United States: Highlights of the Pension Protection Act of 2006

The Pension Protection Act of 2006 (the "Act") was signed into law on August 17, 2006. Some commentators have described it as "the most sweeping reform of pension funding rules since 1974, helping to guarantee that companies uphold their pension promises to workers. A summary of the more important qualified plan, IRA, charitable giving and reform provisions of the Act follows.

Summary of Qualified Plan and IRA Provisions

Permanent Retirement and Savings Incentives The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) substantially increased pension and individual retirement account (IRA) contribution limits (both regular and catch-up) through 2010 and also made other improvements in pensions and retirement savings through enhanced vesting, portability and reduced regulatory burdens. The Act makes these favorable changes permanent, and also indexes the income limits for traditional, spousal and Roth IRAs to minimize the erosion of these benefits due to inflation. Similarly, the favorable EGTRRA provisions regarding qualified tuition plans, which were originally scheduled to expire after 2010, have also been made permanent by the Act.

Rollovers into Roth IRA Accounts For distributions after 2007, the Act allows distributions from qualified retirement plans, tax-sheltered annuities and governmental (Code Sec. 457) plans to be rolled over directly into a Roth IRA, subject to the usual adjusted gross income (AGI) rules that apply to rollovers from a traditional IRA into a Roth IRA. The AGI rules do not apply to distributions for tax years beginning after December 31, 2009, meaning that both traditional IRAs and qualified retirement plans, tax-sheltered annuities and governmental (Code Sec. 457) plans can be converted into Roth IRAs regardless of the individual's AGI.

Liberalized Hardship Distribution Rule For purposes of the 401(k) hardship distribution rules, "hardship" includes hardship of a beneficiary under the plan, even if the beneficiary is not a spouse or dependent. This provision is effective August 17, 2006.

Rollovers by Nonspouse Beneficiaries Under pre-Act law, only participants and surviving spouses were able to rollover amounts from qualified plans, 403(b) annuities and IRAs to another plan or IRA; nonspouse beneficiaries were not eligible to rollover inherited amounts. The Act provides that, for distributions after 2006, nonspouse beneficiaries may rollover, to an IRA structured for such purposes (in a trustee-to-trustee rollover), amounts inherited.

Defined Contribution Plan Investment Rules Under the Act, participants must be allowed to immediately diversify any employee contributions or elective contributions invested in employer securities. For employer contributions, participants must be able to diversify out of employer stock after they have been in the plan for three years. The diversification requirement applies to plans with publicly traded employer securities.

Defined Benefit Plan Change The Act made numerous highly technical changes to various defined benefit plan provisions (including age discrimination testing, employer funding, Form 5500 informational reporting, Pension Benefit Guarantee Corporation premiums and conversions into cash balance plans), explanations of which are beyond the scope of this discussion. In general, these provisions are intended to create more pension transparency so that participants, regulators and investors can have a better understanding of the financial health of traditional pension plans.

Direct Deposit of Tax Refunds into IRAs The Act requires the IRS to establish procedures for depositing federal tax refunds directly into an IRA.

IRA Distributions for Charitable Purposes The Act provides an exclusion from gross income for certain distributions of up to $100,000, per year, from a traditional individual retirement account (IRA) or a Roth IRA, where the distribution is contributed to a tax-exempt organization to which deductible contributions can be made. This provision is effective for 2006 and 2007, applies only to distributions made on or after the date the IRA owner attains age 70 1/2, and must be made directly from the IRA trustee to the charitable organization. Distributions that are excluded from income under the new provision are not allowed as a deduction. The provision can save taxes for those who itemize their deductions to the extent that AGI limitations would have otherwise reduced the amount of charitable contributions currently deductible. In addition, excluding the IRA distributions from AGI also results in a lower AGI, which may make deductions affected by AGI (such as medical deductions and miscellaneous itemized deductions) easier to deduct, and may also reduce the amount of Social Security benefits that are subject to tax.

Automatic Enrollment Arrangements Current law allows automatic enrollment in 401(k) plans (where the employer withholds contributions unless the participant opts out of the program), but, because of state garnishment laws and fiduciary liability concerns, employers have been discouraged from implementing automatic enrollment provisions. The Act addresses these concerns and provides incentives for automatic enrollment and for automatic increases in contribution percentages. Participants have the ability to opt out within 90 days, but participants, once in, do not typically opt out. These provisions are at least partially in response to recent studies that have shown that, in the second and third quarters of 2005, the saving rate for the first time in the last 60 years has fallen into negative territory. In other words, Americans as a whole are spending more than they are saving. Furthermore, studies have also shown that only 8.4% of 401(k) participants contribute the maximum amount allowed.

Guard and Reservists Called to Active Duty Under the Act, distributions from an IRA or pension plan to members of the National Guard and Reserves called to active duty through 2007 are not subject to early withdrawal penalties. Withdrawn amounts may be repaid to the IRA or pension plan within two years of the distribution without regard to the annual contribution limit.

Long-Term Care/Annuity Products The Act authorizes a new insurance product that allows annuities to carry a long-term care rider so that annuity earnings can also be used to provide coverage against long-term care needs.

Qualified Conservation Contributions The Act raises the charitable deduction limit from 30% of AGI to 50% of AGI for qualified conservation contributions. Furthermore, the charitable deduction limit is raised to 100% of AGI for eligible farmers and ranchers, provided that the contribution does not prevent use of the donated land for farming or ranching purposes. The Act also authorizes the carryover of unused deductions for up to 15 years, an increase from the current five-year carryover. This provision is effective for 2006 and 2007.

Basis Adjustment for S Corporation Contributions Under the Act, for 2006 and 2007, the amount by which an S corporation shareholder's stock basis is reduced (due to a charitable contribution by the corporation) is limited to the shareholder's pro rata share of the contributed property's adjusted basis, as opposed to the fair market value (FMV) of the property. This can result in a larger post-contribution stock basis if the FMV of the property exceeds its basis on the date of the contribution.

Cash Contributions With regard to charitable contributions of money, for tax years beginning after August 17, 2006, the donor must maintain a canceled check, bank record, or receipt from the donee organization showing the name of the organization, the date of the contribution and the amount of the contribution. Previously, only contributions in excess of $250 required substantiation to this extent.

Clothing and Household Items In general, for contributions made after August 17, 2006, no deduction is allowed for charitable contributions of clothing and household items that are not in "good" used condition (or better). In addition, the IRS can deny a deduction for any item with minimal monetary value.

Notification Requirement for Exempt Organizations The Act requires certain exempt organizations to file an annual notice with the IRS containing basic contact and financial information. This requirement applies to organizations that currently do not have an annual filing requirement because their gross receipts are less than $25,000.

Appraisal Reform The Act makes it easier for the IRS to impose accuracy-related penalties on a taxpayer who claims a deduction for donated property for which a qualified appraisal is required, and defines a "qualified appraiser" and a "qualified appraisal."

If you have any questions about the information in this Alert or would like to learn more about the Pension Protection Act of 2006, please contact Michael A. Gillen, CPA, CFE, Director of Tax Accounting, or the practitioner with whom you are regularly in contact.

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