Exploring tax benefits of the Pension Protection Act of 2006

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Published: September 18,2006

Recently, Congress passed the Pension Protection Act of 2006 (the Act), a massive, 900-page bill that provides protection for traditional private pension plans. Many of these pension plans, also known as defined benefit plans are seriously under-funded, reportedly by as much as $450 billion.

The government, through the Pension Benefit Guaranty Corporation (PBGC), provides insurance for plans that fail. Several plans have failed recently, requiring the government to provide funds to make up for the shortfall.

President George W. Bush gave a stern warning to corporate America, saying, “You should keep the promises you make to your workers. If you offer a private pension plan to your employees, you have a duty to set aside enough money now so your workers will get what they’ve been promised when they retire.”

While this may have been the primary focus of the Act, it encompasses more than simply strengthening these traditional pension plans. This Act, signed into law August 17, 2006, extends and improves retirement tax-savings benefits, creates new rules regarding charitable donations, and creates stricter rules for exempt organizations. Many of the favorable provisions of the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA) were set to expire December 31, 2010. This bill eliminates the uncertainty associated with these rules.

Retirement plans

The new law identifies troubled pension plans with the intent to stabilize them before the sponsoring companies file bankruptcy. Employers with targeted plans are required to become fully funded over a seven-year period. Employers will be able to make increased deductible contributions to defined benefit plans. This is the carrot offered to employers to encourage full funding. Under the new rules, an employer will be able to deduct up to 150% of the amounts in excess of the current plan liability. Previously, excess contributions were hit with a 10% penalty tax.

The Act also covers other retirement plans such as IRAs, 401(k)s and other defined contributions plans, which are the primary source of retirement for most employees in the United States. The new law makes it easier for employers to automatically enroll their employees into the company’s 401(k) plan. This is a tremendous benefit to both employer and employee. It will, in many cases, have a positive impact on certain tests the employer has to perform. In order not to participate, employees must actively opt-out and more employees should participate in their 401(k) plans, thus taking individual responsibility for their own retirement.

The Act also allows retirement plan providers to offer personalized investment advice to accountholders. Other positive changes of the Pension Protection Act of 2006 include:

1. Taxpayers may now directly deposit their tax refunds directly into their IRA.

2. Non-spousal beneficiaries can now roll over a deceased person’s IRA or retirement plan into a new IRA. This allows non-spousal beneficiaries to receive the tax deferral advantages offered by IRA rollovers.

3. Beginning in 2008, eligible individuals can arrange for direct rollovers of distributions from their retirement plans into Roth IRAs.

4. Military reservists may avoid the 10% penalty tax on premature distributions from tax-favored retirement plans. In addition, a reservist may “recontribute” all or part of a qualified distribution to an IRA during the two-year period after active duty.

Some provisions of the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA), which were scheduled to expire in 2010 are now made permanent. These include:

1. Higher maximum contribution amounts for traditional and Roth IRA’s.

2. Larger contribution limits for defined contribution retirement arrangements (i.e. Simplified Employee Pensions and 457 Plans).

3. Larger maximum annual benefits allowed under defined benefit plans.

4. Continuance of the catch-up contributions for individuals 50 and over (currently $5,000 for 2006).
5. The ability to defer contributions to Roth 401(k)s and Roth 403(b)s.

6. Improved tax-free rollover rules between tax-favored retirement accounts and plans.

7. Continuance of the saver’s tax credit of up to $1,000 for those with modest incomes who contribute to 401(k) plans and IRA’s. Before the Act, this credit was set to expire in 2006.

8. The small employer tax credit for starting up new retirement plans, which is worth up to $500 per year for three years.

9. Extension of favorable tax treatment for Section 529 qualified tuition programs.

10. Faster vesting schedule applied to all types of employer contributions.

Charitable contributions

Some charitable contributions will be more difficult to claim. Each year, many taxpayers receive tax deductions for donations of non-cash items (clothes and household items) to charities such as Goodwill and the Salvation Army. In the future, they can only deduct clothing and other household items if they are in “good condition” or better. However, the Act fails to defined “good condition”, creating yet another gray area in the tax code. The Act, though, does define household items which include furniture, electronics, appliances and linens but exclude food, paintings, antiques, art, jewelry, gems and collectibles.

Another even more strict provision requires that taxpayers must now substantiate all cash contributions to charities with either a receipt or a bank record. Moreover, noncash contribution amounts must be reduced by the excess of the deduction amounts over the donor’s basis in the property.

On the positive side, taxpayer can, through December 31, 2007, withdraw money from an IRA tax-free to give to charity up to $100,000. Unfortunately, a tax-free IRA distribution to a charity disallows the charitable deduction.

Exempt organizations

Congress has noticed a lot of abusive exempt organizations. To quell this abuse, the Act increased excise taxes on private foundations if they violate self-dealing rules, fail to make minimum distributions, keep excess business holdings, and invest in a way that would risk the charitable purpose. Furthermore, small exempt organizations who previously had not had to file returns now must file information forms. In addition, Form 990-T (unrelated business taxable income) must be available to the public for certain charities.

In conclusion, there are a lot of tax benefits in this Act. It shifts our retirement system from one of a defined benefit system to one of a defined contribution system. It also provides many benefits to individuals who will need to be more responsible for their own retirement planning. Please consult your tax advisor or CPA for details regarding how this Act affects you.

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