Rollover and Transfer Rules for Beneficiaries of IRAs and Employer Plan Accounts

Who Owns Most of the Wealth Today?

Last year, The New York Times published an article saying that baby boomers own a significant portion of Americans’ assets, with $16 trillion transferred within the next ten years. Now, when I hear ten years, my ears perk up. Why? Because we have a 10-year rule that applies to most beneficiaries who inherit retirement accounts. Baby boomers are aged 60 to 78, with an average life expectancy of 76.4 years.

What does that mean? If you work with clients who own retirement accounts, they will eventually be passed on to their beneficiaries. And so, we have to be ready to have that conversation when your client comes to you and says, “Someone that I love died, and I inherited their account. What is my next move?”

We all know that most Americans need to save more for retirement. However, research shows that those with anything saved for retirement hold over 80% of their assets in tax-deferred retirement accounts.

As you meet with clients and discuss their financial planning goals and objectives, you must ask, “How much is in your IRA or other tax-deferred retirement accounts, and what are your plans for those who will inherit your retirement account?” We know most people will only spend it some, with over $38.4 trillion in tax-deferred retirement accounts right now and only $13.6 trillion in IRAs. Do you know what the research shows? The majority of assets that are held in employer plans will eventually be rolled over to IRAs.

Now, beneficiaries will do some of those rollovers, and the question becomes: can a beneficiary do a rollover? And if so, what are the rollover options? The answer depends on the class of beneficiary. What you do not want to have happen is for you to tell a beneficiary that you can do a rollover. They request the distribution, thinking it can be rolled over within 60 days. However, they can only do that if they are the spouse beneficiary. That is where I find a significant percentage of the mistakes made with rollovers: non-spouse beneficiaries think they can do a rollover.

Now, there is talk that this will be fixed, or some solution will be provided. In Secure Act 2.0, the IRS was instructed to implement a corrective procedure, but so far, nothing has been done, and until then, we have to be very careful.

SECURE Act 1.0: Key Changes for Beneficiaries

One of the things that came out of Secure Act 1.0 is the 10-year maximum period for beneficiaries. Now, you remember when Secure Act 1.0 was signed into law, the big thing was the “stretch is dead.”

What does that mean really? Because we know under the old rules, if you inherited a retirement account and your life expectancy was 50 years, let us say you died ten years later: then, your successor beneficiary had 40 years to continue taking the distribution. However, they explained in Secure Act 1.0 that you are a beneficiary. This is not your retirement savings. Therefore, we will not allow you to stretch it over your life expectancy, and they provided certain exceptions for a class of beneficiary referred to as an eligible designated beneficiary.

Now, when you discuss rollovers, transfers, and distribution options, you have to know whether the beneficiary is a designated beneficiary, an eligible designated beneficiary, a non-designated beneficiary, or, here is the one that people miss: a successor beneficiary. Even IRA custodians who help their clients calculate RMDs get it wrong. I’ve looked at some of the largest custodians in the country and their process for calculating beneficiary RMDs, and they need to ask the right questions.

Who is Your Beneficiary?

One of those pertinent questions is: are you the primary beneficiary? Because the answer to that helps to drive the solution that the IRA custodian or professional provides to the IRA owner.

Let us discuss some things we must do before you meet with a client who has an IRA. Please ask your client, “Who is your beneficiary?” They will probably tell you, “Oh, my spouse,” because most people think that. When they set up their 401(k), 403(b) account, or IRA, they think, “Oh, all the paperwork I have says that my spouse is a beneficiary.”

We know that they must be named on the beneficiary form to be the beneficiary. If there is no named beneficiary form or the beneficiary does not survive the account owner, we look to the default provisions of the agreement. We should look for IRA agreements that are what I call estate-planning-friendly.

You may like Firm A because of their cheap trade fees and other benefits, but what about your beneficiaries? What happens if you die, and you do not have a surviving beneficiary? Are the assets going to go to your estate? Are they going to go to your spouse? Are they going to go to your children? The terms of the IRA agreement will determine that. That has to be part of the process of choosing which custodian is the best custodian for your IRA.

