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2006 Tax Law - Part 3

 What Your Company Needs to Know

Stabilizing and strengthening traditional defined benefit pension plans maintained by large employers was ostensibly the main reason for the Pension Protection Act of 2006. The new defined benefit pension rules are highly technical and not of interest to everyone. Therefore, some of these provisions are briefly summarized below,

New Law Boosts Automatic 401(k) Plans

    Does your company have a 401(k) plan and employees who don't participate? If so, you could make participation “automatic” in the future. And, if employees are already participating, their 401(k) contributions could be increasing soon, even if they don’t lift a finger.
It all has to do with several key provisions in the new Pension Protection Act. The new provisions generally take effect in 2008, but employers can implement changes before then.
Here are the details: Currently, most 401(k) plans require employees to make a decision to participate. If an employee elects to defer part of his or her salary by making contributions, the employer might match the contributions, in whole or in part, within the prescribed tax law limits.
This can be a tough sell for younger employees who aren’t worried about retirement and lower-paid employees who don't have much disposable income. Higher-paid employees may also be constrained by nondiscrimination rules designed to ensure that they don’t receive a disproportionate amount of benefits under a plan.
    In the past, some employers have used an “automatic-enrollment” feature to avoid these problems. Simply put, participants are enrolled in the plan automatically unless they choose not to be. The employer must meet “safe-harbor” requirements to comply with the nondiscrimination laws. (However, some states have prohibited the use of such automatic plans.)
    The new law overhauls the rules for automatic-enrollment 401(k)s. For starters, it gives plans the official stamp of approval on a nationwide level. Employers may limit the automatic feature to new-hires or extend it to the existing workforce as well. Although employees can still choose to opt out of a plan, they may be more likely to stick with it once they’re automatically enrolled.
To further encourage retirement savings, the new law makes it easier for employers to automatically increase the percentage of an employee’s salary directed to the account. For instance, an employer may step up contributions from a minimum level of 3 percent the first year to 4 percent the second year, 5 percent the third and 6 percent in the fourth year.
    Note: The new act does not, however, raise the tax law limits on amounts that can be contributed annually by employers and employees.
   One side effect of installing such a policy would be larger allowable salary reduction contributions for higher-paid employees, because lower-paid workers would be contributing more.
Bottom line: Both employers and employees should consult with their professional advisers for the best approach to take.

New Rules for Multi-Employer Plans

    The Pension Protection Act establishes new rules relating to multi-employer plans, including identification of troubled plans, funding obligations and actions required by trustees. Note: A plan may be prohibited from increasing benefits if it could jeopardize its financial health.

along with other important retirement plan changes.
  • Stricter Funding Standards for Defined Benefit Plans. The Pension Protection Act includes a number of new provisions intended to encourage employers to fully fund defined benefit pension plans. It also discourages employers from promising or paying additional or accelerated benefits for which adequate funding may not exist. In general, underfunded plans are given seven years to reach full funding. (Currently, plans are required to cover only 90 percent of their liability.) Note: New plans established after 2007 do not benefit from the transitional rules.

  • "At-risk" plans generally face accelerated funding requirements. If a plan is treated as an at-risk plan, it is required to accelerate contributions. A plan is considered “at-risk” if it is less than 80 percent funded without regard to at-risk liabilities and less than 70 percent funded counting at-risk liabilities. At-risk liabilities are determined by assuming that employees eligible to retire within the next ten years will retire at the earliest date. (However, some underfunded airline and other company plans are given longer to catch up.)

  • Benefit limitations for "at risk" plans. Employers that fall below the 80 percent funding level are barred from providing enhanced or new benefits. New accruals will be frozen in plans falling below the 60 percent level. Note: Other restrictions may apply to underfunded plans.

  • Bigger Employer Deductions. To further encourage full funding, the Pension Protection Act allows employers to make larger deductible contributions to defined benefit pension plans. The new rules allow employers to contribute and write off amounts in excess of 100 percent of current plan liabilities. (The calculations for deductions is complex so consult with your tax adviser.) The new law also permits larger deductible contributions by employers that maintain defined benefit pension plans in tandem with defined contribution plans.

  • New Rules on Interest Rate Assumptions and Pension Benefit Guaranty Corporation (PBGC) Premiums. The Pension Protection Act establishes complex new rules regarding interest rate assumptions that employers can use to determine their defined benefit pension plan liabilities and funding requirements. The new law also includes revised rules for determining PBGC premiums.

  • Earlier In-Service Distributions. The Pension Protection Act allows defined benefit pension plans to make distributions to employees who are still working (so-called in-service distributions) after reaching age 62. This change applies to plan years beginning after 2006.

  • Better Protection for Spousal Beneficiaries. The Pension Protection Act directs the Department of Labor to issue updated rules that will allow more flexibility in modifying qualified domestic relations orders (QDROs). Also, some pension plans must offer more generous joint-and-survivor annuity benefits to surviving spouses.

  • Faster Vesting Required for Non-Matching Employer Contributions. For plan years beginning after 2006, the Pension Protection Act mandates faster vesting schedules for non-matching employer contributions to defined contribution plans. These contributions will fall under the same vesting schedules that already apply to employer matching contributions.

  • Liberalized Hardship Distribution Rules. The Pension Protection Act directs the Treasury Department to issue liberalized rules to allow 401(k) hardship distributions based on hardships and unforeseen financial problems faced by designated beneficiaries of plan participants.

  • Faster Diversification Out of Employer Stock. The new law requires defined contribution plans to permit employees to diversify more quickly out of employer stock into alternative investments. Faster diversification must be allowed for stock acquired with both employee elective deferral (salary reduction) contributions and employer contributions.

  • Investment Advice Is Sometimes Allowed. Beginning in 2007, retirement plan sponsors and fiduciaries are allowed to hire and compensate “fiduciary advisers” to supply investment advice and make investment transactions for participants and beneficiaries of defined contribution plans and beneficiaries of IRAs. A fiduciary adviser can be a registered broker or dealer, a registered investment adviser, a bank or similar financial institution, an insurance company, or an affiliate, employee, agent or representative of one of the above.

  • Legal Protection for Conversions to Cash Balance Plans. The new law provides legal protection to employers who want to convert an existing traditional defined benefit pension plan into a hybrid “cash balance” plan. It insulates employers from age-discrimination lawsuits by employees who could claim that such a switch harms older workers.

This is just a brief overview of several key provisions in the new law. Be aware that the law is extremely complex and filled with numerous technical applications. Give me a call at (856)665-2121 to discuss this in greater detail.

Click Here for Part 1 of 2006 Act Changes

Click Here for Part 2 of 2006 Act Changes Ronald J. Cappuccio, J.D., LL.M.(Tax) 1800 Chapel Avenue West Suite 128 Cherry Hill, NJ 08002 Phone:(856) 665-2121      Fax: (856) 665-9005 Email:
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