Fall, 2006 Edition

• Pension Protection Act of 2006
• Income Limit Removed For Post-2009 Roth IRA Conversions
• New Tax Law Permits Non-Spouse IRA Rollovers
• PA Residents Get 529 Plan Tax Deduction

 

Pension Protection Act of 2006

The Pension Protection Act of 2006 (PPA), recently passed by Congress and signed into law by the President, contains numerous changes and additions to the existing rules governing retirement plans. This article will summarize the changes that most affect our clients.

EGTRRA Provisions Now Permanent

Since the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), there has always been the underlying problem that it was scheduled to "sunset" in 2010. EGTRRA's provisions (see Winter 2002 newsletter) include increased Pension/IRA contribution limits, Age 50+ Catch Up contributions and the Roth 401(k) (see Spring 2006 newsletter). The PPA makes these provisions permanent, eliminating the possibility that the Pension world would revert back to pre-EGTRRA rules and limits. The Roth 401(k), especially, should see an increase in interest since plan sponsors will know that it won't be taken away in 2011.

401(k) Automatic Enrollment

One of the goals that lawmakers have when drafting Pension legislation is to increase the participation by employees in retirement plans. The PPA again tries to do this by creating incentives for employers to use "automatic enrollment" plans, effective for Plan Years beginning in 2008. In most 401(k) Plans, for employees to contribute, they must complete a form to make an affirmative election. In an automatic enrollment situation, employees will have a particular amount deducted from their paycheck and contributed to the 401(k) Plan unless they elect otherwise. Not surprisingly, Plans using automatic enrollment generally have higher levels of participation. Automatic enrollment plans have been around for a number of years, but the PPA specifically provides employers with incentives to adopt these plans.

The PPA creates a "Safe Harbor" framework that allows employers to automatically satisfy the 401(k) non-discrimination tests and the Top Heavy rules. In order to satisfy these Safe Harbor requirements, the Plan must automatically defer for any eligible employee at least a specified amount of compensation unless the employee elects otherwise. The minimum deferral rate actually increases based on how many years an employee has participated in the plan:

Year of Participation	Minimum Contribution
1st 2nd 3rd 4th and after	3% 4% 5% 6%

The employer must also make a minimum contribution for each eligible employee, either (1) a straight 3% of compensation or (2) a Matching contribution of 100% up to the first 1% of pay contributed, plus a 50% Match on contributions greater than 1% up to 6% of compensation. The Safe Harbor contributions must be 100% vested after two years. This differs from current Safe Harbor Plans which require immediate 100% vesting.

The PPA also specifies that federal law will preempt any state law that may restrict the use of the automatic enrollment feature. In some areas, the use of automatic enrollment was seen as a possible violation of state law since it involves withholding an employee's earnings without the employee's consent.

Distribution Rule Changes

The PPA contains some interesting changes regarding distributions from qualified plans and IRA's:

1. Direct Rollovers may be made from qualified Plans directly to Roth IRA's, beginning in 2008. Currently, participants who want to execute a rollover to a Roth IRA would first have to rollover the funds to a traditional IRA and then convert the traditional IRA to a Roth IRA.
2. Non-spouse beneficiaries may roll over benefits from a qualified Plan to an IRA, beginning in 2007 (see New Tax Law Permits Non-Spouse IRA Rollovers).
3. Distributions from IRA's to owners who have attained age 70 1/2 (the Minimum Required Distribution age), may exclude from income distributions up to $100,000 if made to a charity. This is only if the gift to the charity would otherwise be tax deductible, and is only available for two years, in 2006 and 2007.

Other Changes

1. Beginning in 2007, the vesting schedules for all employer contributions have been accelerated to reflect the current, Top Heavy vesting schedules. These require either 100% vesting after three years (3-Year Cliff) or 20% beginning after two years and 20% in each additional year up to 100% after six year (6-Year Graded).
2. Participant Directed Plans will be required to provide benefit statements quarterly, beginning in 2007. The Department of Labor will be providing a model statement for this purpose. It's unclear as to whether participants with earmarked brokerage accounts, for instance, will be required to provide an additional benefit statement. An annual statement will be required for non-Participant Directed Plans.

Although not as sweeping in its scope as the last major retirement law enacted (EGTRRA), the PPA nevertheless does present significant opportunities. We will of course keep you informed as to what provisions may affect you and your retirement Plan.

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Income Limit Removed For Post-2009 Roth IRA Conversions

Incorporated into legislation signed into law in May is a provision which removes the income threshold for conversions of traditional IRA's to Roth IRA's, effective in 2010.

Under current law, such Roth conversions are available only to individuals with modified adjusted gross income of no more than $100,000 adjusted for inflation (the 2006 figure is $108,000). Traditional IRA's permit tax-deductible contributions (unless the individual is covered by a qualified retirement plan and earns above a certain income level) and tax-deferred growth. When amounts are withdrawn from a traditional IRA, they are subject to income taxation at ordinary income rates (except for any contributions which were non-deductible).

Roth IRA's offer no up-front tax deduction. However, if certain conditions are met (funds have been in a Roth IRA for at least five years and the distribution is (1) at or after age 59 1/2 (2) taken by a totally disabled individual, (3) after death, or (4) used for a qualified first time home purchase), distributions are received tax-free.

The negative to a traditional-to-Roth IRA conversion is that all funds in the IRA at the time of conversion (other than non-deductible contributions) are subject to immediate income taxation. For conversions done in 2010, the income tax liability is split equally between 2011 and 2012.

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New Tax Law Permits Non-Spouse IRA Rollovers

The Pension Protection Act of 2006, enacted in August, contains a provision which will benefit many individuals who inherit company-sponsored retirement plan accounts and/or IRA's and who are not the spouse of the deceased.

Spouses have always enjoyed the right to ";roll over" the proceeds of any tax-qualified retirement plan or IRA account to an IRA of their own, to continue the federal income tax deferral. Non-spouse beneficiaries, however, were not permitted to take advantage of the IRA Rollover mechanism. That resulted in required distributions, loss of income tax deferral, and high tax bills.

Under the terms of the new law, a non-spouse beneficiary can transfer the proceeds inherited from a tax-qualified retirement plan or IRA account directly into his or her own IRA. This enables the beneficiary to spread out withdrawals from the IRA over his or her life expectancy.

It is important that such an individual does not take possession of the proceeds - they must be transferred directly from the deceased individual's retirement plan or IRA to the beneficiary's IRA.

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PA Residents Get 529 Plan Tax Deduction

In July, Governor Edward Rendell signed legislation providing a state tax deduction when Pennsylvania residents make a contribution to a "Qualified Tuition Plan" ("529" Plan).

Residents in more than half the states get state tax deductions for 529 Plan contributions, but the great majority limit the tax deduction to situations where the resident invests in his or her own state's 529 Plan. Pennsylvania allows the deduction for any 529 Plan. It is one of only three states to do so.

The maximum contribution on which a state tax deduction can be taken in Pennsylvania is equal to the applicable federal gift tax exclusion, currently $12,000. The tax deduction is available for contributions made in 2006 or later.

529 Plans have become extremely popular over the past several years. Virtually all states have adopted such plans, which allow for tax-free growth (both state and federal) on 529 Plan assets, as long as they are used for "qualified education expenses." There is no federal tax deduction for 529 Plan contributions.

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This publication is not meant to provide legal or other professional advice. It is suggested that a tax advisor be contacted to review applicable areas discussed herein. All rights reserved.