MORE THAN PENSIONS...

Transcription

1 Series MORE THAN PENSIONS... Planning Opportunities with the Pension Protection Act of 2006 Tax Facts Editors Renaissance Administration, LLC P.O. Box Cincinnati, OH

2 This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations. ISBN: Copyright 2006 The National Underwriter Company P.O. Box 14367, Cincinnati, Ohio All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior written permission of the publisher. Printed in U. S. A. ii

3 TABLE OF CONTENTS Pension Reform...1 EGTRRA Retirement Provisions Permanent...1 Defined Benefit Funding...1 Increased Deduction for Defined Benefit Plan Contributions...2 Combined Plan Limits...3 Defined Benefit 415 Limit...3 Cash Balance Plans...3 Fully Insured Plans...4 Safest Available Annuity Standard...4 Combination Defined Benefit/401(k) Plan...5 Automatic Enrollment 401(k) Safe Harbor Plan...6 Defined Contribution Vesting...7 Investment Advice...8 Diversification Requirement...9 Hardship Distributions...10 Phased Retirement...10 Qualified Domestic Relations Orders...10 Notice and Consent Time Period...11 Expanded Survivor Annuity Requirement...11 Minimum Required Distributions...11 Nondiscrimination Testing in Governmental Plans...11 Transfer of Excess Pension Assets to Retiree Health Accounts...12 PBGC Rules...12 Plan Amendments...12 Effective Dates...12 Individual Retirement Arrangements...13 IRA Contribution Limits Made Permanent...13 Additional IRA Contributions for Employees of Bankrupt Companies...13 Non-spouse IRA Beneficiaries May Transfer Accounts...13 Taxpayers May Direct Refunds to IRAs...14 Taxpayers May Directly Transfer Retirement Plans to Roth IRAs...14 Deductible IRA Income Limits for Active Participants Indexed for Inflation...15 Roth IRA Contribution Income Limits Indexed for Inflation...16 Penalty-free Distributions for Reservists...16 Penalty-free Distributions for Qualified Public Safety Employees...17 iii

4 Retirement Saver s Credit...18 Nonqualified Deferred Compensation...19 COLI Death Proceeds...20 Long-Term Care Insurance Provisions Plans...23 Charitable Provisions...24 Charitable IRA Rollover...24 Increased AGI Limit and Carryover Period for Certain Qualified Conservation Contributions...26 New Reporting Requirement for Certain Charity-Owned Life Insurance Contracts...26 Recapture of Deduction Claimed for Contributions of Tangible Personal Property...27 Enhanced Recordkeeping Requirement for Contributions of Money...29 Gifts of Fractional Interests in Tangible Personal Property...29 Changes to Thresholds for Determining Substantial and Gross Valuation Misstatements...30 Donor Advised Funds Defined...32 Limitations on Charitable Deductions for Gifts to Donor Advised Funds...34 New Limitation on Charitable Contributions of Clothing and Household Items...34 iv

5 ABOUT THE AUTHORS The Pension Protection Act of 2006 was signed into law on August 17, This summary of selected provisions (other than the Charitable portions) was written by the editors of Tax Facts April K. Caudill, J.D., CLU, ChFC John H. Fenton, J.D., M.S.B.A. Sonya E. King, J.D., LL.M. Joseph F. Stenken, J.D., CLU, ChFC William J. Wagner, J.D., LL.M., CLU The summary of selected Charitable Provisions was written by Gregory W. Baker, JD, CFP, CAP Mr. Baker is a Senior Vice President at Renaissance Administration LLC with over 17 years of experience in charitable planning. A frequent lecturer on charitable planning, Mr. Baker s advice has assisted advisors in closing over $4 billion of charitable gifts for their high net worth clients. Ted R. Batson, Jr., MBA, CPA Mr. Batson is a Senior Vice President at Renaissance Administration LLC with over 12 years of experience in charitable planning and charitable gift administration. Mr. Batson works with over 1,000 financial advisors each year on advanced cases involving real property, closely held businesses, and unique fact patterns. Renaissance Administration LLC Founded in 1987, Renaissance Administration LLC is the nation s leading third-party administrator of charitable planned gifts. Renaissance currently serves the advisors and donor/trustees of over 6,000 charitable planned gifts (CRTs, CLTs, DAFs, and private foundations). Through the Renaissance Charitable Foundation, Renaissance offers an open-platform donor advised fund to advisors and their clients. v

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7 PENSION REFORM In a sweeping move experts are calling the most comprehensive pension legislation since ERISA, Congress has shored up the pension system and amended or added hundreds of provisions to make retirement plans operate more smoothly. EGTRRA RETIREMENT PROVISIONS PERMANENT Roth 401(k) plans and catch-up contributions are among the retirement provisions of EGTRRA 2001 that are now permanent under PPA Other now-permanent provisions include broader funding opportunities for the 45 million Americans covered by 401(k) plans, and higher levels of permitted contributions to other elective deferral plans, as follows: 2006 CONTRIBUTION LIMITS Elective Deferral* Catch-up Contribution Traditional/ safe harbor 401(k) $15,000 $5,000 SIMPLE 401(k) $10,000 $2,500 SIMPLE IRA $10,000 $2,500 SAR-SEP $15,000 $5, Plan $15,000 $5, (b) Plan $15,000 $5,000 *excludable amount in the case of a 403(b) plan [Act Sec IRC Secs. 402(g), 402A(a)(1), 408(k)(11), 408(p), 408(k), 457(e)(15). Tax Facts on Insurance & Employee Benefits (2006): Qs 401, 396, 124, 473.] Planning Point: Thousands of employers have been hesitant to adopt Roth 401(k) plans on the grounds that they could sunset at the end of This will no longer be an issue. DEFINED BENEFIT FUNDING For plan years beginning after 2007, the Act replaces the minimum funding standard account for single-employer defined benefit plans and the deficit reduction contribution that applies to certain plans with one basic minimum required contribution, consisting of a target 1

