Key Provisions in the Pension Protection Act of 2006

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1 Key Provisions in the Pension Protection Act of 2006 H.R.4, the Pension Protection Act of 2006 (the Act ), was signed into law on August 17, Among other changes, this massive 800-plus-page law overhauls the funding and disclosure rules for defined benefit plans, revises the deduction limits for qualified plans, addresses conversions of pension plans to cash balance plans, carries liberalized payout and rollover rules, and makes a host of other changes relating to pension plans and their beneficiaries. It also revises key charitable giving rules. Provisions related to some of these changes could provide opportunities for your customers and are detailed below. Revised Funding Rules for Defined Benefit Plans Nonqualified deferred compensation funding restrictions for employers with troubled plans. Under the pre-act law, employers may set aside or reserve money to pay nonqualified deferred compensation as long as the plan is not considered funded. New law. For transfers or other reservation of assets after the enactment date, the Act prevents a set aside or reserve in a non-qualified deferred compensation plan for certain executives (e.g., CEO, four (4) highest paid employees) if the employer or a member of its controlled group: (1) is bankrupt; (2) has an at-risk plan (generally less than 80% funded); or (3) has a plan that has terminated without having sufficient assets to pay all benefits. These provisions apply as of the enactment date. If you are instituting a non-qualified deferred compensation plan in a business that also has a defined benefit plan, the defined benefit plan must be at least 80% funded prior to any funding of the nonqualified plan. Increase in Pension Plan Diversification and Participation Defined contribution plans required to provide employees with freedom to invest their plan assets. Some plans allow participants to invest in employer stock, or receive employer contributions of employer stock. Under the pre-act law, plans may restrict the ability of the participant to sell the stock. New law. Generally for plan years beginning after 2006, plans must allow the participant to diversify immediately any employee contributions or elective contributions invested in employer securities. For employer contributions, plans must allow participants to diversify out of employer stock at any time after the employee has been in the plan for three years. The diversification requirement applies to plans with publicly-traded employer securities.

2 The ability of some customers to divest themselves of company stock in a 401(k) will allow you more involvement in assisting them in their retirement plan investments. Distributions during working retirement. Under the pre-act law, defined benefit plans are prohibited from allowing in-service distributions before normal retirement age as defined in the plan. New law. For distributions in plan years beginning after 2006, the Act allows inservice distributions once the participant is age 62. In-service distributions from a defined benefit plan may allow your customers to roll money into an IRA earlier and allow you to help them invest this money prior to the normal retirement date in the plan. Liberalized Rules for Qualified Plan and IRA Contributions, Distributions, and Rollovers Qualified plan to IRA rollovers OK'd for non-spouse beneficiaries. The pre-act law did not allow non-spouse beneficiaries to roll over inherited qualified retirement plan accounts to IRAs; such rollovers were permitted only for spousebeneficiaries (who could treat the recipient IRA as their own). New law. For distributions after 2006, the Act permits rollovers of distributions from an eligible retirement plan (e.g., a qualified plan) of a deceased employee to a nonspouse beneficiary's IRA. The rollover is treated as an eligible rollover distribution and distributions from the beneficiary's IRA are subject to the RMD rules that apply to inherited IRAs of non-spouse beneficiaries. To the extent provided by IRS, the change applies to benefits payable to a trust maintained for a designated beneficiary to the same extent it applies to the beneficiary. Most retirement plans require non-spouse beneficiaries to take an immediate withdrawal of inherited accounts, causing current taxation. Now, non-spouse beneficiaries may rollover such accounts to an IRA and begin RMDs over their lifetime. This will increase IRA sales, as customers will have more opportunity to defer income tax. There may also be increased movement from one institution to another as beneficiaries may be inclined to move accounts to their own financial professional after the death of an account owner. It will be more important to cultivate relationships not only with your customers who have significant IRA accounts with you, but also their beneficiaries in order to retain these assets. Direct rollovers permitted from qualified retirement plans to Roth IRAs. Taxpayers with modified AGI of $100,000 or less generally may convert amounts in a traditional IRA into a Roth IRA. The amount converted is includible in income as if a

