Pension Reform - 2006
General Business News
Pension Reform - 2006
Most of us tend to think of "pensions" in terms of the traditional system where an employer guarantees a set lifetime income for retired employees. Over time, however, the term pension has become synonymous with the broader term "retirement plan," which includes Individual Retirement Accounts, 401(k) Accounts, and numerous other "qualified" retirement plans. It is because of this broad definition that the PPA will affect anyone who has set aside tax-deferred savings in the form of retirement accounts, but most of the changes are directed at employers.
Some Good News for Individuals
If youve worked hard and built up a sizable estate that includes substantial IRAs, someday you will be required to withdraw taxable income from them. Put another way, at some point you will pay tax on your IRAs.
What if you dont need the money and prefer to give it to a charity? Under current law, you must first withdraw taxable income from the IRA and then take an itemized charitable deduction. This can be particularly distasteful if part of that deduction is lost because your income is too high.
The PPA allows you to give up to $100,000 annually from your IRA to a charitable organization without incurring income taxes. Of course, you wont be able to deduct the donation since the withdrawal is not included in income.
Until the PPA was enacted, a number of provisions in tax laws were set to expire in the near future. Many of these have now been made permanent. Some, but certainly not all, of the permanent provisions include:
- Increased limits on additions to a defined contribution plan of $40,000 and indexed for changes in the cost of living ($44,000 for 2006);
- "Catch-up" contributions in excess of elective deferral limits for individuals over age 50;
- Individuals can contribute up to 100% of their salaries to 403(b), government and 401(k) plans;
- Higher limits on deductible IRA contributions.
According to the House Committee on Education & the Workforce, "Without comprehensive reform to fix outdated federal pension laws, more companies will default on their worker pension plans - increasing the likelihood of a multi-billion dollar taxpayer bailout - and more companies will stop providing defined benefit pension plans." This is the philosophy at the heart of the PPA.
To meet the goals of stabilizing the countrys pension systems and encourage continued employer support for defined benefit pension plans, the PPA includes both incentives and penalties related to everything from funding to reporting issues. The provisions of the PPA affect not only qualified plans, but also non-qualified deferred compensation plans that have been used to sweeten benefits packages of executives.
Whether a plan is fully funded or not depends on assumptions about an employers workforce and future investment earnings. To help employers determine proper funding amounts, the PPA provides for a uniform method of determining the appropriate interest rates for valuing plan liabilities and assets. Using three interest rates based on high quality corporate bonds, the so-called modified yield curve approach will include interest components that are matched to the timing of future benefits.
The three rates used for the modified yield curve approach will also be required when calculating a lump sum distribution to separated participants. Previously, the required rate was the 30-year treasury rate, which is lower than corporate borrowing rates and, as a result, caused higher lump sum payouts.
Of course, another measure of a plans funding status is the value of its assets. In the past, if a plan was underfunded, employers were able to make up that shortfall over an extended period of time. The PPA dramatically shortens the time employers will have to fully fund them, but also increases the amount an employer will be able to deduct for tax purposes.
As an "incentive" for employers with underfunded plans to meet target funding rates, the new law provides a penalty for public companies who fund benefits under a nonqualified deferred compensation plan, if the companys defined benefit plan is underfunded. In general, where a plan is classified "at-risk," as defined in the law, assets transferred into a trust to provide funding for nonqualified deferred compensation will become immediately taxable to the employee benefiting from them and subject to a 20% penalty.
With respect to defined contribution plans, the new law provides several mechanisms to encourage greater participation by employees and reduce the complex testing requirements designed to prevent discrimination against non-key employees.
To encourage participation, the PPA allows plan provisions that will automatically enroll employees in defined contribution plans. If an employee does not wish to participate, he or she must opt out of the plan. As long as the employer meets the matching and contribution requirements set forth in the PPA, they will be able to avoid certain tests that may limit deferrals of higher paid employees. This will be attractive to small employers who have been unable to make the maximum allowable contributions in the past.
Employees who have participated in self-directed defined contribution plans in the past are well aware that plan sponsors and fiduciaries are not allowed to give investment advice. For higher paid employees who can afford outside advice, this did not create a problem, but some rank and file workers found making decisions about investment options overwhelming. The PPA will allow fiduciaries to offer investment advice to plan participants as long as certain disclosure requirements, fee arrangements and investment options are met.
The retirement savings lost by Enron employees who invested primarily in employer stock prompted several provisions of the new law. To begin with, employees will now have greater control over diversifying their savings when contributions include employer stock. Additionally, unless certain criteria are met, fiduciaries will lose the protections they previously enjoyed when employees were unable to direct their investments.
The PPA requires that participants in single and multi-employer pension plans be notified of the value of its assets and liabilities, its funded status, and various other key indices of its health within 90 days of the plans year-end. Multi-employer plans will also be required to provide employers and labor organizations certain information within 30 days of any request.
The principal source of information for private pension plans is Form 5500, which is required to be filed annually and provides for increased disclosure.
Disclosures to employees in defined contribution plans will also be enhanced to allow them to better determine the performance of their plans and their options to enhance their retirement savings.
The Pension Protection Act of 2006 aims to address deficiencies in todays pension and retirement savings plans for American workers. This article touches on only a few provisions of the PPA, which become effective at varying times. If your business is currently a plan sponsor or considering adopting a retirement plan for your workers, the only safe option is to contact qualified advisors who will be able to help you navigate the maze of rules and regulations applicable to them.
Have a great September!
These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.