Pension Reform’s Message: You're on Your Own

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Pension Reform’s Message: You're on Your Own
by Charles Schwab & Co., Inc.
September 28, 2006

Reprinted from On Investing, a magazine for Schwab clients.

More than ever, you are responsible for funding your own retirement. That's the underlying message contained in the 900-plus page pension bill signed by President Bush in August, which provides some significant help in achieving that goal.

Although designed primarily to strengthen the funding rules for traditional defined benefit pension plans, the pension reform law also makes it easier for individuals to save for their own retirement, as well as fund their children’s education. Among the most important changes, the bill makes permanent higher IRA and 401(k) contribution limits, catch-up contributions for those age 50 and older, and a rule that permanently extends tax-free withdrawals from 529 college savings plans. These were all set to expire after 2010.

"While the elimination of sunset provisions that would have reduced retirement contributions after 2010 is good, and should help individuals save more for their retirements in future years, there is little, if anything, in this bill that should cause workers to do anything differently today than they should have already been doing all along—save as much as possible," said Rande Spiegelman, CPA, CFP®, vice president of financial planning with the Schwab Center for Investment Research.

If anything, some aspects of this law may actually lead to smaller defined benefit (DB) pension plan benefits down the road. Says Spiegelman: “Restrictions designed to strengthen existing DB plans could have the unintended effect of further reducing the already scarce availability of traditional pensions. On top of that, beginning in 2008 the formula used to calculate lump sum payments for DB plan participants will start changing to include a blended corporate interest rate. By 2012, the higher corporate rate will fully replace the lower 30-year Treasury rate currently in use. Why does that matter? Simple: the higher the interest rate DB plans are allowed to use, the lower the lump sum they have to pay out. The message is clear—if you aren't already saving the maximum allowed by law in your 401(k), 403(b), or 457, and/or you aren't taking full advantage of your IRA options, then you need to get started immediately."

Higher savings limits
Without the pension reform act's passage, annual 401(k) contribution limits would have rolled back to $10,500 in 2011, rather than the current peak of $15,000. Likewise, annual IRA contribution limits—now set at $4,000—would have rolled back to $2,000. Catch-up contributions for those age 50 and older to 401(k) and IRA accounts would have been eliminated altogether. The new law makes current contribution limits and catch-up provisions permanent, with an automatic annual inflation adjustment (the one exception being the $1,000 catch-up contribution amount for IRAs, which is not indexed for inflation). See the chart below for details.

Annual contribution limits

	401(k), 403(b), 457 or other qualified employer plan		Traditional IRA and Roth IRA
	Contribution	50 or older catch-up	Contribution	50 or older catch-up
2006	$15,000	$5,000	$4,000	$1,000
2007	$15,000*	$5,000*	$4,000	$1,000
2008 and beyond	$15,000*	$5,000*	$5,000*	$1,000

* Will be adjusted for inflation periodically.

Take advantage of all the retirement savings options available to you by maximizing your contributions. Spending an entire career with a company that offers a traditional pension plan is now more the exception than the rule. As more companies offer 401(k) plans, it’s up to you to ensure that you are on track to meet your retirement goals. Maximizing contributions to tax-advantaged accounts is a smart way to help you get there.

Read Saving for Retirement: IRA vs. 401(k) for strategies on how to best use these plans.

Roth 401(k) now permanent
The bill also makes the new Roth 401(k) (and Roth 403(b)) plans permanent, which is likely to result in wider offerings of these plans to employees. With a Roth 401(k), employees contribute after-tax dollars according to the 401(k) plan contribution limits stated above. Your savings grow tax-deferred and qualified withdrawals are tax-free.

The Roth 401(k) plan opens a new tax-advantaged savings opportunity to workers who are ineligible to contribute to a Roth IRA. If your employer offers one, a Roth 401(k) is worth investigating if you expect to be in the same or higher tax bracket in retirement, compared to your working years.

Starting in 2008, you'll also be able to directly convert your traditional 401(k) savings into a Roth IRA without having to roll it over into a traditional IRA first, say if you change jobs. Remember that you'll need to pay federal income taxes on your pre-tax contributions and earnings. And, Roth conversion eligibility requirements still apply. That means if you earn over $100,000 in modified adjusted gross income (MAGI), you won't be eligible to roll your money—until 2010, that is, when the $100,000 MAGI rule is set to expire.

