Converting Inherited Accounts

IRS guidance leaves questions

By Kaye A. Thomas
Posted March 27, 2008

Pending law may provide retroactive change.

Right there on page 105 of our book Go Roth! it says you can't do a Roth conversion if you inherit a traditional account (401k, 403b or IRA) from someone other than your spouse. (A spouse can elect to treat an inherited IRA as his or her own, and that makes a conversion possible.) Recent guidance from the IRS seems to say conversions are now possible for inherited traditional accounts — both IRAs and accounts in employer plans — but it isn't clear whether we should rely on that guidance.

Rollovers of inherited accounts

Under previous law rollovers weren't permitted if someone other than a spouse inherited a 401k or 403b account. That was a lousy result for a child, domestic partner or other person inheriting the account because they lost the ability to move the money to an IRA and take withdrawals over a number of years, instead of all at once. Congress changed the law effective 2007 to allow a direct transfer from the trustee of the employer plan to the trustee of an IRA, provided that the IRA will be treated as an inherited IRA.

IRS guidance

Recent guidance from the IRS (Notice 2008-30) addresses various issues relating to the Pension Protection Act of 2006, the law that made this change. Tax pros were surprised to see a statement (Q/A 7) to the effect a distribution from an "eligible retirement plan" other than a Roth IRA can go to a Roth IRA. In other words, you can use this provision to do a Roth conversion for an inherited account. Furthermore, because the term "eligible retirement plan" includes IRAs, the IRS seems to be saying you can use this provision to convert an inherited traditional IRA to a Roth if you otherwise meet the eligibility requirements for a Roth conversion. But there are problems with this guidance.

Technical correction

A big, complicated law like the Pension Protection Act of 2006 always has some little glitches that need to be corrected in a law called a technical correction act. Tax staffers in both houses of Congress, and on the Joint Committee on Taxation, try to identify all the items that need to be fixed, and invite public comment on proposed versions of the legislation.

A technical correction act is currently pending, and it includes a change that would clarify that the new rule for inherited accounts applies only to employer accounts, not to inherited IRAs. As is often the case, the technical correction (in its current form) is retroactive to the effective date of the original law, because the correction is merely clarifying the original intention. It appears that the technical correction would eliminate the possibility of converting an inherited traditional IRA (contrary to the recent IRS guidance but in agreement with what the IRS says in Publication 590).

What about employer accounts?

This change begs the question of what Congress intended when they changed the law for employer accounts. Nothing in the legislative history suggests an intention to permit conversion of those accounts. The purpose of the change was to allow rollovers followed by gradual withdrawals, rather than Roth conversions. Furthermore, if Congress did intend to allow conversions of inherited employer accounts, why not allow conversions of inherited traditional IRAs? There is no reason to allow conversions for only one type of account, yet that is the result that would follow from the technical correction.

I've had some discussions with people in Washington who should be knowledgeable about these rules but the response was a lot of head-scratching, so we'll just have to wait and see how it gets sorted out.