Tax Highlights from the New Law

Like most laws containing tax provisions, the title of the newly passed Pension Protection Act of 2006 only tells part of the story. The legislation, which President Bush signed on August 17, 2006, does contain numerous provisions involving pension plans, but it also includes changes in

Unfavorable New Rule For Corporate-Owned Life Insurance     For corporate owned life insurance (COLI) issued after the August 17, 2006 enactment date of the Pension Protection Act, an unfavorable new provision generally requires businesses to include death benefit proceeds (in excess of premiums paid) in taxable income.     Exceptions apply in any of the following situations:      The insured individual was employed within 12 months of the date of death.      The death benefit proceeds are paid to buy back certain equity ownership interests.      The insured individual was a "highly compensated employee" when the COLI contract was issued. A highly compensated employee is defined as someone who is a more-than-5 percent owner, a director, or any employee ranked in the top 35 percent by pay.

Penalty-Free Early Distributions For Public Safety Workers     The Pension Protection Act creates a new exemption from the 10 percent premature withdrawal penalty tax for early distributions from government defined benefit pension plans to qualified public safety employees who leave their jobs after age 50. Under the normal rules, the 10 percent penalty tax generally applies to those who leave jobs before age 55. The new exemption applies to eligible distributions after August 17, 2006.

the tax rules for charitable contributions, college savings plans, and more. Here are eight highlights from the massive piece of legislation spanning more than 900 pages.

Highlight #1

Taxpayer-Friendly Retirement Plan Rules Are Now Permanent

Thankfully, the new law eliminates uncertainty when it comes to saving for retirement. The reason has to do with numerous rules that were set to end in the future.

Background: Under a tax law passed in 2001, a host of beneficial rules for retirement plans and accounts were scheduled to expire after 2010 under a “sunset” provision. For 2011 and beyond, the less-favorable rules were scheduled to kick back in.

However, the Pension Protection Act now makes the tax breaks permanent. This is welcome news for retirement savers and employers since it allows them to plan ahead with more certainty. Here are the most important provisions from the 2001 law (the Economic Growth and Tax Relief Reconciliation Act), which will be permanent fixtures in the tax code:

 Higher maximum amounts for defined contribution retirement arrangements including simplified employee pensions, as well as additional elective deferral contributions for participants age 50 or older.

 Higher maximum amounts for SIMPLE plans and additional elective deferral contributions allowed for participants age 50 or older.

 Larger maximum annual benefits allowed under defined benefit pension plans.

 Bigger maximum amounts for traditional and Roth IRAs; additional catch-up contributions allowed for account owners age 50 or older.

 Roth 401(k) and Roth 403(b) arrangements, which were first allowed in 2006. These accounts combine some characteristics of Roth IRAs and employer-sponsored 401(k) or 403(b) plans. Because they were set to expire in 2010, some employers were reluctant to set them up. Their permanent status may make more organizations willing to get onboard.

 The "saver’s tax credit" of up to $1,000 for those with modest incomes who contribute to 401(k) plans and IRAs (subject to income-based phase-out ranges that depend on filing status). Before the Pension Protection Act, this credit was scheduled to expire after 2006. For 2007 and beyond, the new law also mandates inflation adjustments to the income-based phase-out ranges. Therefore, more individuals will be able to claim the saver's credit in future years.

 More flexibility to arrange for tax-free rollovers of funds between various types of retirement accounts and plans. Also, faster vesting for employer matches of employee contributions to retirement plans.

 The revised top-heavy nondiscrimination and coverage rules and revised rules for employee stock ownership plans.

 The small employer tax credit for starting up new retirement plans, which is worth up to $500 a year for three years.

Highlight #2

Taxpayer-Friendly College Savings Plan Rules Also Made Permanent

The current super-beneficial federal tax rules for Section 529 college savings plans were also part of the 2001 tax law. And like the retirement provisions described above, these favorable provisions were scheduled to expire after 2010. This includes the federal-income-tax-free treatment of qualified withdrawals from Section 529 plans. (Before 2002, tax had to be paid on distributions at the child's rate.) The Pension Protection Act makes the existing rules permanent.

Now for the bad news: The new legislation also grants the IRS power to issue “anti-abuse” rules to prevent taxpayers from using Section 529 plans in certain tax-saving strategies that go beyond what Congress intended. For example, the government doesn’t like the fact that individuals can currently use Section 529 plan accounts as estate tax avoidance vehicles that allow them to retain a great deal of control over how the funds are used.

Highlight #3

Beginning in 2007: More Beneficiaries Able to Roll Over Money from a Deceased Individual’s Retirement Plan

Under the current rules, only an individual who is a deceased person’s surviving spouse can roll over, into his or her own IRA, distributions received as a beneficiary of the decedent’s qualified retirement plan. Other beneficiaries cannot take advantage of the tax-saving rollover strategy. However, beginning in 2007, the Pension Protection Act will allow a non-spousal beneficiary’s IRA to receive a tax-free rollover of a qualified distribution from the decedent’s retirement plan. To qualify, the rollover must be accomplished with a direct (trustee-to-trustee) transfer. Similarly, rollovers will also be allowed for amounts paid to a non-spousal beneficiary of a decedent’s Section 403(a) annuity, Section 403(b) annuity, or governmental Section 457 plan.

