When the Pension Protection Act of 2006 became law, much attention was devoted to changes that affect the accumulation aspect of pension plans. But you should also be aware that the act includes flexible new rules that apply to retirement plan assets inherited by nonspouse beneficiaries.

Whether you are expecting to inherit employer–sponsored retirement plan assets or leave them to your heirs, understanding the new rules may help you avoid costly mistakes.

Put Taxes Off Until Tomorrow

In the past, when someone other than a spouse inherited assets in an employer–sponsored retirement plan, it was not possible for the beneficiary to roll the money into a traditional IRA in order to preserve the tax-deferred status of the funds. The beneficiary was at the mercy of the plan's rules, which often required the inherited assets to be withdrawn within just a few years. This typically resulted in a potentially larger initial tax bill and the lost opportunity to stretch the tax–deferred assets over the beneficiary's lifetime.

In a perfect world, the original account owner would have rolled the money from his or her workplace retirement plan into a traditional IRA, and the beneficiary would have the option to take distributions over his or her lifetime. But now the new law allows a nonspouse beneficiary to transfer inherited retirement plan assets to a properly titled inherited IRA maintained in the name of the decedent. If set up correctly, the account can continue compounding on a tax–deferred basis. If the beneficiary takes only the required minimum distributions, he or she can potentially stretch the account out over several years — or even over a lifetime.

Of course, this transaction is more complex than a routine IRA rollover. If it is performed incorrectly, the tax deferral will be immediately lost. If the beneficiary does not take the correct distributions based on his or her life expectancy, the penalty is 50% of the amount that should have been taken. Distributions from traditional IRAs and most employer–sponsored retirement plans are taxed as ordinary income. The 10% federal income tax penalty on distributions prior to age 59½ does not apply to retirement plan beneficiaries, who must take minimum distributions right away.

The Pension Protection Act of 2006 made it easier to inherit tax-deferred assets—but remember that nothing is truly easy when it comes to the IRS. It's wise to rely on professional advice whenever taxes are involved.

New Rules Help Stretch Inherited Assets