The Pension Protection Act of 2006 was signed into law on Aug. 17. Although portions of the act have little to do with pensions, and certain provisions do not so much protect individuals as create additional hurdles, some commentators have termed it "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 IRA, qualified plan and charitable giving and reform provisions of the act follows.
IRA Provisions
For distributions after 2007, the act allows distributions from qualified retirement plans, tax-sheltered annuities, and governmental (Section 457) plans to be rolled over directly into a Roth IRA, subject to the adjusted gross income (AGI) rules that limit rollovers from traditional IRAs into Roth IRAs. Those AGI rules, however, do not apply to distributions for tax years beginning after Dec. 31, 2009, meaning that both traditional IRAs and qualified retirement plans, tax-sheltered annuities, and governmental (Section 457) plans can be converted into Roth IRAs regardless of the individual's AGI.
Additionally, under pre-act law, only participants and surviving spouses were able to rollover amounts from 403(b) annuities, qualified plans and IRAs to another plan or IRA; nonspouse beneficiaries were not eligible to rollover inherited amounts. The act makes changes to this rule. For distributions after 2006, nonspouse beneficiaries may rollover, to an IRA structured for such purposes (in a trustee-to-trustee rollover), amounts inherited.
Finally, the act also requires the IRS to establish procedures for depositing federal tax refunds directly into IRAs, in an effort to encourage individuals to make IRA contributions.
Qualified Plan Provisions
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) substantially increased individual retirement account (IRA) and pension 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 help protect these benefits from the effects of 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.
For purposes of the 401(k) hardship distribution rules, "hardship" shall now include the hardship of a beneficiary under the plan, even in cases where the beneficiary is not a spouse or dependent of a plan participant. This provision became effective Aug. 17, 2006.
Under the act, and presumably due in part to the collapse of Enron and other publicly traded companies, participants must be allowed to immediately diversify any employee contributions or elective contributions invested in employer securities, where the securities are publicly-traded. For employer contributions, there is a three-year waiting period before participants are able to diversify out of employer stock.
The act made numerous highly technical changes to various defined benefit plan provisions (including Form 5500 informational reporting, employer funding, age discrimination testing, conversions into cash balance plans and Pension Benefit Guarantee Corp. premiums), explanations of which are beyond the scope of this discussion. In general, these provisions are intended to create more pension transparency to ensure that interested parties (including participants, regulators and investors) can have a better understanding of the financial health of traditional pension plans.
Current law allows automatic enrollment in 401(k) plans (where, assuming the participant does not opt out of the program, the employer withholds contributions), but, due in large part to state garnishment laws and fiduciary liability concerns, employers have been less than eager to implement automatic enrollment provisions. The act addresses these concerns and provides incentives for automatic enrollment as well as for automatic increases in contribution percentages.
Participants continue to have the ability to opt out within 90 days, but participants, once in, do not typically opt out. These provisions are due in part to recent studies that have shown that the saving rate, in the second and third quarters of 2005, for the first time in the last 60 years, has become negative. Put another way, Americans are, as a whole, spending more than they are saving. Furthermore, studies have also shown that only 8.4 percent of 401(k) participants contribute the maximum amount allowed.
The act also provides that distributions from a pension plan or an IRA to members of the National Guard and Reserves called to active duty through 2007 are not subject to early withdrawal penalties. In addition, withdrawn amounts may be repaid to the pension plan or IRA within two years of the distribution without regard to the annual contribution limits that would otherwise apply.
Finally, 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.
Charitable Giving
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 only for 2006 and 2007, applies only to distributions made on or after the date the IRA owner attains age 70 and a half, 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 immediate benefit of this provision is that AGI is lower than it would be if the distributions were included in income. Since certain itemized deductions (including medical deductions, taxes, charitable contributions and miscellaneous itemized deductions) are reduced when AGI reaches certain thresholds, excluding these distributions will result in lower AGI, which in turn will result in deductible itemized deductions higher than those that would otherwise be allowed.
Similarly, this provision may also reduce the amount of Social Security benefits that are subject to tax. The long-term benefit is that the IRA monies will be out of your estate, in the event that your will does not specify a charitable bequest of your IRA.
With regard to charitable contributions of money, which in general started Jan. 1, the individual donor must maintain a canceled check, bank record, or receipt from the donee organization showing the date of the contribution, the name of the organization and the amount of the contribution. Prior to this change, only contributions in excess of $250 required substantiation to this extent.
In general, for contributions made after Aug. 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. These two provisions are two of the hurdles mentioned above.
The act also provides that, 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 prorata 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.
Furthermore, for charitable conservation contributions, the deduction limit is raised by the act from 30 percent of AGI to 50 percent of AGI. In addition, the charitable deduction limit is raised to 100 percent of AGI for eligible farmers and ranchers, as long as the contribution does not prevent use of the donated land for farming or ranching purposes. The act also authorizes the carryover of unused deductions, with respect to conservation contributions, for up to 15 years, an increase from the current five-year carryover. This provision is effective for 2006 and 2007.
Another hurdle created by 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, because their gross receipts are less than $25,000, currently do not have an annual filing requirement. The act also makes it easier for the IRS to impose accuracy-related penalties on an individual who claims a deduction for donated property for which a qualified appraisal is required, and defines a qualified appraiser and a qualified appraisal.
Bruce J. Rogers is manager of the Tax Accounting Group at Duane Morris.
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