After many negotiations between the House and the Senate, the Pension Protection Act of 2006 (PPA) was signed into law by President Bush on August 17, 2006. PPA brings about the most significant changes that have been made for pension plans since the Employee Retirement Income Security Act of 1974 (ERISA). While the most significant changes under PPA have been made to pension plans, this article will discuss some of the key provisions that apply to defined-contribution plans as well as individual retirement accounts (IRAs).
EGTRRA Made Permanent: Effective Immediately
When the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) was signed into law on June 7, 2001, it created some comprehensive changes to retirement plan rules, including increasing contribution limits for employer plans and IRAs, relaxing the portability rules for employer plans and IRAs and providing additional tax benefits for small business owners that adopt retirement plans for their businesses. However, under EGTRRA, these provisions were scheduled to sunset for tax years beginning 2011. PPA made these provisions permanent. The following describes some of these provisions:
- Increases contribution limits to IRAs: Prior to EGTRRA, contributions to IRAs were limited to $2,000 and had been so for many years. EGTRRA provided new IRA limits, which increase in incremental amounts from $3,000 in 2002 to $5,000 in 2008, with the potential for cost of living increases (COLAs) for 2009 and beyond.
- Permits individuals who are at least 50 years old to make catch-up contributions: Prior to EGTRRA, there were no opportunities to make catch-up contributions to defined-contribution plans and IRAs. Under EGTRRA, catch-up contributions were allowed, beginning at $500 in 2002 and increasing in $500 increments to $2,000 by 2006 for IRAs. For salary deferral SEPs (SARSEPs), 401(k) and 403(b) plans, catch-up contributions were permitted at $1,000 in 2002, increasing in $1,000 increments to $5,000 in 2006.
- Increases in deduction limits for SEP IRAs and profit-sharing plans from 15% of eligible employee compensation to 25%. This negates the need for employers to adopt money purchase pension plans for the sole purpose of being able to make deductible contributions of up to 25% of eligible compensation. Prior to EGTRRA, employers would pair money purchase pension plans with profit sharing plans or SEP IRAs in order to have the option of making deductible contributions of 25% of compensation, while having the flexibility of discretionary contributions that were available under SEP IRAs and profit-sharing plans.
- Increases in salary deferral contribution limits to 401(k), 403(b), 457, salary deferral SEPs (SARSEPs) and SIMPLE IRAs, with deferrals to 401(k), 403(b), 457 starting at $11,000, increasing in $1,000 increments to $15,000 in 2006, and for SIMPLEs, starting at $7,000, increasing in $1,000 increments to $10,000 in 2005. Both are indexed for inflation.
- Relaxes portability rules: This allows for the movement of assets between Traditional IRAs, qualified plans 403(b) accounts and 457(b) plans.
- Allows Roth contributions under 401(k) and 403(b) plans: Under a designated Roth contribution program, employers are allowed to add a Roth component to their 401(k) or 403(b) programs, which allows employees to designate their salary deferral contributions as after-tax Roth contributions.
- Allows tax credits for start-up costs for expenses incurred establishing and/or administering employer-sponsored plans. (To read more, see Tax Credit For Plan Expenses Incurred By Small Businesses and Increased Savings Opportunities.)
Savers Credit Made Permanent: Effective Immediately
Under EGTRRA, individuals with adjusted gross income (AGI) up to certain amounts receive a non-refundable tax credit of the lesser of 50% or $1,000 for contribution amounts made to IRAs and salary deferral contributions made to employer-sponsored plans. This provision was to be repealed for tax years after 2006. PPA made this provision permanent. (See The Saver's Tax Credit: An Added Incentive to Fund Your Plan for more details.)
Direct Conversions from Qualified Plans to Roth IRAs: Effective for distributions that occur after December 31, 2007
Under tax law currently in effect, assets from qualified plans, 457(b) and 403(b) plans must first be rolled to a Traditional IRA before being converted to a Roth IRA. Under PPA, the rules change for tax years beginning 2008, and allow the direct conversion of assets from these plans to Roth IRAs. This does not affect the Roth conversion eligibility requirements (i.e. the individual's modified AGI must be $100,000 or less, and the tax filing status cannot be married filing separately).
New Exception to the 10% Excise Tax for Qualified Reservist Called to Active Duty: Effective for distributions that occur after September 11, 2001
Generally, distributions that occur from an IRA, qualified plan or 403(b) account before the participant reaches age 59.5 are subject to an excise tax of 10%, unless the amount is eligible for an exception to the tax as provided under Internal Revenue Code Section 72(t). In addition to the list of exceptions already provided under Code Section 72(t), a new exception has been added for a distribution amount that satisfies the definition of a 'qualified reservist distribution'. Under PPA, a qualified reservist distribution is defined as one that is:
- distributed from an IRA or attributable to elective deferrals under a 401(k) plan or 403(b) account,
- distributed to a member of the Reserves that is called to active duty for a period in excess of 179 days or for an indefinite period,
- distributed during the period beginning on the date the Reservist is called to active duty and ending at the close of the active duty period and
- distributed by individuals ordered or called to active duty after September 11, 2001 and before December 31, 2007.
Individuals who receive qualified reservist distributions may roll over the amounts at any time during the two-year period beginning on the day after the end of the active duty period.