8 normal cost and, if applicable, a shortfall amortization charge and a waiver amortization charge. Unfunded liabilities will be funded over seven years. Plans subject to the deficit reduction contribution in 2007 will be subject to the full 100% funding target in 2008, but other plans will be permitted to use a phase-in provision over a 3-year period. More aggressive actuarial assumptions (and potentially a loading factor) are required for plans that are deemed to be at-risk. At-risk plans are subject to a new qualification requirement that will suspend many benefit increases, plan amendments and accruals in single-employer plans when funding falls below specified levels ranging from 60%-80%. The new provision also restricts distributions and lump sum payouts if the employer is in bankruptcy. This requirement takes effect for plan years beginning after December 31, 2007, to plans in existence for at least five years (counting predecessor plans). Interest rate assumptions used for the permissible interest rate range and to calculate current liability in will be based on a yield curve that is derived from a 2-year weighted average of interest rates on investment grade corporate bonds. After 2007, the use of segmented rates derived from a yield curve will be phased in. [Act Secs , IRC Secs. 430, 431, 436 (added); 412 (amended). Tax Facts on Insurance & Employee Benefits (2006): Qs ] Comment: The interest rates used for extend the relief implemented by PFEA Early feedback suggests the use of the segmented interest rates over the 7-year amortization period will require further guidance. INCREASED DEDUCTION FOR DEFINED BENEFIT PLAN CONTRIBUTIONS For 2006 and 2007, the Act increases the deduction for single-employer defined benefit plan contributions to 150% of current liability minus current plan assets. Thereafter, the deduction will be determined by calculating the excess, if any, of (1) the funding target for the plan year, plus (2) the target normal cost for the plan year, and (3) a cushion amount, over (4) the value of plan assets. [Act Sec IRC Sec. 404(o). Tax Facts on Insurance & Employee Benefits (2006): Q 383.] 2

9 Comment: The increased deduction reflects that the new law goes beyond requiring only that plans be adequately funded; it encourages that they create a funding cushion. COMBINED PLAN LIMITS The deduction limit that applies to the combination of a defined benefit and defined contribution plan has been amended. The Act provides that for plan years beginning after December 31, 2007, contributions to defined benefit plans insured by the PBGC will be excluded from the combined plan limit. The Act also provides that effective for plan years beginning after December 31, 2005, the combined plan limit applies to defined contribution plans only to the extent that contributions exceed 6% of compensation paid or accrued during the taxable year. The Act continues to disregard elective deferrals for purposes of the deduction limits. [Act Secs. 801, 803. IRC Sec. 404(a)(7)(C). Tax Facts on Life Insurance & Employee Benefits (2006): Q 366.] DEFINED BENEFIT 415 LIMIT Under preexisting Code language, the determination of a participant s highest three years of service in a defined benefit plan was the three consecutive years in which he was both an active participant in the plan and had the greatest aggregate compensation from the employer. The Act deletes the language from IRC Section 415(b) that requires the employee to be an active participant in the plan for years of compensation to be considered. This amendment is effective for plan years beginning after December 31, [Act Sec IRC Sec. 415(b). Tax Facts on Insurance & Employee Benefits (2006): Q 372.] Planning Point: This amendment reverses the position taken by 2005 proposed regulations. Earlier regulations, still in effect, had taken the position that years of service in which the employee was not an active participant could be taken into account. CASH BALANCE PLANS The Act clarifies that defined benefit plans, including cash balance plans, will not be considered age discriminatory if a benefit accrual standard is satisfied. The standard 3

10 compares the accrued benefit of an older participant to that of a similar situated younger participant. Certain features can be disregarded for this purpose, such as permitted disparity, early retirement subsidies, and permitted offsets. The Act also creates standards for interest crediting provisions under which the interest rate may not exceed a market rate of return. Vesting must take place after not more than three years of service (including service before the effective date). Conversions of defined benefit plans to cash balance plans must preclude the possibility of wearaway (i.e., a period when the participant is not accruing any benefit). The benefit after conversion must not be less than the sum of the participant s benefit before the conversion under the prior formula, plus the benefit the participant earns under the new formula for service after the conversion (i.e., known as the A+B approach). [Act Sec IRC Secs. 411(a)(13), 411(b). Tax Facts on Insurance & Employee Benefits (2006): Q 374.] Planning Point: It is important to note that these provisions do not affect the treatment of pre-existing cash balance plans, nor those in ongoing litigation over other provisions. However, these provisions should go a long way toward preventing future litigation and encouraging employers to make use of these plans. FULLY INSURED PLANS The provisions for fully insured plans, long known to the industry as 412(i) plans, have been moved, to IRC Section 412(e)(3), fully intact. No substantive changes were made to this section. [Act Sec IRC Sec. 412(e)(3). Tax Facts on Insurance & Employee Benefits (2006): Q 407.] Comment: Fans of these plans will probably always call them 412(i) plans, even though the Code section for which they were named no longer exists. The reason for the change is that much of what comprised the Section 412 funding rules are now consolidated into just fi ve subsections ((a) through (e)). SAFEST AVAILABLE ANNUITY STANDARD The Act directs the DOL to issue regulations clarifying that the selection of an annuity contract as an optional form of distribution from an individual account plan to a participant or beneficiary is not subject to the safest 4