Once in the IRA, the rolled-over amount will fall under the required minimum distribution (RMD) rules that apply to inherited IRAs.

This new provision is significant because it extends the valuable tax-free rollover privilege to beneficiaries who are not spouses. Remember that only direct rollovers will qualify. Because required minimum distributions must be taken with respect to rolled-over amounts (calculated under the rules for inherited accounts), a new IRA should be established to receive the rollovers. In general, the timing and amount of the required withdrawals from that IRA will depend on: the age of the deceased individual at the time of his or her death and calculations based on the age of the beneficiary using the IRS-approved life expectancy tables.

Highlight #4

Direct Deposits of Tax Refunds into IRAs Allowed

For tax years beginning in 2007, an individual will be allowed to arrange for a direct deposit of all or a portion of his or her federal income tax refund into his or her IRA (or into a spouse’s IRA if the individual files jointly). This will allow more people to save for retirement with less effort.

Highlight #5

In 2007: Liberalized Rules for Rolling Over After-Tax Contributions

Under current law, individuals are allowed to make tax-free direct rollovers of after-tax contributions from qualified retirement plans into defined contribution plans. For this privilege to be available, however, the receiving plan must provide separate accounting for the after-tax contributions and the related earnings. The same taxpayer-friendly rule applies to direct rollovers of after-tax contributions between Section 403(b) tax-sheltered annuity arrangements (subject to the separate accounting requirement). Rollovers of after-tax contributions can also be put into IRAs (no separate accounting is required in this case).

Beginning in 2007, the new law will permit rollovers of after-tax contributions from a qualified retirement plan into a defined benefit plan (subject to the separate accounting requirement). To qualify, the rollovers must be accomplished via direct (trustee-to-trustee) transfers.

Highlight #6

Inflation Adjustments to Phase-Out Ranges for Deductible Traditional IRA and Roth IRA Contributions.

Because of income based phase-out rules, some individuals face restrictions on IRA contributions. Beginning in 2007, the new legislation will require inflation adjustments to the phase-out ranges for:

• Deductible contributions to traditional IRAs (the phase-out rules only apply for years during which the taxpayer or spouse participates in an employer-sponsored or self-employed retirement arrangement).
• Roth IRAs.

Before this favorable change, the phase-out ranges (which are based on modified adjusted gross income) were fixed without any inflation adjustments.

Key Point: Inflation adjustments will allow more individuals to make deductible contributions to traditional IRAs and contributions to tax-free Roth IRAs.

Highlight #7

In 2008: Direct Rollovers from Retirement Plans into Roth IRAs Will Be Allowed

Beginning in 2008, the Pension Protection Act will permit eligible individuals to make direct (trustee-to-trustee) rollovers of distributions from retirement plans into Roth IRAs. This new Roth conversion privilege will apply to rollovers from qualified retirement plans, Section 403(b) tax-sheltered annuity arrangements, and governmental Section 457 plans. Unfortunately for 2008 and 2009, only individuals with modified adjusted gross incomes of $100,000 or less will be eligible for Roth conversions. For 2010 and later years, the $100,000 rule will be eliminated (thanks to the Tax Increase Prevention and Reconciliation Act passed earlier this year). So, many individuals will eventually be able to take advantage of the Roth conversion strategy.

Key Point: Under current rules, an individual must first roll over retirement plan distributions into a traditional IRA and then convert that account into a Roth IRA. Under the Pension Protection Act, this two-step procedure won’t be necessary after 2007.

Highlight #8

Retroactive: Favorable New Rules for Retirement Account Distributions Received by Military Reservists

The new law opens up a brand new exception for military reservists to the 10 percent premature withdrawal penalty tax (which generally applies to distributions from tax-favored retirement arrangements made before age 59 1/2). Even better, this new exception is retroactive. Qualified reservist distributions are defined as early payouts taken from: an IRA; or elective deferral contributions to a 401(k) plan or 403(b) tax-sheltered annuity plan; or a similar arrangement. Qualified distributions must be received by a person who,

Earlier this year, another new law expanded retirement planning options for members of U.S. armed forces serving in combat zones. Click here for a rundown of the HERO Act.

because of his or her status as a member of a military reserve component, was ordered or called to active duty after 9/11/01 and before 12/31/07 for a period of more than 179 days or for an indefinite period. Also, qualified distributions must occur during the period that begins on the date of the order, or call to duty, and ends when the active duty concludes.

The Pension Protection Act also permits a reservist to "recontribute" all or part of a qualified distribution to an IRA during the two-year period that begins on the day after the end of active duty (or, if later, the two-year period that ends two years after August 17, 2006). By taking advantage of this beneficial rule, federal income tax is avoided on the amount paid back into the IRA.

Strategy: If following the new rules would result in a lower federal income tax bill for a tax year that is closed for amended return purposes, a reservist can still request a refund by filing a claim within the one-year period that begins on August 17, 2006.