Rollovers by Non-Spouse Beneficiaries: Effective for distributions after December 31, 2006
A spouse beneficiary who inherits assets from qualified plans, 403(b) accounts and 457 plans can roll over those amounts to another qualified plan in which the spouse is a participant or to the spouse's own IRA. The option to roll over inherited retirement plan assets was not available to a non-spouse beneficiary. Additionally, rollover contributions are usually not permitted to inherited IRAs. Under PPA, non-spouse beneficiaries can roll over assets they inherit from qualified plans, a 457(b) plans and 403(b) accounts, provided the rollover contribution is processed as a direct rollover to an inherited IRA. The inherited IRA would be subject to the usual distribution rules that apply to inherited IRAs. (To read more, see Inherited Retirement Plan Assets - Part 1 and Part 2.)
Direct Deposit of Tax Refund to IRAs: Effective for tax years beginning 2007
Taxpayers are allowed to direct their tax refunds to their savings and/or checking accounts via direct deposit. Under PPA, the accounts to which the refunds can be directed via direct deposit now include IRAs. Under PPA, the Secretary of the Treasury Department has been instructed to develop a form that would be used for this purpose.
Note: In August 2006, the IRS issued a draft form of Form 8888, Direct Deposit of Refund, for which they requested comments.
Additional Contributions Allowed by Employees of Bankrupt Employers: Effective for taxable years beginning after December 31, 2006, and before January 1, 2010
In addition to the regular IRA contribution limits, individuals may contribute up to $3,000 per year for 2006 to 2009, provided the following applies:
- The individual must have been a participant in a 401(k) plan in which the employer matched at least 50% of the salary deferral contributions made by the employee with employer stocks.
- For the year preceding the year for which the additional contribution is being made, the employer must have been a debtor in a bankruptcy case and must have been indicted or convicted as a result of the events leading up to the bankruptcy.
- The individual must have been a participant in the 401(k) plan at least six months before the bankruptcy case was filed.
Individuals who make these additional contributions are not eligible for the IRA catch-up contributions available for individuals who are at least 50 years old.
Important Note: In August 2006, a discrepancy existed between the explanation for the regulation and the 'effective date'. The explanation provides that under the provision, an applicable individual may elect to make additional IRA contributions of up to $3,000 per year for2006-2009. This seems to say that in 2006, the contribution can be made for 2006. Under effective date, it says: "The provision is effective for taxable years beginning after December 31, 2006, and before January 1, 2010." This seems to exclude 2006. We anticipate that this will be clarified in future Technical Corrections. However, we have no estimated time frame within which these corrections will be issued.
Tax-Free Distributions from IRAs for Charities: Effective for distributions made during 2006 and 2007
Otherwise taxable distributions of up to $100,000 for the year will be excluded from the IRA owner's taxable income, provided the distribution is made on or after the date the IRA owner reaches age 70.5, and is made payable to an eligible charity. The $100,000 limit applies on a per-year basis.
Unlike regular distributions from Traditional IRAs, where the individual has IRAs that include the amount attributable to rollover of after-tax amounts (or non-deductible contributions), and where distributions would include a pro-rated amount of pretax and after-tax amounts, qualified charitable distributions would be deemed to occur first from pretax amounts. This allows the IRA owner to retain any nontaxable amounts in the IRA for tax-free distributions to him or herself.
These amounts would not be eligible for charitable deductions. (To learn more about tax rules and retirement, read An Overview Of After-Tax Balance Rules and Retirement Plan Tax Forms You May Need to File - Part 2.)
This provision applies to Traditional and Roth IRAs. It does not apply to employer-sponsored plans, including SEP and SIMPLE IRAs.
Combination Defined-Benefit/Defined-Contribution Plan: Effective for plan years beginning after December 31, 2009
Under PPA, small employers are permitted to establish a combination defined-benefit/defined-contribution plan (an "eligible combined plan"), where the assets would be held in a single trust. Under an eligible combined plan, separate accounting must occur so as to determine the portion of the plan balance to which specific treatments, such as nondiscrimination testing, should apply. For the purpose of an eligible combined plan, a small employer employed an average of at least two (but not more than 500) employees on business days during the preceding calendar year and at least two employees on the first day of the plan year.
For eligible combined plans, certain functions, such as filing a Form 5500 series return and providing a summary annual report, is provided as if for one plan.
New Exemption Added to Allow Investment Advice by Disqualified Persons: Effective for investment advice provided after December 31, 2006, except as noted below
A prohibited transaction exemption has been added under ERISA and the Code that allows registered investments advisors and certain other financial service providers to provide investment advice under an "eligible investment advice arrangement" to participants and beneficiaries of defined-contribution plans who direct the investment of their accounts under the plan in addition to owners of IRAs, health savings accounts (HSAs), Archer medical savings accounts (MSAs) and Coverdell education savings accounts (ESAs). Under a qualified plan, the investment advice is to be provided using an approved computer model. For IRAs, the secretary of labor and the secretary of the Treasury are required to determine by December 31, 2007, whether a computer model investment advice program may be used for IRAs, HSAs, Archer MSAs and Coverdell ESA assets.
Should a computer model not be available for these plan types, a separate class exemption is to be issued.
These are only some of the provisions under the PPA. In most cases, these provisions create new opportunities for individuals as well as financial service providers. For instance, now that a beneficiary is able to roll over assets from a qualified plan, this will create opportunities for stretch payments that may not have been available for assets under qualified plans, as most qualified plans require beneficiaries to take immediate distributions of their entire balances.