Avoiding the 5-Year Distribution Rule for a Nonspouse Designated Beneficiary
When it comes to inheriting an IRA or defined contribution plan [such as a 401(k) plan] , there are certain rules which, if not properly followed, may require the account balance to be withdrawn within five years of the participant’s death. This may or may not be in the beneficiary’s best interest as withdrawals will likely increase one’s tax burden. This issue is especially apparent when a large sum is required to be taken within a limited number of years when it might otherwise have been spread over a lifetime.
This article seeks to outline the important steps that a nonspouse beneficiary of a defined contribution plan or IRA will need to follow in order to make distributions based on their life expectancy, and not subject to the 5-year rule requirement.
Different rules are available to a surviving spouse, and this article does not seek to address them.
The 5-year rule.
According to Internal Revenue Code (I.R.C.) § 401(a)(9)(B)(ii), when an employee dies before their required distribution date, their entire interest is required to be distributed within five years of the death of that employee. However, there is an exception to this rule which allows distributions based on the designated beneficiary’s lifetime. This can be advantageous in order to “stretch” the IRA over a longer period of time, potentially providing an opportunity for continued growth in the account, as well as the possibility for distributing the tax burden over an increased number of years.
Access to this exception may be obtained if distributions begin no later than one year after the date of the employee’s death [§ 401(a)(9)(B)(iii)]. This rule is further clarified per Reg. § 1.401(a)(9)-3 A-3. (a), which indicates that a nonspouse beneficiary may make distributions over the course of their lifetime if they begin distributions on or before the end of the calendar year immediately following the calendar year in which the employee participant died.
In other words, if the designated beneficiary begins distributions by December 31st of the year following the year of the participant’s death, the applicable distribution period may be made over the life of the designated beneficiary, instead of subject to the 5-year rule.
When there are multiple beneficiaries.
Things can become more complicated when there are multiple designated beneficiaries inheriting the defined contribution plan, or IRA.
When there are multiple designated beneficiaries, the applicable distribution period for plan withdrawals is determined by the oldest beneficiary’s life expectancy. With multiple designated beneficiaries, this may be an unattractive requirement for beneficiaries that are younger than the oldest. Basing the applicable distribution period off of the age of the oldest designated beneficiary necessarily depletes the account balance more quickly than in the situation where the applicable distribution period is based off of the younger designated beneficiary’s age.
Fortunately, according to Reg. § 1.401(a)(9)-8 A-2(a)(2), this rule may be avoided if separate accounts are established by the end of the year following the year of the participant’s death.
In this case, each designated beneficiary becomes the beneficiary of the separate account to which their portion of the death benefit is assigned. Distributions moving forward will be based on their individual applicable distribution period, irrespective of the other beneficiaries.
Rules under the inherited plan.
The retirement plan that one inherits may dictate a distribution period. In some cases, the plan may dictate that the applicable distribution period for the designated beneficiary occur according to the 5-year rule requirement.
Distribution rules under an inherited retirement plan for a nonspouse beneficiary also apply to a beneficiary IRA where the benefits are transferred to. In other words, if the inherited plan making the direct rollover to a beneficiary IRA required the 5-year rule apply to a nonspouse designated beneficiary, the 5-year rule will also apply under the beneficiary IRA (Notice 2007-7, A-19).
Fortunately, there is a special rule allowing the nonspouse designated beneficiary to determine required minimum distributions using the life expectancy rule if the direct rollover to the beneficiary IRA is made prior to the end of the year following the year of death [Notice 2007-7, A-17(c)(2) (“Special Rule”)].
Some final thoughts.
Individual circumstances must be taken into account in order to determine your best path forward. Understanding your options, and how to abide by the rules, is important in order to make sure that you aren’t forced into a decision that you would otherwise wish to avoid.
The content you just read is for informational purposes only. Yes, I’m a financial advisor, but this article really isn’t intended as advice for you specifically. Your unique situation needs to be taken into account, and the ideas presented here may not apply.
So, please make sure you do your due diligence BEFORE implementing anything. Due diligence includes hiring a qualified professional who understands your situation completely and can offer you personalized advice.