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Retirement savings plans
Background: The 401(k) plan allows a worker to set aside money—before taxes—from each paycheck and to invest those savings—usually in mutual funds. Many employers match a portion of the worker's contribution. Employees generally do not have to pay income taxes on their 401(k) savings until they begin to withdraw their funds at age 70½.
Although the 401(k) plan is a valuable way to save for retirement, studies show that about a third of the workers at major companies do not join. Often these are younger, newer or low-wage workers who think they can't afford to save or are confused about making investment choices. The new pension law encourages all workers to save.
The new rules
Individuals have been given a chance to do the following:
- Contribute as much as $4,000 a year to Individual Retirement Accounts (IRAs) and $15,000 a year to 401(k) plans. These limits, once temporary, have become permanent and will be indexed for inflation.
- Increase their savings as they near retirement. Catch-up contributions for those age 50 and older have been permanently set at $5,000 a year for 401(k) plans and $1,000 a year for IRAs. These limits also will be indexed for inflation.
- Roll over money directly from 401(k) and other qualified retirement plans directly to a Roth IRA—subject to taxes—providing that one's adjusted gross income is no more than $100,000 whether single or married and filing jointly. The rule is effective in 2008.
- Make use of a 529 college savings plan, knowing that its tax-exempt status has been made permanent.
- Continue to use the now-permanent Retirement Savings Tax Credit, which is available to low- and middle-income taxpayers who contribute to a qualified retirement savings plan. The maximum credit is 50 percent of contributions up to $2,000, which would provide a tax credit of $1,000.
- Take advantage of a new rule which allows a nonspouse beneficiary to roll over an inherited IRA into his or her own IRA. Taxes will not be due until money is withdrawn. The new rule will apply to domestic partners.
- Ask the IRS to split their 2006 tax refunds into as many as three different bank or investment accounts.
Employers have been given the go-ahead to do the following:
- Automatically enroll their workers in the company's 401(k) savings plan—unless a worker affirmatively opts out of the plan.
- Set these workers' initial contributions at a minimum of 3 percent of their pay.
- Boost their contributions by 1 percent a year up to six percent.
- Select investment choices for the auto-enrolled workers' money.
- Make investment advice available to all 401(k) plan members.
- Permit 401(k) participants with three years of service to diversify the money they have invested in company stock.
- Offer employees a new Roth 401(k) account. It allows an employee to contribute after-tax money, which, with earnings, would qualify for tax-free withdrawals.
- Offer phased retirement to employees age 62 and older, who can work part-time and draw pension benefits to maintain their current level of earnings.
Traditional (defined-benefit) pension plans:
Background: The Pension Protection Act of 2006 attempts to strengthen the American pension system by requiring companies to do a better job of funding their defined-benefit plans.
The new law uses a "carrot and stick" approach to get the job done. It offers greater tax incentives for companies that increase funding for their pension plans. But it also levies financial and other penalties for companies that underfund their pensions.
The question in the pension community is whether the new and costly rules will have the unintended effect of persuading some companies to either freeze or terminate their plans or to switch to other types of plans. Since most of the new rules take effect in 2008, the question is yet to be answered.
The new rules
- Pension plans have seven years to become 100 percent funded. Previously, they did not have to add money if they were 90 percent funded. Plans will be allowed to gradually move up to the 100 percent level by 2011.
- Companies that dump their plans on the PBGC and then emerge from bankruptcy must pay a penalty—$1,250 per participant—for up to three years. * The law raises the limit on the amount of money companies can put into plans during good times to help keep the plans solvent during lean times.
- To encourage companies to fully fund their plans, they will be allowed to take increased tax deductions for their contributions.
- Plans that are less than 80 percent funded will not be allowed to provide any new or enhanced benefits.
- Hybrid "cash balance" plans, a blend of defined-benefit and savings plans, will be protected from claims of age discrimination by older workers who argue that hybrids reduce their pensions because they have fewer years until retirement than younger workers.
- Starting in 2008, participants in hybrid plans must be vested after three years.
- The law prohibits the "wear-away" of a worker's previously earned benefits, which can occur when a defined-benefit plan is converted to a hybrid cash balance plan.
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