11 available annuity standard under Interpretive Bulletin 95-1, and is subject to all otherwise applicable fiduciary standards. This provision is effective on the date of enactment, August 17, 2006; however, the DOL has one year to issue the regulations. [Act Sec. 625.] Comment: In 2005, the Advisory Council on Employee Welfare and Pension Benefi t Plans recommended a change from the IB 95-1 approach, which was established in the wake of some notable insurer insolvencies, to a more process-based approach for choosing annuity options in a defi ned contribution plan. COMBINATION DEFINED BENEFIT/401(K) PLAN Under a new provision, a combination defined benefit/401(k) plan will become available to employers with up to 500 employees, starting in Generally, the defined benefit and 401(k) components will be subject to their already-existing qualification requirements, but they will be required to file only one Form 5500 and will have a single plan document and trust fund. The top heavy rules will be deemed satisfied for a combined defined benefit/401(k) plan, and the 401(k) portion will be exempt from ADP/ACP testing. The plan s design will generally be subject to the following requirements: (1) the benefit requirement for the defined benefit portion will be satisfied with a formula of 1% of final average pay times up to 20 years of service, or a specified cash balance formula which increases with the participant s age; (2) the contribution requirement is met if the 401(k) plan provides for automatic enrollment and requires the employer to match 50% of elective deferrals of up to 4%; (3) the defined benefit portion of the plan must be fully vested after 3 years of service; matching contributions under the defined contribution portion must be nonforfeitable, including those in excess of the required match; nonelective contributions may be subject to up to 3-year cliff vesting; (4) a uniformity requirement provides that all contributions and benefits and all rights and 5

12 features must be provided uniformly to all participants; and (5) the foregoing requirements must be met without taking into account permitted disparity and amounts under other plans. [Act Sec IRC Sec. 414(x). Tax Facts on Insurance & Employee Benefits (2006): Q ] Planning Point: The foregoing criteria are the only circumstances under which a combination defi ned benefi t/401(k) plan may constitute a single plan and trust. This new plan design takes effect for plan years beginning after December 31, AUTOMATIC ENROLLMENT 401(K) SAFE HARBOR PLAN Effective after 2007, the Act creates a new safe harbor 401(k) plan, called a qualified automatic contribution arrangement, based on its requirement of automatic enrollment. Such a plan will satisfy the ADP/ACP requirements and be excluded from the top heavy requirements. Effective on the date of enactment, ERISA is also amended to preempt any state laws that would restrict or prohibit automatic contribution arrangements, under standards to be established by the DOL. The threshold amount of the automatic deferral percentage under the new plan is 3% for the first year the deemed election applies (the election may not exceed 10%). Employees may affirmatively elect out of the plan or elect a different deferral percentage. In the second year, this percentage must increase to 4%, then 5% in the third year, and 6% in the fourth year and thereafter. Furthermore, the employer must provide either a matching contribution (100% of the first 1% of compensation deferred plus 50% of the amount of elective contributions over 1% but not exceeding 6%) or, in the alternative, the employer may provide nonelective contributions of 3% of compensation for all employees eligible to participate in the arrangement. A written notice requirement applies, including specific timing and content requirements. The plan may provide for vesting of 100% after two years of service with respect to employer contributions. 6

13 While the plan is subject to the same restrictions that apply to other 401(k) distributions, special relief is provided for amounts erroneously contributed to the plan. For 90 days after the first elective contribution, such amounts may be distributed without any penalty under Section 72(t), and will not be treated as violating any restriction on 401(k) distributions. Finally, a plan that satisfies the definition of an eligible automatic contribution arrangement set forth in new IRC Section 414(w) is subject to a new, extended time period for making distributions of refunds of excess contributions and excess aggregate contributions. The time period for such refunds is extended from 2½ months to six months. [Act Sec IRC Secs. 401(k)(13), 401(m)(12), 414(w) (added); 4979(f)(6). Tax Facts on Insurance & Employee Benefits (2006): Qs , 405, 406.] Planning Point: Surveys suggest that automatic enrollment boosts participation from 60-70% to 90% or more. For employers who struggle to pass ADP/ACP testing each year, this can be a big help. DEFINED CONTRIBUTION VESTING The Act extends the faster vesting requirements that have applied to employer matching contributions since the beginning of 2002 to employer nonelective contributions as well. This change is generally effective with respect to plan years beginning after December 31, These requirements are satisfied under either of the following schedules: Years of Cliff Graduated Service Vesting Vesting % 3 100% 40% 4 60% 5 80% 6 100% [Act Sec IRC Sec. 411(a). Tax Facts on Insurance & Employee Benefits (2006): Q 333.] Comment: This change effectively makes all employer contributions in defined contribution plans subject to the faster vesting requirements. 7

14 INVESTMENT ADVICE The Act creates an exemption from ERISA s prohibited transaction rules for certain fiduciary advisers who provide investment advice under an eligible investment advice arrangement. Such an arrangement may be established either of two ways: (a) it may provide that any fees or commissions received by the fiduciary for investment advice for purposes of the investment of plan assets do not vary on the basis of any investment option selected, or (b) it may use a computer model that meets additional criteria. The computer model must: (1) apply generally accepted investment theories that take into account the historic returns of different asset class over defined periods of time; (2) use relevant information about the participant, such as age, life expectancy, retirement age, risk tolerance, other assets or sources of income, and preferences as to certain types of investments; (3) use objective criteria to provide asset allocation portfolios comprised of investment options offered under the plan; (4) operate in a manner that is not biased toward investments offered by the fiduciary advisor, or a person in relationship with the advisor; and (5) take into account all investment options under the plan in specifying how a participant s account should be invested, and not be inappropriately weighted with respect to any investment option. Furthermore, the utilization of the computer model must be certified by an eligible investment expert as meeting the foregoing criteria, and the only advice provided under the arrangement can be that generated by the computer model and any transaction requested by the participant. The arrangement must also be audited annually and meet written disclosure requirements, and records of 8