Now, for a qualified plan, like a 401(k) plan and ERISA plans in general, the spouse is usually the default beneficiary unless the spouse properly consents to someone else being a co-primary beneficiary or the only beneficiary. Remind your clients to update their beneficiary designation forms after every life-affecting event. Was there a marriage, death, divorce, birth, or adoption? Review them at least once per year, even if they think that the designation and file are correct because sometimes, we just do not remember.

There is a real-life case where this woman started working at about age 20 and was unmarried; she named her mother, uncle, and sister as beneficiaries of her 403(b) account. She got married 20 years later. After being married, she dies. Now, you know her husband’s thinking, “What is mine’s hers, what is hers is mine.” So, of course, that includes her 403(b) because if he had died, she would have gotten his 401(k)-retirement savings account. But the 403(b) is a non-ERISA account, and when she died, her sister, who was the only surviving of the three beneficiaries, went to the school, took the money, and ran, and she did not give the husband any. He sued the school board, and he lost because they said, “You are not the beneficiary on record at the time of death. So, therefore, it is not your money.”

Almost a million dollars, and all because, all along, they thought they were each other’s beneficiaries. It turned out not to be the case. Suppose someone says, “As per my will on the beneficiary form,” that does not mean anything. The estate might inherit the account, or the IRA custodian might invalidate that beneficiary designation. It is determined according to the default provisions. Now, if your sister is a beneficiary under your will, then name your sister on the beneficiary form. Do not say, “As per my will,” because that does not fly when it comes to an IRA.

Another action plan is to check default beneficiary provisions. Some default to the estate, some to a spouse, then children, some to a spouse, and some include varying provisions. I have seen those that even include parents and grandparents. So, you tell your client, “Even if you do not think you will need the default provisions, check it anyway. How does it fit into your plans?”

Check for Distribution Limitations

This is so important. I have worked with spouse beneficiaries on several cases. Now, we know that spouse beneficiaries have more options than those available to other beneficiaries. They can stretch it over your life expectancy; they can roll it over. But in this particular case, when the spouse beneficiary’s attorney came to me, she had a check for over $5 million in her hand and a letter that said, “This is your RMD, and you cannot roll it over.”

The attorney thought, “But that does not sound right.” But when we checked the terms of the plan document, the husband had died before 2020. So, it is the old rules where a spouse beneficiary could say, “Oh, you have the five-year rule, or the life expectancy rule, if the participant died before their required beginning date, which was the case here.” So, she followed up after five years when she got the check.

By that time, the entire $5 million was her RMD. She could not roll it over. She had to include $5 million in income in one year, which was no longer eligible for tax deferral. Not only that, but she also owed the IRS a 50% excise tax on that $5 million, right?

We got the excise tax away due to reasonable error, but come on. She is thinking $5 million; that is my retirement nest egg. I am going to wait until I am RMD age and take a little bit every year, and all of that was thwarted. Even though I felt sorry for her because she was dealing with a lot—her husband died—there has to be something in place where beneficiaries know what to do when the retirement account owner dies.

So when your client comes to you and says, “I inherited an employer plan,” like a 401(k), tell them right away, “Go get a copy of the summary plan description agreement because we are going to use that to determine how soon we need to take action to protect your inherited benefits.”

So, in this case, what could we have done? Check the terms of the plan document. They had given her five years, which would be ten years under the new Secure Act rules. In that case, we will say to the spouse beneficiary, “Do a direct rollover of those assets, either to your own IRA or a beneficiary IRA, and do that by December 31^st of the year following the year of death, and you will have all the options available to you as a spouse beneficiary.” I will talk about that more later.

Check for stretch limitations. Successful beneficiaries are allowed to continue taking distributions after the primary beneficiary dies, but it is sometimes limited. With Secure Act 1.0, I use an example of a beneficiary who inherited an account, had a 50-year life expectancy, and died ten years later. Under the old rules, the successor beneficiary would have had 40 years, but under the new rules, if the beneficiary dies after 2019, they have only ten years.

But here is what I am finding. We worked with a custodian whose policy is that when the primary beneficiary dies and the successor beneficiary inherits the account, the successor beneficiary has to name their estate as the beneficiary. When that successor beneficiary dies, the estate has to take an immediate distribution.

