Spousal rollover rights when trust is qualified plan beneficiary.

Under Sec. 402(c)(9), lump-sum and certain other "nonannuity" distributions from a qualified retirement plan paid to an employee's spouse after the employee's death are eligible for rollover to an individual retirement account (IRA) for the spouse. Amounts rolled over within 60 days after receipt are not included in the surviving spouse's gross income until paid from the IRA.

In recent years, so-called "living trusts" have grown in popularity as an estate planning tool. Living trusts are grantor trusts, which are typically revocable. The principal advantage of a living trust over a traditional will is that, on the death of the grantor, the time and expense of probate of the assets of the living trust is avoided. In some states, the probate process can take years and can cost as much as 10% of the value of the estate. In contrast, on the grantor's death, the assets of a living trust bypass probate and go directly to designated beneficiaries.

A decedent's interest in an employer's qualified retirement plan, a Keogh plan or an IRA pass directly to a designated beneficiary by operation of law, thereby avoiding probate. In other words, a decedent's qualified retirement plan assets avoid probate when there is a properly executed beneficiary designation, even in the absence of a living trust. Nevertheless, individuals regularly name their living trusts as primary beneficiaries under qualified retirement plans. This practice raises the issue of the eligibility of distributions for rollover treatment when the spouse is the trust beneficiary. On its face, the literal language of Sec. 402(c)(9) would appear to preclude rollover treatment for plan distributions other than those made directly to a surviving spouse. The IRS, however, has permitted rollover treatment under the predecessor to Sec. 402(c)(9) in various letter rulings when a trust was named primary beneficiary under a qualified retirement plan.

In Letter Ruling 9232041, a decedent's remaining balance in a qualified retirement plan was paid to a grantor trust established by the decedent for the benefit of the decedent's spouse. On receipt by the trust, the trustees paid the full amount of the distribution to the spouse. The spouse then contributed the trust distribution to an IRA within 60 days after payment from the qualified plan. The Service concluded the distribution was a valid rollover. (Rollover treatment was also allowed under similar circumstances in Letter Rulings 9234032 and 9047060.)

In each of these favorable rulings, the IRS was willing to look through the trust because, under the terms of the trust, the surviving spouse had sole authority to compel vesting of trust corpus and income in himself. Thus, under the terms of the trust, the surviving spouse would be deemed to be its owner under Sec. 678(a).

In contrast, the Service reached a different conclusion in Letter Ruling 9145041 as to a proposed distribution from a qualified plan to a revocable trust. The surviving spouse proposed to make the maximum permitted principal withdrawal from the trust and roll over the distribution to an IRA within 60 days after payment from the qualified plan. The IRS concluded that rollover treatment was not available because the payment from the qualified plan to the trust was not the equivalent of payment to the spouse. Pursuant to the terms of the trust, the surviving spouse could not be considered the owner of the trust under Sec. 678(a) because the spouse did not have an unlimited right to the corpus and income of the trust.

Accordingly, estate planners may want to reconsider the naming of a living trust as the primary beneficiary under a qualified retirement plan. When the spouse is the primary beneficiary under the living trust following the grantor's death, but the spouse's rights to withdraw principal are restricted, a valuable tax deferral may be lost.