plans under IRC Section 402(a), annuity contracts under IRC Section 402(b), or IRC Section 457 deferred compensation plans of certain governmental and other tax-exempt employers.
By definition, an “eligible rollover distribution” includes “any distribution to a designated beneficiary which would be treated as an eligible rollover distribution” from those types of employer-sponsored retirement plan trusts.2
Important Exceptions Apply
A payment won’t qualify as an eligible rollover distribution if it forms part of a series of substantially equal periodic payments made (not less frequently than annually) over:
more than 10 years,
- for the employee’s lifetime (or for the life expectancy) of the employee, or
- for the joint lives of the employee and the employee's designated beneficiary.3
Required (RMD) distributions are excluded from the definition of eligible rollover distributions.
Non-taxable distributions other than net unrealized appreciation in employer securities are excluded from the definition of eligible rollover distributions.4
Direct Transfers for Non-Spouse Beneficiaries
Designated beneficiaries who are individuals are entitled to make a rollover to an IRA by direct transfer.5 Trusts are also entitled to do so, under rules to be prescribed by the Secretary of the Treasury.6 Estates aren’t among those entitled by statute to make a direct transfer rollover, but, in practice, it’s usually possible to achieve.
The IRS has published a safe harbor Notice that may be used to advise both employees and beneficiaries of their rollover options.7 The Notice informs an employee who’s separated from service that a Roth IRA conversion may be made by direct transfer, but doesn’t mention anywhere that a designated beneficiary may make do likewise. That omission is puzzling.
The Notice points out that a death beneficiary who isn’t the decedent’s surviving spouse only has one option to move the death benefits into an inherited IRA: make a direct rollover. In a direct rollover, also known as a “direct trustee-to-trustee transfer,” an inherited IRA of the payee-beneficiary entitled to the distribution receives the distribution proceeds, rather than the beneficiary.
Roth IRA Conversions by Designated Beneficiaries Is Permitted
The IRS has acknowledged that a designated beneficiary may make a Roth IRA conversion contribution from an eligible retirement plan other than a Roth IRA in Q&A-7 of IRS Notice 2008-30.8 Furthermore, the IRS observed that the amount so converted may later be recharacterized as an inherited (non-Roth) IRA under the same rules that apply to lifetime Roth IRA contributions and conversion. However, Q&A-7 goes on to say plans aren’t required to offer the direct rollover option to death beneficiaries.
Importantly, it isn’t possible for a beneficiary of an inherited IRA who isn’t the decedent’s surviving spouse to make a conversion to a Roth IRA. Thus, if a death beneficiary makes a direct rollover from a decedent’s qualified plan to an inherited IRA, a Roth IRA conversion may not later be elected. The only opportunity to make a Roth IRA conversion is by direct transfer from the decedent’s qualified plan account to that beneficiary’s inherited Roth IRA.
Without mention of the Roth IRA conversion opportunity in the statutory Notice, many beneficiaries will be left unaware, unless that beneficiary somehow discovers it can be done.
The better solution would be for the IRS to include the Roth IRA conversion opportunity in its model statutory Notice.
Is the Model Notice Out of Compliance?
Qualified plans sponsored by employers must contain IRC-mandated provisions. If the model statutory notice fails to include a required disclosure, then using the notice without modification could disqualify the plan. That’s because a plan must not only contain required provisions but also must be operated in accordance with those provisions. Plan trustees will therefore need to add any missing provision (if there is one) to the safe harbor notice to bring the plan into compliance.
Among mandatory qualified plan provisions is one that permits the distributee of any “eligible rollover distribution” to elect a direct trustee-to-trustee transfer to an “eligible retirement plan” specified by the distributee.9
An eligible rollover distribution includes any distribution following the death of the plan participant to a “designated beneficiary,” which would be treated as an eligible rollover distribution by reason of Section 402(c)(11) or Sections 403(a)(4)(B), 403(b)(8)(B) or 457(e)(16)(B), if the requirements of Section 402(c)(11) were satisfied.10
The designated beneficiary must meet the definition that term under rules governing RMDs following the death of the participant. The designated beneficiary must be either an individual or a trust qualifying under regulations.
The requirements of Section 402(c)(11) are met when a direct trustee-to-trustee transfer is made to an “individual retirement plan” established for the purposes of receiving the distribution on behalf of an individual who’s a designated beneficiary and who isn’t the surviving spouse of the employee.
The plan must provide a direct transfer to an individual retirement plan of the distributee if the distributee fails to elect a direct trustee-to-trustee transfer to an eligible retirement plan, the account value exceeds $1,000 and the distributee fails to request a distribution.
The key to understanding the requirement that the Roth IRA transfer must be allowed lies in the definition of an “individual retirement plan.” That term is defined for all purposes of the Internal Revenue Code as an individual retirement account under IRC Section 408(a) or an individual retirement annuity under IRC Section 408(b).11
Section 408A(a) provides that a Roth IRA shall be treated for purposes of the IRC in the same manner as an individual retirement plan except as provided otherwise in Section 408A. There’s nothing in Section 408A that treats a Roth IRA differently from an individual retirement plan when it comes to any of the provisions permitting a trustee to trustee transfer to a Roth IRA by a designated beneficiary following the death of the Roth IRA owner. Thus, a designated beneficiary may make an eligible rollover to a Roth IRA by trustee-to-trustee transfer. Qualified plans must make that option available.
Because the safe harbor Notice excludes notification to designated beneficiaries of the mandatory Roth IRA rollover election by trustee-to-trustee transfer, the safe harbor Notice isn’t not in compliance with all statutory notice requirements.
Trustees and the IRS Must Fix the Safe Harbor Notice
Because a qualified plan must contain a provision permitting a designated beneficiary to elect a direct trustee-to-trustee transfer to an eligible retirement plan specified by the distribute and because the definition of an eligible retirement plan includes a Roth IRA, offering a Roth IRA conversion to designated beneficiaries by direct transfer is mandatory.
That being the case, the safe harbor Notice has omitted a required disclosure to designated beneficiaries. Until such time as the IRS amends the Notice to include such a disclosure, plan trustees should add one to it.
Endnotes
1. Internal Revenue Code Section 402(f).
2. IRC Section 402(f)(2)(A), defining “eligible rollover distribution” for purposes of Section 402(f).
3. Ibid.
4. Treasury Regulations Section 1.402(c)-2, Q&A-3(a)(3). See also Q&A-4 for additional items excluded from qualifying as eligible rollover distributions.
5. IRC Section 402(c)(11)(A) authorizes direct rollovers by an individual who’s the beneficiary of an eligible retirement plan.
6. IRC Section 402(c)(11)(B) authorizes direct rollovers by a trust under rules to be prescribed by the Secretary of the Treasury.
7. IRS Notice 2014-74, 2014-50 I.R.B. 1 (Dec. 8, 2014), updating Notice 2009-68; 2009-39 I.R.B. 423.
8. IRS Notice 2008-30; 2008-12 I.R.B. 638, Q&A-7, referenced in Notice 2009-75; 2009-39 I.R.B. 436.
9. IRC Section 401(a)(31).
10. Section 401(a)(31)(D), incorporating by reference Section 402(f)(2)(A).
11. IRC Section 7701(a)(37).