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Pension Protection Act of 2006. In the most sweeping and massive pension legislation in 30 years, Congress is...
August 17, 2006

IRA Update from Ed Slott

Author of “Parlay Your IRA Into a Family Fortune” (Viking/ Penguin 2005)

August 17, 2006

Highlights from “Ed Slott’s IRA Advisor” © 2006 by Ed Slott

New IRA Tax Rules

Pension Protection Act of 2006
In the most sweeping and massive pension legislation in 30 years, Congress is putting you on alert that when it comes to planning for a secure retirement, you are on your own. Even though the law is called the “Pension Protection Act”, the result will be exactly the opposite as far as company pension plans are concerned. Fewer companies will be able to provide pensions from here on in. But you can use these rules to build and protect your own retirement plan and this law contains many provisions to help you do that.

The Pension Protection Act of 2006 was signed into law on August 17, 2006 and contains over 900 pages of numerous provisions designed to strengthen the ailing federal pension insurance program and protect company employee pensions which are on life support at best. But included in the new tax act are IRA and plan provisions that create new retirement planning opportunities for everyone concerned about saving for their retirement.

So far, 2006 is a banner year for creating many new and more flexible retirement planning opportunities that will allow people to put more retirement money away and keep it growing tax deferred.

The common theme here is that Congress finally realizes that you are on your own when it comes to retirement security. So the only thing Congress can do to help people is to make it easier for people to contribute more money to their retirement plans and keep it there longer with new more flexible and liberal retirement plan provisions and that is exactly what they have done. If this does not get you saving for your own retirement, then you have really missed the boat here.

Even though this legislation is intended to secure defined benefit plans and other big company pension plans, it may have the exact opposite effect. There are so many new rules, hurdles, reporting and funding requirements, that many companies might just say “the heck with this,” or more colorful language that I cannot print here, and discontinue these plans rather than strengthen them.

New IRA and Plan tax planning opportunities for YOU!

Non-Spouse rollovers from an inherited company plan are permitted

Beginning in 2007, a non-spouse beneficiary (like a child or grandchild) who inherits your 401(k) or other company plan balance can transfer that plan balance directly to a properly set up inherited IRA that can be stretched over their lifetime. This also applies when trusts are named as the plan beneficiary. The transfer must be done as a direct rollover (trustee-to-trustee transfer) from the plan to an inherited IRA though. Before this, a non-spouse beneficiary who inherited a company plan would usually end up having pay tax on all of those funds in a few years and the stretch IRA opportunity would be lost.

For non-spouse plan beneficiaries, this is by far the biggest and best part of the new law. This single provision could have a multi-billion dollar effect on non-spouse plan beneficiaries who can now stretch inherited company plan funds in an inherited IRA over their lifetimes. But be careful. This has to be done correctly or else the benefit will be lost and the inherited funds will be immediately taxable.

For one, this does not change the rule that a non-spouse beneficiary cannot do a rollover. They still cannot do that. The transfer from the plan, although technically called a “rollover,” must be a direct transfer (a direct rollover is also called a trustee-to-trustee transfer where the beneficiary never touches the inherited funds) or all bets are off. If a check is issued directly to the non-spouse beneficiary in his or her name, that is a rollover and the entire amount of the distribution will be immediately taxable because a non-spouse beneficiary cannot a rollover. The transfer must go directly from the 401(k) or other plan to the properly titled inherited IRA. If it goes to the non-spouse beneficiary’s own IRA or to a non-IRA account by accident, the distribution is taxable and the new law will not help preserve the stretch IRA. Inheritors and financial advisors must be extra careful here to make sure that all transfers under this provision are done exactly right. The direct transfer must go to a properly titled inherited IRA, which means the inherited IRA must be maintained in the named of the deceased plan participant “Dad IRA (Deceased February 10, 2007) FBO, son”.

New IRA Trust Opportunities

This provision also applies to trusts, meaning that the transfer from the plan will work when a trust is named as the beneficiary of the company plan. Of course the trust must meet all the regular IRS requirements for a see-through trust in order to maintain the stretch IRA. A properly titled inherited IRA must still be set up though to receive the transfer from the plan and then required minimum distributions will be paid from the inherited IRA to the trust.

Tax Refunds can go to IRAs

Beginning with 2007 tax forms (for tax year 2006) you can direct that part or all of your tax refund can go directly to your IRA or Roth IRA so your annual IRA contribution will be made instantly. You no longer have to wait for your refund and then make your IRA contribution.