3 withdrawal had been made, but the 10% early withdrawal tax does not apply. Under the pre-act law, distributions from qualified retirement plans, tax-sheltered Code Sec. 403(b) annuities, or governmental Code Sec. 457 plans can't be converted into a Roth IRA. Amounts that have been distributed from such retirement plans must first be rolled over into a traditional IRA, and then converted from the traditional IRA into a Roth IRA. New law. For distributions after 2007, the Act allows distributions from qualified retirement plans, tax-sheltered annuities, and governmental Code Sec. 457 plans to be converted directly into a Roth IRA, subject to the usual rules that apply to conversions from a traditional IRA into a Roth IRA. Under TIPRA, for tax years beginning after Dec. 31, 2009, the $100,000 modified AGI limit on conversions of traditional IRAs to Roth IRAs is eliminated. Thus, taxpayers will be able to make conversions from their qualified retirement plans, tax-sheltered annuities, and governmental Code Sec. 457 plans to Roth IRAs without regard to their AGI. It will now be easier for customers to do a Roth IRA conversion from a qualified retirement plan since there will no longer be a requirement to roll assets to a traditional IRA first. Customers must still meet the modified AGI limits. However, with the modified AGI limits being eliminated after December 31, 2009, Roth IRA sales should increase. Key traditional IRA income limits indexed after In general, if an individual (or his or her spouse) is an active participant in an employer-sponsored retirement plan, a deductible cash contribution to a traditional IRA phases out over a specified dollar range of adjusted gross income (AGI). Under the pre-act law, the AGI phase out range for deductible traditional IRA contributions for active participants in an employer-sponsored retirement plan had no adjustments for future years. New law. For tax years beginning after 2006, the Act indexes the income limits for deductible contributions for active participants in an employer-sponsored retirement plan. Income limit for Roth IRA contributions indexed after Under the pre-act law, the maximum annual contribution that can be made to a Roth IRA is phased out for taxpayers with adjusted gross income (AGI) as follows: (1) for single taxpayers, $95,000 to $110,000; (2) for married taxpayers filing joint returns, $150,000 to $160,000; and (3) for married taxpayers filing separate returns, $0 to $10,000. New law. For tax years beginning after 2006, the Act indexes the $95,000 and $150,000 AGI figures, above (i.e., the point at which the Roth IRA phases out for single taxpayers and joint filers). Indexed amounts will be rounded to the nearest multiple of $1,000. Direct deposits of tax refunds to IRAs.

4 Under the pre-act law, taxpayers may direct that their federal income tax refunds be deposited into a checking or savings account with a bank or other financial institution (such as a mutual fund, brokerage firm, or credit union) rather than being sent to the taxpayer in the form of a check. New law. For tax years beginning after 2006, taxpayers will be able to elect to have all or part of a tax refund made directly into an IRA (or his or her spouse's IRA, in the case of a joint return). By indexing AGI limits for IRA contributions for individuals who are an active participant in an employer retirement plan, more individuals will be able to contribute to both a qualified retirement plan and a traditional IRA By indexing AGI limits for Roth IRA contributions, more individuals will be able to contribute to a Roth IRA. Direct deposits into individual IRAs will make it easier for individuals to open IRAs EGTRRA's Pension and IRA Changes, Low-Income Saver's Credit, and Sec. 529 Changes Made Permanent Many EGTRRA pension and IRA changes made permanent. EGTRRA (Economic Growth and Tax Relief Reconciliation Act of 2001) made a host of changes to pensions and IRAs. However, because of budgetary considerations, under the pre-act law, all of them were to sunset at the end of New law. The Act repeals the sunset provisions of EGTRRA as they relate to pension and IRA provisions. Thus, 38 pension and IRA changes made by EGTRRA are now made permanent. Among the changes are the following: Increases in the IRA contribution limits, including the ability to make catch-up contributions for individuals age 50 and older. Increases in the limits on contributions, benefits, and compensation under qualified retirement plans, tax-sheltered annuities, and eligible deferred compensation plans (457 (b)). Option to treat elective deferrals as after-tax Roth contributions. Catch-up 401(k), SEP and SIMPLE IRA contributions for individuals age 50 and older. The permanency of the higher IRA and other retirement plan contribution limits will allow individuals to continue to save more for retirement. Low-income saver's credit make permanent; income limits indexed after 2007.

