More Tax Law Reform

On August 17th, President Bush signed the Pension Protection Act of 2006.  This massive new law aims to strengthen our traditional pension system as well as improving over 20 retirement tax-savings benefits. Like many pieces of legislation, it also contains other diverse topics such as recordkeeping rules for charitable contributions.  We have highlighted those provisions that have the greatest impact on our clients. 

§529 Plans:  Sunset Provisions No Longer a Concern
The popular §529 college savings vehicle has had one of its most attractive features protected by the Pension Protection Act. 

§529 plans enable families to invest tax free for qualified higher education expenses for their children. Kochis Fitz has recommended these plans for many clients to assist their children and/or grandchildren.  The tax benefits are attractive not only because plan assets are withdrawn tax free for qualified higher education expenses, but account owners can aggregate five years of gifts ($12,000 in 2006 for an individual or $24,000 for a couple) into one gift-tax free lump sum contribution.  Thus, an individual could contribute up to $60,000 ($120,000 for a couple), in 2006 to a §529 plan, without incurring a gift tax. 

However, under its initial legislation, the benefit of tax free withdrawal from §529 plans was scheduled to sunset, or expire, after 2010.  At that point, investment gains within the distributions from these plans would have become taxable at the tax rate of the plan beneficiaries. The Pension Protection Act now makes eligible withdrawals tax free permanently.

Some states (notably New York and Connecticut) offer a small state-tax deduction when assets are invested in a §529 plan.  Unfortunately, California does not yet offer any state-tax benefit (no deduction and all distributed investment gains are taxable).  Kochis Fitz regularly monitors the plans offered by California and by other states to seek out those plans that offer both competitive pricing, in the form of low fee structure, and superior investment alternatives.  One needn’t be a resident of a particular state to use that state’s plan.

Charitable IRA Distributions
For the remainder of 2006 and all of 2007, clients over the age of 70 ½ will be eligible to make charitable gifts directly from their IRA without realizing income on the distribution.  Gifts must be transferred directly from an IRA (neither a SEP nor a SIMPLE IRA qualify) to a public charity (not a donor advised fund, private foundation or supporting organization) and are limited to $100,000 in each of 2006 and 2007.  There is no tax deduction, but there is no tax on the amount of the IRA distribution that is given to charity.

These charitable IRA distributions count toward the minimum required distribution (MRD) so this is an attractive way for clients to meet charitable goals and avoid realizing otherwise mandatory taxable income.  If the IRA has basis (from prior after-tax IRA contributions), the basis stays with the IRA.

Optimal charitable gift planning will usually limit the amount of this gift to an individual’s MRD, even if that is less than $100,000.  Preserving the tax deferral benefits of the IRA (by limiting any withdrawal to the minimum required) and making any intended further charitable gitfs by transfers of highly appreciated assets will usually combine to achieve the best overall results.  We of course stand ready to advise you based on the specfics of your IRA and portfolio circumstances and your specific charitable objectives.

Qualified Retirement Plan to Roth Rollover
Beginning January 1, 2008 clients can transfer their qualified retirement plan directly to a Roth IRA, but must pay tax on that transfer (see our 2nd Quarter 2006 Wealth Management Commentary for more on Roth conversion).  Until then, clients must first transfer their qualified retirement plans to a “Rollover IRA” and subsequently to a Roth IRA, if eligible.   As we discussed in our last Wealth Management Commentary, until 2010, Roth conversions are limited to individuals or couples with adjusted gross income less than $100,000; married couples filing separately are prohibited from converting.  Beginning in 2010, these income limitations go away.  An added benefit is that half of the income realized from a 2010 Roth conversion can be counted on the 2010 tax return and the other half deferred to the 2011 tax return.

Higher Eligible Contributions Now Permanent

• Higher dollar limits on defined contribution plans ($44,000 in 2006); elective deferrals on 401(k) and 457 plans ($15,000)
• Cost-of-living adjustments for IRA contributions ($4,000 in 2006 and $5,000 in 2008)
• Cost-of-living increases in annual benefit limits under a defined benefit plan ($175,000 in 2006)
• Individuals over age 50 can continue to make additional “catch-up” contributions  ($5,000 for 401(k)s and $1,000 for IRAs)
• Limitation on deductible contributions to profit-sharing plans increased to 25% of compensation

Private Foundations:  New Excise Tax Rules
The Act expands the base of net investment income that will be subject to a 1% or 2% excise tax, and specifically includes realized capital gains.  Additionally, the penalty tax for failure to distribute required amounts has been increased from 15% to 30% of the undistributed amount.

Non-Spouse Beneficiaries
Non-spouse beneficiaries (parents, siblings, children, domestic partners, etc.) can rollover a distribution from a decedent’s qualified plan into an IRA after December 31, 2006 and stretch out distributions over their life expectancy. This law eliminates the previous common situation where company plans required an immediate lump sum distribution with accompanying immediate taxes.  Required minimum distributions are governed by the rules that apply to inherited IRAs.  

Roth 401(k) and Automatic 401(k) Enrollment
In the 4th Quarter 2005 Wealth Management Commentary we reported on a new type of 401(k) plan, called the Roth 401(k) which, like Roth IRAs, allows participants to save after-tax dollars and then enjoy tax-free growth.  At the time, few employers were adopting this new 401(k) because they were scheduled to "sunset" in 2010.  The Pension Protection Act removes the sunset and, consequently, we expect that many more employers will begin to add the Roth feature to their 401(k) plans.  Contact your client service team if your employer adds a Roth feature, as it could have important tax-diversification and estate planning benefits.

While probably of little direct impact for our clients, but possibly for their children just beginning their working careers and almost certainly for society as a whole, employers can now automatically enroll employees into company 401(k) plans.  While employees can “opt-out”, actual participation will probably increase.  Many of our clients will indirectly benefit as well since this would increase the likelihood that 401(k) plans will meet “discrimination testing” and allow highly compensated employees to contribute the maximum amount to their 401(k) plans. 

Charitable Gifts and Required Record Keeping
All cash contributions, regardless of amount, must be kept in the form of a bank record, cancelled check or written communication from the donor showing the name of the donee organization, date of contribution and the amount.
Contributions of clothing or household items must be in good condition or better and any single such item valued at over $5,000 must carry a qualified appraisal.  The cost of acquiring such an appraisal clearly discourages any large contributions of this kind of property. 

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