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The Pension Protection Act of 2006

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September 2006
The Pension Protection Act of 2006

How this new law affects you

In August, Congress passed and the President signed into law the most comprehensive changes to retirement legislation in 30 years. Much of the 1,000-page law deals with helping companies shore up their pension plans, but there are several important changes that affect investors who are saving for retirement in IRAs and 401(k)s, and for college in 529 savings plans. The following is a summary of some principal provisions. For greater detail, and to find out how the law affects your situation, you should consult your financial representative or tax advisor.

IRA contribution limits are here to stay

In 2001, the Economic Growth and Tax Relief Reconciliation Act established a schedule that gradually increased the amount you could contribute to your IRA each year (the current contribution limit of $4,000 rises to $5,000 in 2008, and is adjusted for inflation after that). The old rules also established "catch-up" contributions that enable people age 50 and older to contribute an extra $1,000 annually. However, these higher limits were temporary and set to "sunset" in 2010 unless extended by Congress.

And that's exactly what the Pension Protection Act of 2006 does, making permanent the contribution limits that will be in place by 2008. Moreover, the amount you can save in an IRA will be periodically adjusted upward based on the rising cost of living.

IRA contribution limits

Traditional Roth

2006-2007 $4,000 $4,000

2008 and beyond* $5,000 $5,000

Catch-up contribution $1,000 $1,000

* Adjusted upward periodically for inflation.

Significantly, the income limits affecting whether contributions to Traditional IRAs are deductible, and whether contributions to Roth IRAs can be made, are also indexed to inflation under the new law. Beginning in 2007, those limits will increase periodically for inflation in $1,000 increments.

As a reminder, Traditional IRAs allow you to deduct the amount of your contribution under certain circumstances, but your contributions and earnings are taxable when you withdraw them in retirement. Roth IRAs offer no deductions, but earnings are tax free when withdrawn in retirement.

Along with the increase in IRA contribution amounts, the Pension Protection Act makes permanent the higher contribution levels for other retirement plans, including 401(k) plans, SEP IRAs, and SIMPLE IRAs.

529 savings plans stay tax free

Like IRAs, 529 college savings plans received certain perks under the 2001 law that were set to expire in 2010, the most important of which was that withdrawals for qualified higher education expenses were federal income tax free. These popular plans enable parents and other family members to put away money on behalf of a child, and that money accumulates tax free. The accounts typically can be used to pay for tuition and other college expenses anywhere in the country, and unlike UGMA accounts, they do not automatically transfer to the beneficiary when he or she reaches age 18.

The Pension Protection Act of 2006 makes the federal income-tax-free treatment of qualified distributions from 529 accounts permanent. That's good news for parents who were hesitant to open 529 plans in fear that the perks were going to disappear.

Some current features of 529 plans extended under the new law

Other beneficial features that were set to expire in 2010 are also extended indefinitely, allowing these plans to remain a truly powerful way to save for education.

? Federal income-tax-free withdrawals for qualified education expenses

? Assets in one state's 529 plan may be rolled over into a different 529 plan tax free, subject to a 12-month waiting period between rollovers, without changing the beneficiary

? Ability to include first cousins as "family members" for the purposes of rollovers and beneficiary changes

? Expansion of "qualified expenses" to include offcampus room and board

? Ability to make contributions to both a Coverdell Education Savings Account and a 529 plan in the same year for the same beneficiary

New: Direct rollover to a Roth IRA

The new law also fixes a quirk in the 2001 Tax Act, which stipulated that if you rolled money out of your employer retirement plan and wanted to invest in a Roth, you had to first roll your account into a Traditional IRA. Only IRA money could roll into a Roth IRA.

