As its name implies, the Pension Protection Act of 2006 ushers in new rules to shore up the beleaguered corporate pension system. But its more than 900 pages of provisions also address other areas of investor concern, including individual retirement planning, college saving, and charitable giving.

Pension Reform Finalized

The law introduces rules meant to stabilize the traditional pension system, which has stood on shaky ground during the past several years due to chronic underfunding problems (financial projections revealed that some companies would not be able to completely fulfill their promises to pay future benefits to retirees). How bad is the situation? According to tax authority CCH and the U.S. Department of Labor, 30,000 pension plans are currently underfunded by a total of $450 billion.*

The Act requires companies to comply with new, more stringent funding rules. Companies must fully fund their plans within seven years. Plans that are deemed to be “at risk” will have even shorter periods to meet their funding requirements. However, the Act also increases the annual deduction limit applicable to pension plan participants.

The Act also clarifies protections for employers who choose to convert their traditional pension plans to “hybrid plans” — those that combine elements of a traditional pension with employee savings plans. Many employers have been hesitant to consider such hybrid plans, also known as cash balance plans, for fear of litigation by older workers who may not benefit as much under the new structure.

EGTRRA Benefits Extended Permanently

To the relief of many workers, employers, and financial service providers, the Act also permanently extends provisions originally enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) that had been slated to expire after December 31, 2010. Among them:

• The increased contribution limits on both IRAs and employer-sponsored retirement plans, such as 401(k) plans
• Catch-up contributions that workers aged 50 and older can make to IRAs and some employer-sponsored retirement plans
• Increases in the maximum annual benefit allowed by traditional pension plans
• Faster vesting schedules for employer-sponsored plans
• The new Roth feature in 401(k) and 403(b) plans, just recently established in 2006
• Increased portability among plan types

In addition, the Act extends permanency to the Saver’s Credit, which provides individuals and married couples in certain tax brackets a credit of up to $2,000 on their income tax for contributing to a retirement plan or IRA. This rule was originally set to expire at the end of tax year 2006. An added benefit is that, beginning in 2007, the adjusted gross income used to qualify taxpayers for the Saver’s Credit will be indexed for inflation. (Note, however, that the credit itself will not be indexed.)

Finally, the Act affects 529 college savings plans by making permanent the provision that allows qualified withdrawals to be made free of federal income taxes. It also makes permanent the rule allowing tax-free same-beneficiary rollovers to other plans.

New Retirement Savings Benefits

The Pension Protection Act will also pave the way for enhancements to traditional retirement savings plans:

• Employers are permitted to automatically enroll workers in 401(k) plans by deducting up to 10% of their compensation, subject to certain requirements, and to invest such compensation in a default investment. Workers can choose not to participate by opting out in writing.
• Companies will be prohibited from forcing employees to invest their own contributions in company stock.
• 401(k) and other defined contribution plan providers will be able to provide personalized investment advice to plan participants. Some observers have voiced concern that advice providers might try to benefit themselves at the expense of their clients; however, the Act’s provisions include protections, such as complete fee disclosure, intended to prevent such occurrences.
• Reservists called up to active duty for at least 180 days after September 11, 2001, and before December 31, 2007, may tap their retirement savings without incurring the 10% early withdrawal penalty. Reservists are permitted to recontribute such withdrawn funds at any time within two years after the end of activation.
• Taxpayers can elect to have all or a portion of their federal income tax refunds deposited directly into an IRA.
• Non-spousal beneficiaries can roll inherited qualified plan or IRA proceeds into their own IRA, which is then treated as an inherited IRA, enabling them to preserve the assets’ tax-deferred status. Previously, this benefit was allowed only for spousal beneficiaries.
• Beginning in 2008, direct rollovers will be allowed from qualified retirement plans, tax-sheltered annuities, and governmental plans into a Roth IRA. The rollover will be treated as a conversion — with income taxes due on all proceeds — provided all conditions, including income requirements, are met.

Charities Get a Boost From IRAs, While Taxpayers Get (More) Red Tape

The Pension Protection Act will also have an impact on charitable giving, as several provisions are designed to address sections of the tax code governing this area. Perhaps the two most notable charity-related provisions are those that affect IRAs and cash contributions.

IRA and Roth IRA holders and their chosen charities may be pleased to learn that distributions can be donated, tax-free, to charities through December 31, 2007, provided that the holder of the IRA or Roth IRA has reached age 701/2. The maximum annual amount that can be donated is $100,000.

Perhaps not so appealing to either individuals or charities is the provision that disallows income tax deductions for cash contributions without substantiation by either a receipt or a bank record, such as a cancelled check or account statement. One need look no further than the church collection plate to see how this might impact charitable giving. Not only might individuals be disinclined to contribute, but charity administrative costs may rise due to an increasing number of requests for receipts.

With provisions affecting several major realms of financial planning — from retirement to college to estate planning — the Pension Protection Act of 2006 will have lasting consequences. Investors may want to talk to a financial and tax advisor about how the specific rules and new opportunities will affect their strategies.

*Source: CCH, “Congress Passes Comprehensive Pension Reform Bill,” August 4, 2006.

Article Source: Standard & Poor's Financial Communications