15 compliance must be maintained for six years. The DOL is directed to issue a model form for disclosure of fees and other compensation for purposes of these arrangements. [Act Sec IRC Secs. 4975(d)(17), 4975(f)(8) (added). Tax Facts on Insurance & Employee Benefits (2006): Q 443.] DIVERSIFICATION REQUIREMENT A new qualification requirement has been added to IRC Section 401 for defined contribution plans that hold publicly traded employer securities (determined on a controlled group basis). Such plans will be required to permit participants to direct the plan to divest any employer securities and reinvest an equivalent amount in other investment options. The plan must offer at last three other investment options, each of which is diversified and has materially different risk and return characteristics. With respect to employer contributions only, the plan may restrict the diversification feature to participants with at least three years of service (or their beneficiary, if the participant is deceased). The plan may also limit the diversification election to once per quarter, under the same conditions as other investment changes. The diversification requirement does not apply to a one-participant plan. A one-participant plan is defined as one in which only one individual (or that individual and his or her spouse) is covered, and the individual owns 100% of the plan sponsor (whether incorporated or not). The term also includes a plan that covers only one or more partners (or partners and their spouses) in the plan sponsor. ESOPs that contain no employee contributions, elective deferrals, or match amounts are also excluded from the diversification requirement. The new requirement is generally effective for plan years beginning after December 31, A 3-year phasein is available to the extent that the employer contribution portion of the account consists of employer securities acquired before January 1, However, this phase-in will not apply to participants who have reached age 55 and completed at least three years of service before the first plan year that begins after December 31, [Act Sec IRC Sec. 401(a)(35). Tax Facts on Insurance & Employee Benefits (2006): Q 322.] 9

16 HARDSHIP DISTRIBUTIONS The Act calls for the Secretary of the Treasury to issue regulations on hardship distributions within 180 days of enactment. The regulations are required to modify the hardship distribution requirements to state that if an event would constitute a hardship with respect to a participant s spouse or dependent, it will constitute a hardship with respect to the participant, to the extent permitted under the plan. Similar rules are to be provided for determining whether a participant has had a hardship for purposes of Section 403(b)(11)(B) or an unforeseen financial emergency under provisions of Sections 409A and 457. [Act Sec IRC Secs. 401(k)(2(B), 403(b)(11)(B), 409(A)(a)(2), 457(d)(1)(A). Tax Facts on Insurance & Employee Benefits (2006): Qs 403, 466, 115, 124.] PHASED RETIREMENT Under the title Distributions During Working Retirement, the Code and ERISA have been amended to permit in-service distributions to employees who have reached age 62 and have not yet separated from service. Such a distribution will not be treated as made in a form other than retirement income, or as a distribution prior to termination of covered employment. This amendment is effective for plan years beginning after December 31, [Act Sec IRC Sec. 401(a)(36) (added). Tax Facts on Insurance & Employee Benefits (2006): Q 322.] Comment: The Treasury Department proposed regulations spelling out detailed provisions for phased retirement in November These amendments may help speed the fi nalization of those rules. QUALIFIED DOMESTIC RELATIONS ORDERS The Act directs the Secretary of Labor to issue regulations under which a qualified domestic relations order (QDRO) will not fail to be treated as valid merely because it revises, or is issued after, another QDRO. The regulations must also provide that a QDRO will not be treated as invalid solely because of the time at which it is issued. [Act Sec IRC Sec. 414(p)(3). Tax Facts on Insurance & Employee Benefits (2006): Q 349.] Comment: This seems to be Congress s answer to certain courts that have held post-death QDROs were invalid. 10

17 NOTICE AND CONSENT TIME PERIOD The 90-day election time period for notice and consent to a waiver of a qualified joint and survivor annuity (or qualified preretirement survivor annuity) has been expanded to 180 days, for years beginning after December 31, This provision also applies to notice and consent requirements under IRC Section 402(f) (rollover notices) and IRC Section 411(a)(11) (consent for distributions). [Act Sec IRC Secs. 417(a)(6)(A), 402(f), 411(a)(11). Tax Facts on Insurance & Employee Benefits (2006): Qs 337, 333, 447.] EXPANDED SURVIVOR ANNUITY REQUIREMENT The Act adds a new qualified optional survivor annuity requirement for plans that are subject to the qualified joint and survivor annuity (QJSA) rules (this includes defined benefit plans and money purchase plans). If the participant waives the QJSA (or a qualified preretirement survivor annuity, QPSA), plans subject to the requirement must offer a qualified optional survivor annuity option. If the QJSA value was 50%, as is required under prior law, the optional survivor annuity s value must be at least 75%. If the QJSA had a value greater than 75%, the optional survivor annuity s value must be at least 50%. This provision is effective for plan years beginning after December 31, [Act Sec IRC Sec. 417(a)(1). Tax Facts on Insurance & Employee Benefits (2006): Q 336.] MINIMUM REQUIRED DISTRIBUTIONS The Act directs the Secretary of the Treasury to issue regulations making governmental plans subject to a reasonable, good faith interpretation of the minimum distribution requirements under IRC Section 401(a)(9). [Act Sec IRC Sec. 401(a)(9). Tax Facts on Insurance & Employee Benefits (2006): Qs 338, 486.] NONDISCRIMINATION TESTING IN GOVERNMENTAL PLANS The Act amends the nondiscrimination requirements of the Internal Revenue Code to extend the moratorium on certain nondiscrimination testing by state and local governmental plans to all governmental plans. [Act Sec IRC Secs. 401(a)(5), 401(a)(26), 401(k)(3). Tax Facts on Insurance & Employee Benefits (2006): Qs 326, 373, 404.] 11

