New Pension Law: Tax Incentives for Retirement and College Savings Are Now Permanent

New Pension Law: Tax Incentives for Retirement and College Savings Are Now Permanent

The Pension Protection Act of 2006 goes far beyond what its title suggests. In addition to strengthening traditional corporate pensions, the sweeping new law extends welcome tax breaks to individuals saving for retirement and college expenses. Thanks to the elimination, in some instances, of the "sunset" provision contained in the old tax law, it also makes planning easier.

Incentives Made Permanent. In what will be a relief for just about every investor, the new law permanently extends some provisions originally enacted in 2001 that had been slated to expire after December 31, 2010.

Among them:
  • The increased contribution limits on both IRAs and employer-sponsored retirement plans, such as 401(k) plans
  • Catch-up contributions that workers aged 50 and older can make to IRAs and some employer-sponsored plans
  • Federally tax-free withdrawals from state-sponsored 529 college savings plans when used for qualified education expenses
  • These changes can make a significant difference in the amount of funds that may be accumulated over time on a tax-advantaged basis and earmarked for retirement or college. For example, the annual contribution maximum for an IRA has increased from $2,000 in 2001 to $4,000 for 2006 and 2007 and $5,000 for 2008, after which it will be adjusted annually to reflect inflation. If the new law had not removed the 2010 sunset date, the maximum annual contribution to an IRA would have reverted to $2,000 starting in 2011.
Additional Benefits. The Pension Protection Act includes other changes that affect several aspects of financial planning. For example, taxpayers for the first time will be able to elect to have some or all of their federal income tax refund deposited directly into an IRA.

The new law makes a further change in IRA rules with implications for estate planning. It allows non-spousal beneficiaries to roll inherited qualified retirement plans or IRA proceeds into their own IRA, enabling them to preserve the assets' tax-deferred status. Previously, this benefit was allowed only for spousal beneficiaries.

The Act also offers a special planning opportunity that will appeal to many charitable-minded investors, as well as their chosen charities. It allows distributions from traditional IRAs and Roth IRAs to be donated tax free to charities through December 31, 2007, provided that the holder of the IRA has reached age 70. The maximum annual amount that can be donated is $100,000.

New Rules and Opportunities. As with any major piece of tax legislation, the Pension Protection Act has more provisions and details buried within its 900-plus pages than can be covered in a brief article. For example, if you are covered by a traditional pension plan, you may have specific questions about the Act that you may want to ask your plan administrator. Or, if you have been waiting for your employer to make available a Roth-style option in its 401(k) plan, the new legislation may hasten that day. That could happen because the law permanently extends provisions for Roth 401(k) plans, which had been scheduled to expire at the end of 2010. Legislation in 2001 created the Roth 401(k), which first became available in 2006. It gives employers the opportunity to offer plan participants the ability to make after-tax contributions to their 401(k) accounts and then make qualified withdrawals that are tax free. Because of the far-reaching scope of the new law, consider scheduling a meeting with your advisor to discuss how specific rules and opportunities provided by the legislation could affect your planning and strategies.