So, you might think that you can tell your client, “Make sure the beneficiary names their successor beneficiary for their retirement account,” and you would be right to tell them that because you are doing the right thing; but it does not work unless you check the terms of the IRA agreement to see if the IRA agreement includes a limitation that voids the plan that you are putting in place for your client with the inherited account.

Now, you will help your client put all those plans in place. Does it really mean anything if the successor beneficiary does not know? Well, it does because it affects your distribution options, but there is so much money that has been escheated to states. You know why? Nobody comes forward to claim those assets, and a lot of those are accounts where the account owner died, and the beneficiary does not know that they have inherited the account.

I know you are probably saying, “Well, I do not want anyone to be nice to me because they think they are going to inherit my retirement account. So, I do not want them to know that they are the beneficiary,” which is fine. But if you name your two nieces as your beneficiary, tell someone if you do not want to tell them. Tell an attorney. Tell someone else that you trust. Please put it in writing; give them a letter and say, should you die, give this to my nieces, and that will tell the nieces that they inherited the account and tell them what to do.

I recommend including procedures in the letter. Do not take a distribution. Make sure you move the assets as a transfer. Things like that, which I am going to talk about later, help them protect the inherited assets from unintended distributions.

Operational Procedures

A common question is, how do you title an inherited IRA? The IRS says the title must include the decedent’s and beneficiary’s names. I hear talk that if that does not happen, it results in a distribution. I will tell you why that is not true. If you look at an inherited account and it includes only the beneficiary’s name, find out if it is registered so that distributions are reported with a Code 4 in Box 7 of 1099-R.

That is what makes it an inherited account. Does the wrong title mean that it results in a distribution? No, you see Mitt here giving you the side eye saying, “Come on. You know that is not true,” because a wrong title is an easy fix. All the customer has to do is go into their system, click, click, click, and fix the title. No harm, no foul. The titling is just for the IRS to know who the person who currently owns the account inherited it from, and that is an easy fix.

Now, when conversing with beneficiaries, you need to know the beneficiary class for distribution purposes. Distribution options are based on whether the beneficiary is a designated beneficiary, eligible designated beneficiary, non-designated beneficiary, or a successor beneficiary.

Now, when it comes to rollovers and transfers, what do you want to know? Are they the spouse, non-spouse, or a non-person? That drives the options that are available to them, particularly regarding rollovers and transfers.

How do you move an inherited account? Carefully! See this warning sign? It was added with a specific purpose because if you move the retirement account the wrong way, then, for example, here, a designated beneficiary who would have ten years, that could turn out into a one-year distribution period.

If someone is an eligible designated beneficiary and you tell them, “You can take the distribution over 30 years,” but they take a distribution, thinking that they can roll it over, it turns out that the 30-year period was converted to a one-year period just because they chose the wrong method when moving the retirement accounts.

The same is true for a beneficiary subject to the 10-year rule. So, there are some instances where non-spouse beneficiaries take distributions and roll them over because they think they can. The custodian sometimes accepts them, but that does not mean they are eligible to be rolled over.

What that means is they have an ineligible rollover that creates an excess contribution that will be subject to a six-percent excise tax for every year it remains in the account. I had a case where someone rolled over a distribution from an inherited account of about $400,000, six percent for every year it stayed in the account because they thought it was okay to do so.

Options for Non-person, Non-designated Beneficiaries

Non-person, non-designated beneficiaries cannot roll over a distribution that they take from an inherited account. We are talking about beneficiaries like an estate, a charity, or a non-qualified trust. They cannot do a 60-day rollover or a direct rollover.

So all this is important to know, depending on the type of account. Here is a question we are asking. Who is a beneficiary? A non-designated beneficiary, like an estate. What is the account? An inherited IRA. They can go from a traditional inherited IRA to a beneficiary traditional IRA, a Roth to beneficiary Roth. It has to be done as a transfer because it cannot be rolled over if they take a distribution. I hope I am breaking it down to where you can pull out this presentation and say, “Who? Non-designated beneficiary. What? An inherited IRA.”

Now, for the non-designated beneficiary, what if it is an inherited 401(k)? The only option is for them to make a distribution to the beneficiary or annual distributions over the remaining life expectancy of the decedent if they died on or after the required beginning date or over the five-year period if they died before the required beginning date.