18 TRANSFER OF EXCESS PENSION ASSETS TO RETIREE HEALTH ACCOUNTS The ability of employers to make qualified transfers of excess pension assets from a defined benefit plan (other than multiemployer plans) to Section 401(h) accounts has been expanded. A new provision was added to Section 420, allowing qualified transfers for a qualified future transfer or for a collectively bargained transfer. This amendment is effective for transfers made after August 17, [Act Sec IRC Sec Tax Facts on Insurance & Employee Benefits (2006): Q 370.] PBGC RULES The Act does not change the PBGC flat rate premium, which was raised to $30 per participant in February by the Deficit Reduction Act of 2005 (that Act was signed into law February 8, 2006, but so named in order to take advantage of 2005 funding). The bill extends the variable rate premiums, makes the surcharge premium permanent, and modifies rules governing substantial owners and the effective date of bankruptcy filings. [Act Sec. 401.] PLAN AMENDMENTS Plan amendments for the provisions of the Pension Protection Act will generally be required by the end of the plan year beginning in For governmental plans, the deadline will be the end of the plan year beginning in [Act Sec Tax Facts on Insurance & Employee Benefits (2006): Q 322.] EFFECTIVE DATES The date of enactment of the Pension Protection Act is August 17, Except as otherwise noted, most provisions of the Act take effect for plan years beginning after December 31, 2007; however, as noted, some provisions take effect on the date of enactment or for plan years beginning after December 31,

19 INDIVIDUAL RETIREMENT ARRANGEMENTS IRA CONTRIBUTION LIMITS MADE PERMANENT The Act makes permanent the increased contribution limits, including catch-up contributions, for individual retirement accounts. The limits established by EGTRRA 2001 were previously set to expire after [Act Sec IRC Sec. 219(b). Tax Facts on Insurance & Employee Benefits (2006): Qs 220, 221.] Comment: The maximum contribution for both traditional and Roth IRAs is $4,000 for tax years through The contribution limit increases to $5,000 beginning in 2008 and is indexed for infl ation beginning in The limit is increased by $1,000 for taxpayers who attain age 50 before the end of the tax year. ADDITIONAL IRA CONTRIBUTIONS FOR EMPLOYEES OF BANKRUPT COMPANIES For tax years 2007 through 2009, former employees of bankrupt companies with indicted executives (e.g., Enron) may contribute an additional $3,000 over and above the usual contribution limit (see above). The enhanced catchup provision applies only where the employer matched 50% or more of employee 401(k) contributions in the form of employer stock. [Act Sec IRC Sec. 219(b). Tax Facts on Insurance & Employee Benefits (2006): Qs 220, 221.] Comment: For taxpayers age 50 or older, the enhanced catch-up contribution is available instead of, not in addition to, the usual $1,000 catch-up provision. NON-SPOUSE IRA BENEFICIARIES MAY TRANSFER ACCOUNTS Beginning with distributions in 2007, the Act makes explicit that a non-spouse beneficiary of an IRA may make a trustee-to-trustee transfer into another inherited IRA. [Act Sec IRC Sec. 402(c). Tax Facts on Insurance & Employee Benefits (2006): Q 235.] 13

20 Comment: Nothing under prior law prohibits trusteeto-trustee transfers of inherited IRAs. But some custodians, nevertheless, currently restrict beneficiaries from transferring the money to other IRAs and require full distributions within 5 years rather than over the benefi ciaries lifetimes. The custodians sometimes point to the prohibition on rollovers of inherited IRAs to justify the restriction, but trustee-to-trustee transfers are not rollovers. This new provision should eliminate this misinterpretation of the law and allow beneficiaries to preserve their right to take lifetime distributions. TAXPAYERS MAY DIRECT REFUNDS TO IRAS Beginning with the 2007 tax filing season, taxpayers will be able to elect to have all or part of a tax refund deposited directly into an IRA. [Act Sec. 830.] Comment: This will provide a convenient means for many taxpayers who are not natural savers to make IRA contributions. The mechanics of the arrangement will depend on IRS guidance. For instance, it is unclear whether taxpayers will be able to make IRA contributions for 2007 using their 2007 tax refund if they fi le their tax return by April 15, TAXPAYERS MAY DIRECTLY TRANSFER RETIREMENT PLANS TO ROTH IRAS Beginning with distributions in 2008, taxpayers will be able to directly transfer money from a retirement plan into a Roth IRA. This will eliminate the necessity for a conduit traditional IRA. [Act Sec IRC Sec. 408A. Tax Facts on Insurance & Employee Benefits (2006): Q 222.] Comment: Plan sponsors that choose to allow direct plan-to-roth IRA conversions will assume the burden of reporting the income from the conversion to the IRS. 14