5 Under EGTRRA, for tax years beginning before 2007, an eligible lower-income taxpayer can claim a non-refundable tax credit for the applicable percentage of up to $2,000 of his qualified retirement savings contributions the saver's credit. New law. The Act makes the saver's credit permanent. It also indexes the income limits applicable to the saver's credit, beginning in 2007, with indexed amounts rounded to the nearest multiple of $500. EGTRRA changes for qualified tuition programs made permanent. EGTRRA QTP rules. Distributions from a qualified tuition program (QTP, also known as a Sec. 529 plan ) are excludable from income tax to the extent used to pay for qualified higher education expenses. Distributions from a QTP that aren't used to pay qualified higher education expenses are taxable (and subject to a 10% penalty tax). Generally effective for tax years beginning after 2001, EGTRRA expanded and liberalized the previous QTP rules. However, under the pre-act law, a sunset provision of EGTRRA provided that the changes made by EGTRRA would not apply to tax years beginning after Dec. 31, These EGTRRA changes included: Distributions from a QTP were made excludable from gross income to the extent used to pay for qualified higher education expenses A 10% penalty tax was imposed on the amount of a QTP distribution that is includible in income. Taxpayers were permitted to claim a HOPE or Lifetime Learning credit and exclude amounts distributed from a QTP during the same tax year for the same student. Tax-free 60-day rollovers were permitted (not more than once in 12 months) from one QTP to another QTP with the same designated beneficiary. Family member for purposes of beneficiary changes and rollovers was expanded to include first cousins of the original beneficiary. New law. The Act permanently extends the changes made by EGTRRA relating to QTPs that would have otherwise expired at the end of What this means to your business in the near term The repeal of the sunset gives individuals more certainty in education funding. The permanency of the exclusion from income of 529 distributions for qualified higher education expenses greatly enhances 529 plans as a premier education savings tool. New Charitable Incentives Tax-free IRA distributions for charitable purposes. Under the pre-act law, if an amount withdrawn from a traditional or Roth IRA is donated to a charitable organization, the rules relating to the tax treatment of withdrawals from IRAs apply to the amount withdrawn and the charitable contribution is subject to the normally applicable limitations on deductibility of contributions. New law. For distributions in tax years beginning after 2005 and before 2008, the Act provides an exclusion from gross income for otherwise taxable IRA distributions

6 from a traditional or Roth IRAs (not SEP-IRAs or SIMPLE IRAs) that are qualified charitable distributions. To constitute a qualified charitable distribution, the distribution must be made (1) directly by the IRA trustee to a publicly supported charity (i.e. a charitable organization other than a donor advised fund, supporting organization or certain private foundations) and (2) on or after the date the IRA owner attains age 70 1/2. Distributions that are excluded under the new provision aren t taken into account in determining the individual s deduction, if any, for charitable contributions. This clearly helps those individuals who have larger IRAs and want to use them to make charitable contributions during their lifetimes. Using IRA distributions, rather than other funds, to make charitable contributions will reduce overall gross income and can help to reduce the amount of social security benefits included in gross income. Charitable Reform Provisions Reporting life insurance contracts. The Act includes a temporary reporting requirement with respect to the acquisition of interests in certain life insurance contracts by certain exempt organizations. This is in response to the increase in transactions involving Charitable Owned Life Insurance (CHOLI) - the acquisition of life insurance contracts using arrangements in which both exempt organizations, primarily charities, and private investors have an interest in the contract. An exempt organization that is involved in such transactions must file an information return. The IRS will undertake a study on the use by tax-exempt organizations of insurance contracts for the purpose of sharing the benefits of the organization's insurable interest in insured individuals under such contracts with investors, and whether such activities are consistent with the tax-exempt status of the organizations. CHOLI has officially made it onto the IRS radar screen. Be wary of customers who bring-up such a transaction. Revised rules for Corporate-Owned Life Insurance (COLI) Treatment of death benefits from corporate-owned life insurance (COLI). Under the pre-act law, the payment of life insurance death benefits after the insured party's death is generally not taxable to the recipient. New law. Generally for contracts issued after enactment date, the Act requires businesses to treat proceeds from COLI as income unless the insured was an employee within 12 months of death, proceeds are paid to the insured's beneficiary used to buy back any equity interest owned by the insured at the time of death; or the insured was a highly compensated employee. Highly compensated employees

7 are more than 5% owners, directors and anyone else in the top 35% of employees ranked by pay. The new COLI provision also includes notice and consent requirements, and reporting requirements. What this means to your business in the near term This will end janitor insurance.