Same thing with an inherited Roth 401(k). No rollovers, no transfers.

Options for Non-spouse Beneficiaries

Non-spouse beneficiaries cannot do a 60-day rollover.

Here is a question. Who is the beneficiary? A non-spouse beneficiary. What is it? An inherited IRA. They can go from a traditional inherited IRA to a beneficiary traditional IRA or an inherited Roth IRA to a beneficiary Roth IRA only as a transfer. They cannot roll over a distribution.

Here is a real-life case where a beneficiary inherited a retirement. She inherited two IRAs. Her aunt left her two IRAs. She conversed with her husband, and they agreed, “We do not need the money. We are fine. So, we are going to stretch it over our life expectancy.” They could stretch it then because it was pre-Secure Act. And then, even though they could not stretch it now unless they are eligible designated beneficiaries, the lesson is still the same.

She went to Bank 1, and she said, “My aunt left me this IRA. Here is the proof. I want to roll it over.” The bank associate should have said, “Are you related to the account owner, or are you the spouse of the account owner?” And if she had said no, they should have said, “Well, you cannot roll it over.”

Let us be honest because I have had that experience where I took my mom to one of those giant banks, and they were telling her, “You can put your CD on automatic rollover; every three months, it matures, so you roll it over,” and I had to sit there and quietly explain that you can do a rollover only once during a 12-month period. They do not know. They want to help; they are usually very pleasant; but is that sufficient to help your client? No.

So, in this case, when she said, “I want to roll it over to my IRA,” the bank associate handed her a distribution form and said, “Fill this out.” Then, they gave her a check. She took the check and rolled it over to an IRA at Bank 2. Bank 2 does not ask her anything. They accept the check because their rollover contribution form says, “You confirm that you have had a conversation with your tax or legal advisor, and they have advised you that you can roll over these amounts.”

Now, we know no one’s consulting with a tax advisor. This protects the IRA custodian because when they sign, they are attesting to the fact that they have sought tax or legal advice, which 90% of people do not do before they do an IRA transaction because they just want to get it done. She probably wanted to avoid paying a tax advisor or an attorney for fees to advise her about her options with the inherited account.

So, back to the story. This is an opportunity here for your client to learn from other people’s mistakes, and this is one of them. Bank A gave her the check. She rolled it over. Guess what happened when she went to Bank No. 2? Same thing. It was like copy-paste.

When the IRS got the 1099-R, they saw a Code 4 in Box Seven. Remember we talked about Code 4? So, the IRS knew that she owed them income tax on that amount. She disagreed with the IRS. She took the IRS to court and explained it was a bank error.

The tax court said, “We are sorry for you, but that is no excuse. You have two ineligible rollovers. You have to include those distributions in your income, and you also owe a lot of money for failing to do that, not to mention the six-percent excise tax.”

If it is an inherited 401(k), the spouse beneficiary can roll it over. Traditional 401(k) to a beneficiary, traditional IRA, traditional 401(k) to a beneficiary Roth IRA. This is the only opportunity for a non-spouse beneficiary to do a conversion with inherited accounts, rolling a traditional 401(k) to a Roth IRA.

A Roth 401(k) can be rolled over to a beneficiary Roth IRA. This has to be done as a direct rollover, where the beneficiary accounts are set up, and the plan administrator is instructed to make the assets payable directly to the IRA custodian for the benefit of the inherited retirement accounts.

Spouse Beneficiaries Have All the Options

They can do what other beneficiaries cannot. However, you have to be very careful, even more careful, when you are having conversations with beneficiaries.

A spouse beneficiary can treat a beneficiary IRA as their own, move it to a beneficiary IRA, or roll it over to their own employer plan account.

So, the question for you is, how do you advise your spouse beneficiary client? My advice is that when your client comes in to see you and tells you that they inherited a retirement account, you are going to ask them certain questions. I will tell you what those questions are later.

So, the IRA options are a beneficiary IRA, treat as own, or roll over to employer plan account. Suppose it is an employer plan like a 401(k). In that case, they can keep it in a beneficiary account and take distributions, roll it over to a beneficiary IRA as a direct rollover, roll it over to their own IRA, or roll it over to their employer-plan account.