21 DEDUCTIBLE IRA INCOME LIMITS FOR ACTIVE PARTICIPANTS INDEXED FOR INFLATION Beginning in 2007, the income limits for active participants to deduct their contributions to traditional IRAs will be indexed for inflation. [Act Sec IRC Sec. 219(g). Tax Facts on Insurance & Employee Benefits (2006): Q 220.] Comment: Active participants in qualified or certain other retirement plans begin to lose the deduction for contributions to traditional IRA if their incomes are above certain thresholds (the applicable dollar amount ). Under the Act, the existing thresholds will be indexed for infl ation beginning in (The base year for the indexing will be 2005.) This includes the $80,000 threshold previously scheduled to apply to active participant spouses in Taxpayer Status Applicable dollar amount Single or head-of-household $50,000 Married fi ling jointly, active $75,000 (2006) participant spouse $80,000 (2007) Married fi ling jointly, non-active participant spouse (other spouse $150,000 is active participant) The amount of the reduction in the IRA contribution is calculated as follow: Maximum Deduction x AGI applicable dollar amount $10,000 For an active participant spouse filing a joint return, the denominator increases from $10,000 to $20,000 beginning in

22 ROTH IRA CONTRIBUTION INCOME LIMITS INDEXED FOR INFLATION Beginning in 2007, the income limits for taxpayers to make contributions to Roth IRAs will be indexed for inflation. [Act Sec IRC Sec. 219(g). Tax Facts on Insurance & Employee Benefits (2006): Q 221.] Comment: Taxpayers begin to lose the ability to contribute to Roth IRAs if their incomes are above certain thresholds (the applicable dollar amount ). Under the Act, the existing thresholds will be indexed for inflation beginning in (The base year for the indexing will be 2005.) Taxpayer Status Applicable dollar amount Single or head-of-household $95,000 Married fi ling jointly $150,000 Married fi ling separately $0 The amount of the reduction in the Roth IRA contribution is calculated as follow: Maximum Contribution x AGI applicable dollar amount $10,000 For a taxpayer fi ling single or head-of-household, the denominator is $15,000. PENALTY-FREE DISTRIBUTIONS FOR RESERVISTS Reserve members of the U.S. military called to active duty for 180 days or more may take penalty-free distributions from retirement plans. In addition, they have the right to return the amount of any distributions to the retirement plan for two years following the end of active duty. The new rules apply to any reservists called to active duty since September 11, 2001 and before the end of [Act Sec IRC Sec. 72(t). Tax Facts on Insurance & Employee Benefits (2006): Q 231.] 16

23 PENALTY-FREE DISTRIBUTIONS FOR QUALIFIED PUBLIC SAFETY EMPLOYEES Effective immediately, retired fire, police, and emergency medical service employees may now take distributions from governmental defined benefit plans beginning penalty-free at age 50. [Act Sec IRC Sec. 72(t). Tax Facts on Insurance & Employee Benefits (2006): Q 231.] Comment: Retirees age 55 or older may generally take distributions from qualifi ed plans or governmental plans penalty free following separation from service. This new provision lowers the age to 50 for public safety employees. 17

24 RETIREMENT SAVER S CREDIT The Act made permanent the retirement saver s credit and indexed the income limits for inflation beginning in [Act Secs. 812, 833. IRC Sec. 25B. Tax Facts on Insurance & Employee Benefits (2006): Q 213.] Comment: Certain lower-income taxpayers may claim a non-refundable tax credit for qualifi ed retirement savings contributions (QRSCs). QRSCs include contributions and elective deferrals to Roth or traditional IRAs, 401(k) plans, 403(b) tax sheltered annuities, eligible 457 governmental plans, SIMPLE IRAs, and salary reduction SEPs. The amount of the credit is limited to an applicable percentage of IRA contributions and elective deferrals up to $2,000. The income limits and applicable percentages are as follows: Head of All other Joint Return household cases % $0 30,000 $0 22,500 $0-15,000 50% 30,000 22,500 15,000 32, ,250 20% 32,500 24,375 16,250 50,000 37,500 25,000 10% > 50,000 > 37,500 > 25,000 0% 18

25 NONQUALIFIED DEFERRED COMPENSATION Effectively immediately, new restrictions added to IRC Section 409A prohibit top executives from setting aside assets (such as in rabbi trusts) while the company s defined benefit pension plan is under-funded or while the company is in bankruptcy. The restrictions apply to any transfers or reservations after August 17, [Act Sec IRC Secs. 409A. Tax Facts on Insurance & Employee Benefits (2006): Qs 62, 271.] Comment: Under the new rules, the restricted period is any period during which the employer is in bankruptcy, during which a company s plan is in at-risk status, or during the six months before or after an insuffi cient plan termination. Violating the new restrictions will result in the usual penalties under IRC Section 409A: immediate loss of deferral and retroactive recognition of income, an additional 20% penalty tax, and interest at 1% greater than the usual underpayment rate. 19