No longer. Beginning in 2008, when you leave your job or retire, you can roll your employer retirement plan money directly into a Roth IRA. Bear in mind that moving 401(k) money into a Roth IRA requires you to pay federal income taxes on the pre-tax contributions and earnings you've built up in the 401(k). The benefit of this one-time tax bill is that your account is thereafter free to accumulate in the Roth IRA without federal income taxes. Also, there is currently an income restriction on who can roll over to a Roth, which prevents anyone who earns over $100,000 in modified adjusted gross income from converting to a Roth IRA. However, starting in 2010, the $100,000 rollover ceiling will also disappear. At that point, anyone can convert money from a 401(k) plan or Traditional IRA to a Roth IRA, regardless of their income.

Non-spouse beneficiaries of 401(k) plans now have more options

The Pension Protection Act provides new options for people who are listed as the beneficiaries of 401(k)s but who are not married to the 401(k) owner. Under the old rules, when a 401(k) account owner died and the beneficiary was not a spouse, that beneficiary was not permitted to roll over the 401(k) balance. So the beneficiary either had to take a taxable distribution or maintain the 401(k) account subject to the rules of the 401(k) plan. Even then, in some cases, the 401(k) plan would require the non-spouse beneficiary to withdraw the entire balance (and pay taxes) within one year.

The new law gives non-spouse beneficiaries an important new option: roll the balance over into an IRA. The rollover IRA is then treated as an inherited IRA. That is, the beneficiary must take required minimum distributions over his or her life expectancy (or the employee's life expectancy, if longer), just as if the beneficiary had inherited the IRA rather than a 401(k) account. If the beneficiary is relatively young, the amount that must be withdrawn each year will be relatively small, leaving the bulk of the account to compound tax deferred over time. Moreover, the beneficiary may choose an IRA with investment options or other features that may not have been available in the 401(k) plan.

Other changes affecting your retirement accounts

Automatic enrollment into 401(k) plans

In a clear effort to encourage retirement savings among workers, the Pension Protection Act offers new benefits and protections for employers who automatically enrol new employees into 401(k) plans. In addition, the new law will give employers fiduciary protection for "default investments" under regulations to be issued by the Department of Labor. These new rules are expected to enable employers, for example, to choose diversified portfolios for those employees who are automatically enrolled (and do not make their own investment elections), rather than money-market securities, which historically have been safe investments, but may not have grown sufficiently to meet retirement needs. Beginning in 2008, plans can also avoid certain testing requirements if specific safe harbor guidelines are met.

Advice available within ERISA-qualified retirement plans

The law allows financial advice to be provided to plan participants if:

? Any fees associated with the advice do not vary depending on the investment choices available to the participants, or

? The recommendations are based on a computer model certified by an independent third party

In addition, the investment advice program must be audited annually and the advisor must provide extensive disclosure on fees and any potential conflicts of interest. Numerous other requirements also apply.

Restrictions on company stock investments

In response to industry events, plans that offer employer stock as an investment option must meet certain diversification requirements. Beginning in 2007, participants must be able to diversify their contributions that are currently invested in employer stock if certain requirements have been met. Additionally, plans with company stock must offer at least three diversified investment options outside of that company stock, each with different investment objectives and risk/reward attributes.

Saver's Tax Credit extended

The new law extends the Saver's Tax Credit, which had been scheduled to expire in 2006. Depending on their adjusted gross income, certain taxpayers are eligible to claim a tax credit for contributions made to an IRA or an employer-sponsored retirement plan. The maximum credit that can be applied is $1,000 for an individual or $2,000 for a couple filing jointly.

Tax-free charitable donations from IRAs

In 2006 and 2007, IRA owners over age 70 may make charitable contributions of up to $100,000 directly from an IRA with no tax consequences. Previously, these contributions would be considered taxable distributions out of the IRA account. This provision offers some additional estate-planning alternatives to retirees.

Your financial representative can help

Altogether, the Pension Protection Act of 2006 is a giant step forward for retirement and college savers. There are many more provisions than are listed here, and the best way to find out how they affect you is to talk to your financial representative. He or she can discuss the changes in the new law and how you can take advantage of them today as you prepare for a secure financial future.

courtesy of

Putnam Investments


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