Charitable IRA Rollovers

(Qualified Charitable Distributions)

Up until the end of 2007 if you are charitably inclined and wish to give some of your IRA funds to a charity, you can withdraw up to $100,000 from your IRA tax free and give it to a charity. You receive no tax deduction but also do not have to report the income. A tax infested IRA is the best asset to give to a charity. This new provision allowing Qualified Charitable Distributions only applies though to IRA owners age 70 ½ and over and only applies to outright IRA gifts to charities and not gifts made to grant making foundations, donor advised funds or charitable gift annuities. Better move fast on this one since, unlike the other provisions of this Act, this one expires after 2007.

The big incentive here is that the charitable donation from your IRA will satisfy your required minimum distribution. You won\'t have to pay tax on the amount of your required distribution that you give to charity. This can lower your income and maybe even cut down the tax you pay on Social Security income, not to mention the loss of tax deductions, exemptions and tax credits that are lost when your income is increased. So, if you normally make donations anyway, you should now make those donations from your IRA and reduce your income.

This provision is especially good for those who do not itemize their deductions (they take a standard deduction) and would not normally be able to deduct gifts to charity (unless the donations were large enough to qualify for itemizing deductions). By not having to report the income from the IRA distribution, you effectively receive a deduction that would not otherwise have been available to you.

There’s a technicality here though and financial institutions will have to gear up for it quickly so that your contribution qualifies. Under this provision, the donation must be made DIRECTLY from your IRA to a charity without you or anyone else touching the money in between.

The only way this can be done, especially if you want to use this provision for making regular gifts from your IRA, is to have an IRA checkbook, which most people do not have.

But an IRA checkbook in the wrong hands could be dangerous. If you end up taking the wrong checkbook to the supermarket, your groceries will cost a heck of lot more than you thought when you end up paying tax on the amount distributed. Also, since this provision ends after 2007, I wonder if the banks and other IRA institutions will put a huge investment into offering IRA checkbooks and dealing with the related administration, questions and problems from customers who made mistakes with their IRA checks.

If there is no IRA checkbook, then the bank would have to make direct transfers from your IRA to a charity. They might do that for occasional large gifts, but will they do that for the everyday $10 and $25 gifts? We\'ll have to see how the financial institutions react to this and their reaction time will have to be quick, since unlike many other provisions in this law, this one is effective immediately.

Roth Conversions Directly from Company Plans

Beginning in 2008 , you can convert company plan funds (like your 401(k) money) directly to a Roth IRA. The new law eliminates the current two step process of moving plan funds into a Roth IRA. You still pay tax on the funds converted (except for after-tax plan contributions). This can create a tax loophole allowing you to by-pass the pro-rata rule that applies when you distribute after tax funds from an IRA. Under the new law the 401(k) funds never go to an IRA, but instead go directly to a Roth IRA. If the plan allows a partial distribution of only after tax funds, they can all be converted tax free. If the plan issues separate checks for the pre-tax and after-tax plan funds, then the pre-tax funds can be rolled to an IRA while the after-tax funds can be converted directly to a Roth IRA, tax free, by-passing the pro-rata rule.

Of course, you still must qualify for the Roth conversion, but remember that under the TIPRA legislation (The Tax Increase Prevention and Reconciliation Act, signed into law on May 17, 2006) beginning in 2010 everyone qualifies for a Roth IRA conversion.

Plan distribution rules have not changed. You cannot take a plan distribution any time you wish. The plan must allow it. Some plans allow in-service distributions which under the new law would be allowed to be converted directly to a Roth IRA.

Key Retirement Plan Provisions of EGTRRA 2001 are Made Permanent

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001) gave us many retirement tax and portability provisions that we are already taking for granted as if they would be here forever, but that was never the case. All of these items like everything else in EGTRRA 2001 were slated to be repealed after 2010. The Pension Protection Act of 2006 (PPA 2006) makes many of the best retirement provisions permanent. For example, increases in the basic IRA contribution limits would have been eventually rolled back to the $2,000 a year levels of 2001 if not for PPA 2006. Most people have been figuring on IRA contributions of $4,000 or $5,000 a year into their retirement funding having no idea this was set to be scaled back. But now their plan might just work out the way they thought. Thank goodness they don’t have to re-do their 30 year Excel spreadsheets!

Not all of the EGTRRA 2001 tax provisions were made permanent. For example, the temporary repeal of the estate tax for 2010 and the increased estate tax exemptions are not repealed. Those exemptions if not changed by future legislation will revert back to 2001 amounts, meaning that in 2011, the estate exemption would go back down to $1 million per person and really mess with people’s estate plans.

 

Look for more details in “Ed Slott’s IRA Advisor”

By Ed Slott © 2006

Ed Slott’s IRA Advisor 

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email: Ed Slott
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Ref: Alert PPA 2006 ml

August 16, 2006