26 COLI DEATH PROCEEDS The Act adds new requirements that employer-owned life insurance contracts must meet for the death proceeds to be received income-tax free. If these requirements are not met, the death proceeds will be included in income to the extent they exceed the amount paid for the policy (including premiums paid). One set of requirements is that before an employerowned life insurance contract is issued the employer must meet certain notice and consent requirements. The insured employee must be notified in writing that the employer intends to insure the employee s life, and the maximum face amount the employee s life could be insured for at the time the contract is issued. The notice must also state that the policy owner will be the beneficiary of the death proceeds of the policy. The insured must also give written consent to be the insured under the contract and consent to coverage continuing after the insured terminates employment. Another set of requirements regards the insured s status with the employer. The insured must have been an employee at any time during the 12-month period before his death, or at the time the contract was issued the insured was a director or highly compensated employee. A highly compensated employee is an employee classified as highly compensated under the qualified plan rules of IRC section 414(q) (except for the election regarding the top paid group), or under the rules regarding self-insured medical expense reimbursement plans of IRC Section 105(h), except that the highest paid 35 percent, instead of 25 percent, will be considered highly compensated. Alternatively, the death proceeds of employer-owned life insurance will not be included in the employer s income (assuming the notice and consent requirements are met) if the amount is paid to a member of the insured s family (defined as a sibling, spouse, ancestor, or lineal descendent), any individual who is the designated beneficiary of the insured under the contract (other than the policy owner), a trust that benefits a member of the family or designated beneficiary, or the estate of the insured. If the death proceeds are used to purchase an equity interest from a family member, beneficiary, trust, or estate, the proceeds will not be included in the employer s income. 20

27 In addition, the Act imposes new reporting requirements on all employers owning one or more employerowned life insurance contracts. This provision is effective for life insurance contracts issued after August 17, 2006, except for contracts issued in a 1035 exchange where there was not a material increase in the death benefit or other material change. [Act Sec IRC Secs. 101(j), 6039I. Tax Facts on Insurance & Employee Benefits (2006): Qs 62, 271.] 21

28 LONG-TERM CARE INSURANCE PROVISIONS The Act provides new rules providing that a charge against the cash value of an annuity contract or life insurance contract as a payment for a qualified long-term care insurance contract will not be included in the gross income of the contract owner. Also, no deduction will be allowed for a payment from the cash value of a life insurance or annuity contract. Note that these charges will reduce the investment in the contract. The Act also allows for expansion of the use of Section 1035 exchanges to involve qualified long-term care insurance contracts. A life insurance contract, annuity contract, endowment contract, or qualified long-term care insurance contract may be exchanged for a qualified long-term care insurance contract. Also, for purposes of the 1035 rules, a contract will not fail to be treated as an annuity contract or a life insurance contract solely because it contains a qualified long-term care insurance rider. This provision is effective for contracts issued after 1996, but only for tax years beginning after The provisions regarding 1035 exchanges of contracts are effective for exchanges occurring after [Act Sec IRC Secs. 72(e), 1035, 6050U, 7702B. Tax Facts on Insurance & Employee Benefits (2006): Qs 273, 311.] 22

29 529 PLANS Qualified Tuition Programs (529 Plans). The taxfree treatment for qualified withdrawals from 529 plans (i.e., withdrawals used to pay qualified higher education expenses ) under EGTRRA 2001 has now been made permanent. In other words, this tax break will not end on December 31, 2010, as originally scheduled under EGTRRA Consequently, 529 plans compare even more favorably than before in relation to other college saving vehicles, such as Coverdell Education Savings Accounts (ESAs). [Act. Sec Tax Facts on Insurance & Employee Benefits (2006): Q 812.] 23

30 CHARITABLE PROVISIONS CHARITABLE IRA ROLLOVER Under current law, a distribution from an IRA to a charity is included in the gross income of the owner of the IRA. For tax years 2006 and 2007, each taxpayer may roll over up to $100,000 per year from their IRA to a qualified charity without including the rollover amount in gross income. A qualified charitable distribution must satisfy all of the following: the donor must be age 70½ on or before the date of the rollover; the charity must be a public charity (but not a donor-advised fund or supporting organization); the distribution must be a direct trustee-to-charity transfer; the entire distribution must qualify as a deductible contribution were it not for this provision; the exclusion from gross income applies only to distribution amounts that would be includible in gross income were it not for this provision; and rollovers from SEPs and SIMPLE IRAs do not qualify. Planning Point: Only distributions from a taxpayer s own IRA are includible in determining that a taxpayer has met the $100,000 limit. Therefore, while married taxpayers may make qualifi ed distributions totaling $200,000, each spouse may only make distributions of up to $100,000 from their own IRA. Qualified charitable distributions are taken into account for purposes of the minimum distribution rules. No charitable deduction is allowed for a qualified charitable distribution. For taxpayers that own any IRA funded with nondeductible contributions, the general rule remains that 24

31 withdrawals are treated partly as a nontaxable return of the nondeductible contributions and partly from deductible contributions and earnings (which are subject to tax). However, a qualified charitable distribution is treated as coming first from deductible contributions and earnings. [Act. Sec IRC Sec. 408(d)(8). Tax Facts on Insurance & Employee Benefits (2006): Qs 444, 824.] Example: Bill, age 72, is the owner of five IRA accounts with an aggregate value of $150,000. In one of the IRA accounts, Bill has deposited $30,000 of nondeductible contributions. Bill s required minimum distribution for 2006 is $5,859. Bill instructs the IRA trustee to make a $45,000 qualifying charitable distribution to State University. Under the Act, the entire $45,000 rollover is treated as coming from income first, regardless of the account from which the withdrawal is actually made. In addition, the $45,000 rollover satisfies the required minimum distribution for the year. Bill s remaining aggregate IRA balance of $105,000 consists of $75,000 of deductible contributions and earnings and $30,000 of nondeductible contributions. Planning Point: Participants in 401(k) and 403(b) plans must fi rst rollover to a traditional IRA before taking advantage of a charitable IRA rollover. Planning Point: The Act requires that the entire distribution meet the rules governing charitable deductions. Therefore, extreme care must be exercised to ensure that the donor does not receive any benefit from the charity that would be characterized as more than an insubstantial benefit. For example, because a rollover in exchange for event tickets or in payment of a winning bid at a charitable auction would reduce an otherwise qualifying charitable contribution, such a distribution would not be a qualifi ed charitable distribution. Planning Point: A donor should receive from the charity a contemporaneous acknowledgment of their gift substantiating their contribution. This acknowledgement is a required piece of documentation for the rollover to qualify as a charitable distribution. Planning Point: Rollovers to donor advised funds, supporting organizations, private foundations, charitable remainder trusts, charitable gift annuities, and pooled income funds are not qualified charitable distributions. 25

