In August 2006, Congress passed and President Bush signed the Pension Protection Act of 2006. Although the Pension Protection Act has not received much media attention, it includes many important tax changes that will affect individuals, employers, businesses in general, and charitable organizations. Many of the changes have nothing to do with retirement plans, even though the Act’s stated purpose is to shore up traditional defined benefit pension plans so as to avoid the need for future taxpayer-funded bailouts. This article summarizes what we think are the key points in the new law, starting with the ones most likely to affect small businesses and individuals.

Favorable rules made permanent. A 2001 law, the Economic Growth and Tax Relief Reconciliation, made many favorable changes to help out retirement savers. The most important provisions allow for bigger annual IRA and retirement plan contributions, additional contributions for those who are age 50 and older, and expanded opportunities to arrange for tax-free rollovers between retirement plans and accounts. However, all the favorable changes were scheduled to “sunset” – i.e., expire – after 2010, and the less favorable old rules would have been reinstated for 2011 and later years.

The Pension Protection Act makes permanent all of the taxpayer-friendly changes in the 2001 legislation by repealing the sunset provisions. One will no longer have to be concerned about rules from the “bad old days” kicking in for 2011 and beyond. Therefore, these provisions confirm that today’s planning will not need to be overhauled in a few years for reasons due solely to tax law sunset provisions.

Phase-out ranges for IRA and Roth IRA contributions indexed for inflation. For 2007 and later years, the new law attaches inflation adjustments to the income-based phase-out ranges that limit contributions to traditional IRAs and Roth IRAs. The new inflation-adjusted phase-out ranges should allow more individuals to continue to benefit from these accounts.

Non-spouse beneficiaries can roll over distributions from a deceased person’s retirement plan. Starting in 2007, the Act permits tax-free rollovers of direct trustee-to-trustee transfers from a deceased person’s IRA or retirement plan to a non-spouse beneficiary’s IRA. The same tax-free rollover privilege will be available for trustee-to-trustee transfers from tax-sheltered annuity arrangements and governmental Section 457 plans to a non-spousal beneficiary’s IRA. Under prior law, only surviving spouses were able to take advantage of the tax-free rollover privilege.

Note: This new rule doesn’t kick in until 2007. If you expect to receive funds from an inherited retirement account and you’d like to roll them over to an IRA, you’ll want to wait until 2007. Also, cash distributions apparently will not qualify for this new rule. Therefore, it will be important to arrange for a trustee-to-trustee transfer of funds. Finally, a new IRA will need to be established to receive the funds; they should not be commingled with an existing IRA, since the new account will have different distribution rules. Please give us a call if you have this situation and would like our help.

IRA direct deposits of tax refunds. Starting in 2007, you will be able to arrange to have all or part of your federal income tax refund direct deposited into your IRA (and/or your spouse’s IRA if you file jointly).

More opportunities to rollover after-tax contributions. Starting in 2007, you will be able to rollover after-tax contributions from a qualified retirement plan into a receiving defined benefit plan or a receiving tax-sheltered annuity arrangement.

Direct rollovers allowed from retirement plans into Roth IRAs. Starting in 2008, eligible individuals will be able to arrange for “Roth IRA conversation transactions,” i.e., direct rollovers of distributions from qualified retirement plans, tax-sheltered annuities, and governmental Section 457 plans into Roth IRAs. (Any previously tax-deferred portions of the transferred balances must be recognized in taxable income.) For 2008 and 2009, only individuals with modified adjusted gross incomes of $100,000 or less are eligible for Roth IRA conversions. For 2010 and beyond, however, the $100,000 limitation is scheduled to disappear.

Breaks for military reservists. The Pension Protection Act includes favorable new rules for early retirement account withdrawals taken by qualified military reservists. These beneficial new rules potentially apply retroactively to amounts withdrawn after September 11, 2001, by reservists who were under age 59½ at the time of the withdrawal. If taking advantage of these provisions would reduce your tax bill from a prior year, you may need to take quick action to obtain a refund.

