August 2006
Dear Clients and Friends:
After years of debate, Congress has passed a comprehensive pension reform bill. The new bill brings mostly good news to taxpayers. Keep in mind that the new law is much more than pension reform. It not only makes permanent some important retirement savings incentives that benefit almost everyone, it also creates some new ones. The new law also makes some important changes regarding deductions for contributions to charitable organizations. This letter highlights some of the key developments in the new Pension Protection Act of 2006 and what steps you should take to maximize your retirement and tax savings.
Traditional pension plans in trouble
If you are a participant in a traditional single-employer pension plan or a multi-employer plan, you will likely soon be hearing from your plan sponsor.
Traditional pension plans, which pay a defined benefit over a period of time, are in trouble. Many are underfunded. Others have been turned over to the Pension Benefit Guaranty Corporation (PBGC), the pension payor of last resort. More and more companies have either terminated their traditional pension plans or converted them to 401(k)s or other types of savings arrangements.
Currently, about 30,000 traditional pension plans are underfunded. Some are teetering on collapse. This crisis spurred Congress to enact a comprehensive pension reform bill. The new law aims to prevent any more trouble plans from folding and dumping their obligation on the PBGC, which already has a deficit of nearly $30 billion. Most underfunded plans are required to become fully funded over seven years.
Permanent retirement savings incentives
Five years ago, Congress passed the Economic Growth and Tax Relief Reconciliation of 2001. This law created many new incentives to encourage people to save more for retirement. These incentives include higher contributions to IRAs and pension plans, catch-up contributions for those over 50 years of age, and greater portability. However, all of these tax breaks, including the retirement savings incentives, had been set to expire in 2011. The new pension reform bill makes them permanent. Instead of expiring on December 31, 2010 as scheduled, they are now extended permanently.
Here are some of the highlights:
Higher IRA contribution dollar amounts. The 2001 law gradually raised the amount you can contribute annually to an IRA. For 2006, it is $4,000. That amount rises to $5,000 in 2008. The new law makes the $5,000 amount permanent and adjusts it for inflation after 2008. For those over 49 years old see “catch-up contributions” below.
Higher dollar limits on defined contribution plans. If you have a 401(k), 457 or similar pension plan, the new law makes permanent the 2001 law’s higher dollar limits on defined contribution plans ($44,000 in 2006) as well as elective deferrals for 401(k)s, 457s and SIMPLE plans.
Catch-up contributions. If you are age 50 or older, you should consider making catch-up contributions. The 2001 law allowed individuals age 50 and older to make additional contributions to IRAs, 401(k)s and other arrangements. For 2006, you can make an additional catch-up contribution of $1,000 to an IRA and an additional catch-up contribution of $5,000 to a 401(k) plan. Because the 2001 law is temporary, you would not have been able to make catch-up contributions after 2010. The new pension reform law makes catch-up contributions permanent. It also indexes the $5,000 401(k) catch-up amount for inflation but not the $1,000 IRA catch-up amount.
Roth 401(k)s. Although Roth 401(k)s were created as part of the 2001 law, employers could only start offering them this year. Roth 401(k)s are similar to Roth IRAs. Depending on your income and where you are at in your work life, if you’re just starting out or nearing retirement; Roth 401(k)s can be a valuable addition to your retirement portfolio. Until this new law, many employers were reluctant to offer Roth 401(k)s because they would have expired after 2010. The new law makes them permanent and this could encourage more employers to offer them. If you are self employed this could be a great new addition to your company’s pension plan.
New and enhanced incentives
Besides making the retirement savings breaks in the 2001 law permanent, the pension reform law also creates some new incentives. You can ask the IRS to deposit your tax refund into an IRA (effective for 2007). The new law also allows direct rollovers from a qualified retirement plan, tax-sheltered annuity or government plan directly to a Roth IRA and will treat it as a Roth conversion if all other qualifications are met (effective for 2008).
In another important development, non-spousal heirs can roll over qualified retirement plans, government plans or tax-sheltered annuities into their own IRAs (effective for 2007). Previously, this treatment was only available to spouses.
More incentives
In addition to these valuable savings incentives, the new pension reform law also makes permanent greater portability for 403(b) and 457 plans; faster vesting of employer matching contributions; and the Saver’s Credit. For small businesses thinking of starting a pension plan, the new law makes permanent the tax credit for start-up costs.
New rules for charitable donations
We said the new law was “mostly” good news. Well here’s the one exception. Americans donate billions of dollars to charitable organizations every year in cash and tangible goods, such as household items and clothing. Because of the huge amounts of money involved, charitable donations have always been ripe for abuse.
Effective as of the date of enactment of the new law, no deduction will be allowed for any contribution of cash, check or other monetary gift unless you can show a bank record or a written communication from the charity. This means you’ll have to either get a receipt for every cash donation you make or make your donation by check, credit or debit card, so your bank statement will show it. Congress made this change to crack down on taxpayers who inflate their cash contributions.
The new pension reform law also cracks down on donations of broken or malfunctioning household items and poor or soiled clothing. Household items and clothing must be in “good condition” to be deductible. There is a limited “antiques” exception for donated single items appraised at more than $500. The IRS is expected to issue guidance about what is “good condition” in time for the 2007 tax-filing season as this change is also effective as of the date of enactment of the new law.
While the new law imposes restrictions on contributions of cash, household goods and clothing, it expands some other deductions. If you are age 70 ½ or older, you will be able to make a tax-free distribution of IRA proceeds up to $100,000 to a charitable organization through December 31, 2007. The new law also increases the deduction limits for qualified conservation easements for 2006 and 2007.
Avoiding a bailout
Before closing, let’s take another look at the pension reform parts of the new law. As we said earlier, approximately 30,000 plans are underfunded to the tune of $450 billion. Congress wants these plans to survive, so it is giving plans seven years (longer for the airline industry) to become fully funded. “At-risk” plans, which are critically underfunded, get some additional help but they also have more responsibilities to their participants. The new law also changes the rules for valuing pension liabilities. Most of the pension reform provisions take effect after 2007 with some exceptions.
Start planning
The new pension reform law is 900+ pages. It impacts everyone not only individuals with traditional pension plans. The retirement savings incentives in the new law are invaluable and can significantly maximize your retirement portfolio and give you generous tax breaks. The new charitable contribution rules are a mixed bag.
To take full advantage of the new law, you have to act soon. While many of the new incentives are permanent others are temporary. Some take effect this year but others not until 2007 or beyond.
We can help you maximize your self-employed or small-company pension benefits and clarify the new charitable deduction rules. Please call us if you have additional questions or would like to discuss specifics of your tax situation.