What questions do you want to ask your spouse beneficiary client? “Are you under age 59½?” Why are you asking that? Distributions taken before the spouse beneficiary reaches age 59½ are subject to a 10% early distribution penalty unless made from a beneficiary account, or they qualify for some other exception.

So, you must find out from your spouse beneficiary client, do you plan to take distributions before you reach age 59½? If they do, you have to keep those assets in a beneficiary account so that they are reported with a Code 4 of Box 7 of 1099-R, which tells the IRS this amount is automatically exempt from the 10% penalty. If you are unsure what to do, have your spouse beneficiary client keep the assets in a beneficiary account because they can always move it to their account later. But if they move it to their account, they cannot go back.

This is another case that you can share with your client, where Ms. Sears inherited her husband’s IRA and knew that beneficiary accounts were exempt from the 10% early distribution penalty. Now, his IRA was at Merrill Lynch, and she transferred it to her own IRA at her financial institution.

What is wrong with this picture? When she moved it to her own IRA, it was no longer a beneficiary IRA, and distributions from her IRA were no longer exempt from the 10% penalty due to the death exception. Still, when she filed her tax return, she did not pay the 10% penalty. How did the IRS know that she owed them? The 1099-R showed Code 1 in Box Seven. Code 1 is the custodian telling the IRS that Ms. Sears owes you 10%.

Ms. Sears took the IRS to court, and the tax court said, “Ms. Sears, you did qualify for the exception, but you messed it up when you moved it to your own account, and you cannot go back.” So, she ended up having to pay over $6,000.

So, now the question is, who? Is it a spouse? What kind of account? Is it an inherited account? The spouse beneficiary can transfer a traditional beneficiary account to a beneficiary IRA. That must be a transfer. A traditional IRA to their own traditional IRA can be a transfer or a rollover. The rollover would be subject to the 60-day deadline and the one-per-year, IRA to IRA rollover rule. Roth IRA to a beneficiary Roth IRA must be a transfer. Roth IRA to own Roth IRA can be a transfer or a rollover.

When the spouse beneficiary chooses the rollover option, remind them they have 60 days to put it back. If it is an IRA, the IRA-to-IRA rollover limitation applies. You can do that only once every 12-month period, and only eligible amounts can be rolled over. So, for instance, if an RMD needs to be taken, they have to take that before they do the rollover.

Now, suppose the spouse beneficiary chooses a rollover option. In that case, it can only be made to their own IRA, not a beneficiary IRA, and here we have the issue of the 10% distribution penalty. So, if the spouse beneficiary wants to maintain it as a beneficiary account, they cannot use the rollover option.

Now, what if it is an inherited 401(k)? The traditional 401(k) can be rolled over to a beneficiary traditional IRA. The traditional 401(k) can be rolled over to a beneficiary Roth IRA. That would be a Roth conversion because we are going from traditional to Roth. The Roth 401(k) can be rolled over to a beneficiary Roth IRA. Direct rollover, only if they are rolling to beneficiary accounts, not 60-day rollover.

If it is a 401(k) and they want to roll it to their own IRA, they can do that with any of those accounts, just as they could with the inherited IRA. But in this case, if they roll it to their own IRA, they risk being subject to the 10% early distribution penalty.

So, if your client is under age 59½ and a spouse beneficiary, and they might be taking distributions from the inherited assets; they want to roll it to an IRA: encourage them to roll it to a beneficiary IRA, whether traditional or Roth, and that protects them from the 10% early distribution penalty, because as we talked about earlier, they can change their mind later on and move it to their own IRA, but keeping it in the beneficiary account protects them from the 10% early distribution penalty.

Inherited 401(k) and Roth 401(k) can roll a traditional 401(k) to their own traditional 401(k). Suppose the spouse beneficiary works for an employer with a 401(k), and the plan is designed to accept rollovers. In that case, they might want to consolidate and move it to their retirement account—some people like that: less paperwork, fewer statements, fewer things to keep track of. For a Roth 401(k), they can roll it to their own Roth 401(k); traditional 401(k) to own Roth 401(k). So, many options here are available for a spouse beneficiary.

Now, you have got to be careful because the Roth conversion option might seem great, but the question becomes, “Can the spouse beneficiary afford to pay the income tax that is due? Are they suitable for a Roth conversion?” Because unlike what some people are saying, not everybody is suitable for a Roth. We have to do a suitability assessment to make that determination.