Favorable rules for Section 529 plans made permanent. The Pension Protection Act makes permanent the current ultra-favorable federal income tax treatment of Section 529 plans used to finance college education costs. Of particular importance, qualified Section 529 plan distributions (distributions used for qualified higher education expenses) will continue to be federal income tax free, even after 2010. Previously, these distributions would have been taxable if made after 2010.

Note: This eliminates the concern regarding taxation of funds distributed after 2010, when many 529 plan beneficiaries would be in college and withdrawing the plan assets for educational expenses. If you haven’t previously taken advantage of these plans, it may be time to reconsider them.

Changes affecting charitable donations and charities. The Pension Protection Act includes numerous changes affecting the tax treatment of donations to tax-exempt charitable organizations as well as other provisions that affect charities themselves. Following are highlights of the more important changes.

• Tighter rules for cash donations under $250. The Act completely disallows any deduction for a charitable donation of cash, a check or any other monetary gift unless you have either a bank record (such as a cancelled check) or a written communication from the charity that adequately documents your donation. This minor, zero-tolerance provision is effective for tax years beginning after the new law’s date of enactment.

• Tighter rules for donations of used clothing and household items. The Act completely disallows deductions for contributions of household items that are not in good condition and – read carefully here – used clothing “that has minimal monetary value, such as used socks and used undergarments.”

• Temporary allowance of donations directly out of IRAs. The Act allows persons age 70½ or older to claim tax-free treatment for otherwise taxable distributions from traditional or Roth IRAs in cases where the IRA money is paid out directly to a tax-exempt charity. This favorable new rule for “qualified charitable distributions” applies for 2006 and 2007. However, there is a $100,000 annual cap on the privilege. A qualified charitable distribution does not result in a federal income tax deduction. However, tax-free treatment for the distribution is effectively the same as a 100% write-off. The new rule benefits seniors who don’t itemize and seniors who would be adversely affected by the normal restrictions on itemized charitable contribution deductions.

• Extension of enhanced deduction for donated food inventories and book donations by C corporations. The 2005 Katrina Emergency Tax Relief Act established a temporary enhanced charitable deduction for non-C corporation businesses that made charitable contributions of food inventories on or after August 28, 2005, through December 31, 2005. The Katrina Act also created an enhanced deduction for contributions of books by C corporations for qualified donations made during the range of dates mentioned above. The Pension Protection Act extends both of these favorable provisions through December 31, 2007.

• Temporary liberalizations for qualified conservation contributions. The Pension Protection Act liberalizes the rules for “qualified conservation contributions” made in 2006 and 2007 by individuals and private corporations to charitable organizations. Qualified conservation contributions in excess of what can be currently deducted can be carried forward for up to 15 years.

Defined benefit plans. Shoring up the financial strength of existing defined benefit pension plans of large employers was the main reason for enacting the new law. Provisions intended to help accomplish this goal are outlined below in very general terms, along with various other retirement plan changes.

Various measures were intended to encourage employers to fully fund promised benefits under defined benefit pension plans and to discourage them from promising or delivering additional or accelerated benefits for which adequate funding appears doubtful. Underfunded plans generally have seven years to become fully funded. Special rules apply in some cases. Also, stricter rules apply to keep employees fully informed about troubled plans.

For plan years beginning after 2006, defined benefit plans will be allowed to make distributions to employees who are age 62 or older and still working. Currently, defined benefit plans are prohibited from making such distributions before employees reach normal retirement age.

In addition, the Pension Protection Act provides:

• faster mandatory vesting for employer contributions to defined contribution plans;

• legal bases for employers to automatically enroll their workers for 401(k) elective deferral contributions (i.e., by using negative confirmations that require the employee to affirmatively opt out of making automatic contributions via salary withholding); and

• that defined contribution plans must allow employees to more quickly diversify out of employer stock acquired with both employee elective deferral contributions and employer contributions.

The Pension Protection Act of 2006 is a truly massive piece of legislation. While this article only scratches the surface of the changes, we hope you find it helpful.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.