What you need to know about the Pension Protection Act of 2006
Posted Tuesday, January 16th 2007
Abstract: With its stated goal to strengthen pension funding, the Pension Protection Act of 2006 introduces many changes to the benefits landscape. The act simplifies rules regarding defined benefit plans, brings forth important laws affecting defined contribution plans and makes permanent laws passed under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). This article takes a closer look at the act.
Tax law update
Defined benefit plan implications
Most of the act focuses on defined benefit pension plans. Some of the more important issues addressed are:
Underfunding.Many pensions lack the appropriate balance to ensure there will be enough money available to meet future retirement needs. This is known as "underfunding.”
Beginning in 2008, the act requires pension plans to become fully funded over a seven-year period. Employers with defined benefit plans will be able to deduct the additional cost of these contributions. Companies that don’t correct the plan funding deficiencies will face a 10% excise tax.
Minimum funding.The act replaces minimum funding for defined benefit pension plans with one actuarially based minimum funding calculation. The new regulations use specific requirements to establish interest rates and mortality tables.
Additionally, if a plan with more than 100 participants has a funding shortfall in the previous year, the regulations require quarterly contributions.
At-risk plans.Defined benefit plans that are "at risk” (generally less than 80% funded) will require additional actuarial assumptions providing more aggressive benefits for employees close to retirement or those opting for the most valuable payment option under the plan.
Plans in at-risk status may be subject to negative tax consequences if they set aside amounts for nonqualified deferred compensation plans or the employer is in bankruptcy.
Phased retirement.There is also a "phased retirement” provision that will allow for in-service distributions to a participant who has reached age 62 — even if the plan’s normal retirement age is greater than age 62.
Defined contribution plan implications
The act also addresses defined contribution plans. Some notable highlights are:
Automatic enrollment.Employers aren’t required to have an automatic enrollment feature. But if a plan chooses to have one, it must make the election before the beginning of the plan year. The act overrides any state laws that prohibit automatic enrollments.
Defined contribution plans that allow for automatic enrollment will have a longer time to perform some substantial discrimination testing. The annual deferral percentage (ADP) and annual contribution percentage (ACP) testing, which ensures that deferral and matching contributions don’t discriminate in favor of highly compensated employees, will have a six-month deadline after the plan year end, replacing the existing 2½ month deadline.
The automatic enrollment feature will provide additional safe harbors in 2008 if certain employer contributions are funded. Plans that meet specific, statutory matching and vesting requirements will automatically pass the ADP/ACP test and be deemed to meet top-heavy requirements.
Plans must meet a notice requirement to employees to initiate this safe harbor. Employees must elect within 90 days of implementation of the safe harbor to not participate in the plan, and the plan must distribute all elective deferrals made into the plan on the employee’s behalf.
The plan must pay out these "erroneous contributions” by April 15 of the following year. These amounts aren’t included in the discrimination test or subject to a 10% penalty and are treated as compensation.
Combined defined benefit and defined contribution plan.The act permits a new plan that has both 401(k) components (defined contribution) and defined benefit components. Each component is subject to the tax rules applicable to these types of designs. Employers with fewer than 500 employees are eligible for these plans.
Provided that specific safe harbors are met for both the defined contribution and defined benefit portions, the ADP/ACP test will be deemed satisfied and the plan will be deemed as meeting the top-heavy requirements. The plan will be considered a single plan for tax filing purposes. These new plans will take effect starting in 2010.
Something for everyone
With the new act in place, participants in various types of tax-deferred retirement vehicles will continue to gain more stride in ensuring a secure retirement. Contact your plan provider or sponsor for more information on how your plan is affected.
Sidebar: Give me a (tax) break
The Pension Protection Act of 2006 covers many tax issues. A few important points include:
Employer bankruptcy protection for employees.If an employee has at least 50% of his or her matching contributions invested in employer stock, and the employer goes bankrupt, the employee will have the right to make additional IRA contributions of three times the normal deduction limit. These catch-up IRA contributions can be made only in 2007, 2008 and 2009.
Rollovers from qualified plans to Roth IRAs.Beginning in 2008, participants can directly roll over qualified plan distributions to a Roth IRA instead of a traditional IRA. These rollovers are subject to the Roth IRA conversion rules.
Nonspouse rollover rights.A new provision allows nonspouse beneficiaries to roll over assets inherited from a qualified plan into an IRA without tax implications. Previously tax relief was available only for people who inherited an IRA from a spouse.
Roth 401(k) feature preservation. The act removes the 2010 sunset provision of the Roth 401(k) feature in 401(k) and 403(b) plans. The new law also permanently allows the Retirement Savings Tax Credit, which would have expired at the end of 2006.
These are just some of the many tax changes made by the act. Consult your benefits advisor for more details.