Remind them that if they do the 60-day rollover, they have to complete it within 60 days. There are exceptions to that, but who wants to be bothered with that if you can avoid it? There is too much paperwork, too much work, and too much administrative red tape.

If the payer does an indirect rollover, they must withhold 20% from any taxable portion. Only eligible amounts may be rolled over, and indirect rollovers must be made to their accounts, not beneficiary accounts.

Practice Pointers

Some general practice pointers apply to both spouse and non-spouse beneficiaries.

If, for instance, the participant died and was supposed to take an RMD, or if the beneficiary is supposed to take an RMD for the year to roll over, that RMD must be taken before the rollover.

Why is that? An RMD is not eligible to be rolled over, and for any year that an RMD is due, the first distribution for that year includes the RMD. So, you have got to check that box. If they do the rollover before taking the RMD, the RMD creates an excess contribution in the receiving account, and we do not want that.

Transfers and direct rollovers: Initiate these on the receiving end. Set up the accounts first. Some financial institutions want an acceptance letter from the receiving financial institution. Here is my recommendation: I see a lot of custodians stepping back from the responsibilities that they used to assume years ago.

Once upon a time, you could only do a direct rollover if the receiving custodian provided an acceptance letter. Now, some custodians are saying, “Oh, where do you want to send the money? Here is your check. Tell me who to pay it to,” and then they wash their hands of it. Now, it is not that they are doing anything wrong; they are not doing things they used to do to protect the client. They do not care anymore.

So, the clients take these distributions to the receiving financial institutions, and sometimes, they are deposited into the wrong accounts. I recommend getting an acceptance letter anyway because the acceptance letter confirms the type of account established for receiving the funds. Is it a Roth? Is it traditional? If it says it is a Roth, they will know there is a disconnect if the client checks traditional on the box.

For spouse beneficiaries who want to maintain qualification for the 10% early distribution penalty exception, they must do direct rollovers to the receiving account. With the direct rollover, the assets are paid to the IRA custodian for the benefit of the IRA. So, say, for instance, it is an IRA FBO, Mary Jane, Beneficiary of John. The check would be made payable to IRA custodian ABC Company for the benefit exactly as the IRA is registered.

That protects your clients, too, because if the custodian mistakenly puts those amounts in the spouse beneficiary’s own account, you can go to the custodian and say, “All the paperwork, all the instructions were clear as to what you were supposed to do; and so, the mistake is yours, and you are obligated to fix it.”

Key Takeaways

Check beneficiary designations to ensure they are proper. In almost every client meeting I have participated in, the IRA owner pushes back when the advisor and I recommend bringing all your beneficiary forms.

One reason they do that is that some clients like to spread their money around. “I want to keep some at Firm A, I want to keep some at Firm B,” and that is their right. What they usually do in that case is they do not want the advisor to know.

They want the advisor to think, “Oh, that account that I have with you is the only one I have, and I do not want you to ask me to bring other accounts to you, so I do not tell you about it.” However, you must help your clients understand, “Listen, I am fine if you want to keep money elsewhere, but I am the only advisor who will go above and beyond to ensure you are protected and your beneficiaries are protected. One of the ways that I can do that is to review your beneficiary designation form to ensure that they follow your goals and objectives. Who do you want to be your beneficiary, and are they your beneficiary?” In the case I discussed earlier, where the woman was married for 20 years, and her husband did not get the assets, guess what? All the statements they sent her over the years said her husband was the beneficiary.

They had it somewhere on their system that the husband was a beneficiary, but it was not where it should be – on the beneficiary form. So, do not think that because you get your monthly account statement, and it identifies who you think the beneficiary is. Call and confirm that they have the proper beneficiary. If they made a change on the wrong system, but it shows up on the statement but is not reflected on the beneficiary form, then we have a problem.

Do not use the rollover method for IRA non-spouse beneficiaries. When a non-spouse beneficiary takes a distribution, that is it. Use only direct rollovers for non-spouse beneficiaries.

Look for opportunities for tax savings regarding spouse beneficiaries and ensure that the receiving account is eligible to receive the amount.