Sometimes it seems that our federal tax policy is written by the Marx Brothers. Here’s a curious example.

The Pension Protection Act of 2006 added a provision regarding distributions from retirement plans to beneficiaries who were not the surviving spouse. Why is this important? Under existing law, if a participant in a qualified retirement plan died, and the participant named the surviving spouse as the beneficiary for whatever remained, there were some tax options. Although most retirement plans require that death benefits be paid out promptly after death, in a lump sum, the surviving spouse could roll over the distribution to an Individual Retirement Account and avoid immediate taxation. The spouse could instead take out distributions as needed, and be taxed when distributions were made (subject to certain minimum requirements).

But if the beneficiary were not the surviving spouse, but, instead, the participant’s children, this option wasn’t available. The children would have to take out the balance immediately, under most plans, and be taxed on it. This was a much less favorable income tax situation. So, the Pension Protection Act authorized plans to allow distributions to non-spouse beneficiaries to be transferred to IRAs and avoid immediate taxation.

Many people thought that this meant that qualified plans had to permit such rollovers. But the Treasury indicated, initially, that it was an option for plans; they didn’t have to do it. Treasury representatives asked at the time why any plan would not have such a provision, but it appeared that some employers had decided not to offer this option.

To correct this situation, a technical corrections bill was offered, which contained language making the non-spousal rollover provision mandatory. Then, the Treasury indicated that, in its opinion, the rollover provision was voluntary for the current year, but would be mandatory in future years. However, that technical corrections bill was not enacted, and the Treasury appeared to go back to its original view that the provision was voluntary.

Finally, the matter has been resolved in the recently enacted Worker, Retiree, and Employer Recovery Act of 2008. Non-spousal rollover provisions will be required in qualified plans. Why is this important? For those non-spouse beneficiaries, it can make a huge difference in the incidence of taxation. What should you do about it? If you are participating in a qualified retirement plan (401(k), profit-sharing, etc.), you should find out what provisions the plan has for distributions at death. If the plan has an immediate payout provision, and you have named children or others as primary or secondary beneficiaries, be sure there is an understanding of the tax options if they inherit the retirement account. This could be by way of a memorandum added to your estate-planning file, for example. This is also a good opportunity to review your beneficiary designation for your retirement benefits. Do you know where that designation is? Of course, you don’t; neither do I. But it’s an important addendum to your will, along with beneficiary designations for life insurance policies. It’s a good idea to be sure your assets go where you wish at the appropriate time.

REPRINTED WITH PERMISSION OF THE LEGAL INTELLIGENCER