32 Planning Point: IRA owners may still name any public charity, donor-advised fund, supporting organization, charitable remainder trust, charitable gift annuity, or pooled income fund as the benefi ciary of their IRA. Planning Point: Rollovers to charities by taxpayers who reside in states that tax IRA distributions and do not have a charitable deduction may not escape tax at the state level. INCREASED AGI LIMIT AND CARRYOVER PERIOD FOR CERTAIN QUALIFIED CONSERVATION CONTRIBUTIONS The charitable deduction limitation applicable to qualified conservation contributions has now been increased from 30% of AGI to 50% of AGI in the year of the gift. Additionally, a new 15-year carryover period is now permitted for the excess of the fair market value over the charitable deduction limit. In future years, the carryover amount is subject to the same ordering rules that apply to carryforwards of other charitable deductions. Example: Robert makes a qualified conservation contribution valued at $500,000 in Robert s AGI in 2006 is $180,000 and his cash gifts to charity total $30,000. Robert s charitable deduction for 2006 consists of the $30,000 of cash gifts plus $60,000 of the qualifi ed conservation contribution ($180,000 x 50% minus $30,000). Robert may carryover the remaining $440,000 of unused qualified conservation contribution to 2007 through Generally, the new qualified conservation contribution provisions apply for contributions made in tax years beginning in 2006 and [Act. Sec IRC Secs. 170(b)(1)(E), 170(b)(2). Tax Facts on Insurance & Employee Benefits (2006): Q 824.] NEW REPORTING REQUIREMENT FOR CERTAIN CHARITY-OWNED LIFE INSURANCE CONTRACTS Charities must now report identifying information about certain life insurance contracts acquired through structured transactions involving a pool of such contracts. Failure to file this information with the Internal Revenue Service will result in the assessment of a penalty equal to the greater of $1000 or 10% of the value of the benefit in any contract that must be disclosed. 26

33 The requirement applies to life insurance contracts, annuity contracts, and endowment contracts in which both a charity and another person have at any time held an interest. Exceptions to the reporting requirement include: contracts in which each person other than the charity have an insurable interest in the insured (without relying on the charity s insurable interest); contracts in which the only interest a charity and any other person holds is as a named beneficiary; contracts in which the sole interest of a person other than a charity is as a beneficiary of the trust, so long as the beneficial interest was received as a purely gratuitous transfer; and contracts in which the sole interest of a person other than a charity is as a trustee who holds an interest in a contract described in the previous exceptions. This reporting requirement is in response to a number of charity owned life insurance (CHOLI) arrangements that have been promoted in recent years. Much has been written about the wagering aspect of many of these plans that have become known as dead pools. The reporting requirement applies to contracts acquired between August 17, 2006 and August 17, [Act. Sec IRC Secs. 6050V, 6721(e)(2)(D), 6724(d)(1)(B)(xiv). Tax Facts on Insurance & Employee Benefits (2006): Q 824.] RECAPTURE OF DEDUCTION CLAIMED FOR CONTRIBUTIONS OF TANGIBLE PERSONAL PROPERTY Contributions of related use tangible personal property that is sold, exchanged, or otherwise disposed of within three years of contribution are now potentially subject to recapture of the deduction claimed. If the charity sells, exchanges, or otherwise disposes of the property during the tax year in which the contribu- 27

34 tion is made, the donor s deduction is simply limited to the donor s adjusted tax basis in the property. If the charity disposes of the property after the end of the tax year in which the contribution is made and before the last day of the 3-year period starting on the date of the gift, then the donor must include in ordinary income an amount equal to the excess of the deduction claimed over the donor s adjusted tax basis in the property. Example: Susan contributes a stamp collection to the Hanover Philatelic Museum. The museum expects to put the collection on display. The collection is valued at $300,000 and Susan s adjusted tax basis for the collection is $5,000. Two years after Susan s contribution, the museum sells the collection to a private collector for $400,000. In the year of sale, Susan must include in ordinary income $295,000 ($300,000 minus $5,000). Hidden Trap: It is possible (perhaps even likely) that the applicable marginal tax rate in the year in which the deduction was claimed will be lower than the applicable marginal tax rate in the year in which the deduction is recaptured. Therefore the tax liability created from the inclusion of the recapture amount may exceed the tax savings realized from claiming the deduction. It is often the case that a $300,000 deduction has a different relative impact on a taxpayer s tax burden than a $300,000 item of income. For example, the inclusion of an item in income will cause an increase in adjusted gross income (AGI) and a ripple effect through such items as taxation of Social Security benefits, the loss of the child tax credit, reduction in personal exemptions, reduction in itemized deductions, an increase in the 2% floor for miscellaneous itemized deductions, and an increase in the 7.5% floor for deductible medical expenses. Recapture can be avoided if an officer of the charity in a written statement, under penalty of perjury: certifies that the use of the property was a related use and describes how the property was used and how this use furthered its charitable mission; or states the charity s intended use of the property at the time of contribution and certifies that this intended use has become impossible or infeasible to implement. 28