If you’re currently ineligible for a Roth IRA, consider maximizing contributions to your traditional IRA so that they may be converted to a Roth beginning in 2010. In fact, there’s a special rule in place for 2010 only that will allow taxpayers to recognize the conversion income in 2010 OR split it between the next two years. Remember, tax laws do change so you’ll want to stay on top of the changes (www.irs.gov is a good resource). And be sure to talk with your accountant or other professional tax advisor about how a Roth rollover or Roth conversion will impact your situation.

529 Plan withdrawals remain tax-free
If you're saving for a child's education, a 529 college savings plan with a maximum lifetime contribution limit of upwards of $200,000 (depending on the state) is one of your most powerful tools. Prior to the passage of the pension bill, some may have been reluctant to open a 529, because qualified withdrawals would no longer have been tax free after 2010 under prior law. The pension bill abolished that rule.

Not only can you withdraw 529 savings tax-free for qualified education expenses as far as the eye can see, several other features have been made permanent as well—including the ability to roll 529 assets into another 529 tax-free once every 12 months and the ability to use funds tax-free for off-campus room and board expenses.

With the cloud lifted over the tax-free status of withdrawals from 529 plans, they become an even more attractive savings option, particularly for upper-income people who are not eligible for other tax-preferred education saving vehicles. Remember, there’s no guarantee that your child will get that scholarship, so don’t delay. Learn more about saving for college with a 529 plan.

For the latest developments with these plans, read Pension Plan Lifts 529 Cloud.

Good news for non-spouse beneficiaries
Previously, when a 401(k) account owner died and the beneficiary was someone other than a spouse—say a child or domestic partner—the beneficiary had to keep the assets in the 401(k) account (if eligible) or take a lump sum distribution of the funds which could often result in a sizable taxable distribution. Going forward, non-spouse beneficiaries don't have to worry about this tax hit if they take proper action. Starting Jan. 1, 2007, they are eligible to make tax-free rollovers of distributions from qualified retirement plans, tax-sheltered annuities or government plans directly into an inherited IRA.

If you've inherited non-spousal assets in a qualified retirement plan, you might be able to avoid a big tax bill that comes with a lump-sum distribution by rolling the money into an inherited IRA.

Tax-free charitable contributions from IRAs
If you’re an IRA owner who is age 70½ or older, you may make charitable contributions of up to $100,000 directly from your IRA tax-free. However, you’ll need to act quickly. This provision is only effective for tax years 2006 and 2007.

Before pension reform, these distributions would have been considered a taxable distribution from your IRA with any deduction for a subsequent charitable contribution limited to 50% of your adjusted gross income. Under the new provision, even though you don’t get to take the amount of the contribution as an itemized deduction, you’re still likely better off because the IRA distribution is completely tax-free. Of course, this all presumes your primary goal is to give to a qualified charity.

Determine if now is the time to make a charitable contribution. Consult with your tax advisor to see how this provision will impact your specific tax situation.

Other provisions
The pension bill contains a number of additional features targeted at IRAs and defined contribution plans offered by employers. The bill:

Makes it easier for employers to automatically enroll employees in retirement plans they offer
Ensures that workers get more information about their account performance
Helps employees make better retirement investment choices by allowing employers to offer investment advice.
Allows taxpayers to deposit tax refunds directly into their IRAs.
Permits penalty-free early distributions from retirement accounts for active-duty military.

Be sure to speak with your tax advisor about how certain provisions will impact your individual situation.

Before investing, carefully consider the plan's investment objectives, risks, charges and expenses. This information and more about the plans can be found in the Schwab 529 Guide and Participation Agreement and July 2006 Supplement to the Guide & Participation Agreement available from Charles Schwab & Co., Inc., and should be read carefully before investing. If you are not a Kansas taxpayer, consider before investing whether your or the beneficiary's home state offers a 529 plan that provides its taxpayers with state tax and other benefits not available through this plan. As with any investment, it is possible to lose money by investing in this plan.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, Financial Planner or Investment Manager.

As with any investment, it is possible to lose money investing in a 529 plan. Additionally, by investing in a 529 plan outside the state in which you pay taxes, you may lose any tax benefits offered by your own state’s plan

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