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Helping Employees Take Charge in a Post-pension Defined Contribution WorldNote -- Updated to clarify maximum amount of saver's credit on joint return(RIVERWOODS, ILL., January 2007) – The name “Pension Protection Act” may sound comforting to those who embrace the traditional idea of a paternalistic employer funding and managing their retirement accounts. However the Act, while attempting to assure more solid funding of employer-provided pension plans, implicitly acknowledges the trend away from defined benefit plans, which provide a guaranteed retirement benefit, to defined contribution plans, such as 401(k) plans, under which an employee’s retirement benefit is less certain. Thus, the main effect of the pension plan funding rules and other reforms implemented by the Pension Protection Act may be to protect taxpayers from having to finance a federal bailout of the government agency that protects workers’ pension benefits. However, the Act also makes significant changes to current law that are designed to enable and empower employees to more effectively manage their retirement accounts in a defined contribution world, according to CCH, a Wolters Kluwer business and a leading provider of tax, accounting and pension law information, software and services (CCHGroup.com). “With fewer companies offering defined benefit pensions to workers, 401(k) and similar plans are far more important retirement savings vehicles for employees,” said CCH Pension Law Analyst Glenn Sulzer, JD. This fact has dominated the employee benefits world for some time. However, Sulzer notes, many employees are unprepared for the responsibility of managing their retirement savings, or unaware of how much they really need to be contributing to their accounts. Whether you’re the average-income worker just trying to figure out where to invest your retirement money, a lower income worker who needs all the help you can get to make your retirement dollars go further or a higher-income worker or entrepreneur who needs further opportunities to save more, the challenges to retirement planning can be daunting. The Act addresses these concerns by implementing numerous changes to 401(k) (as well as 403(b) and government 457(b)) plans that will impact retirement planning. Automatic Enrollment Allows for Automatic SavingsAmong the most welcome provisions of the Act are the measures designed to make it easier for employers to automatically enroll workers into a company’s 401(k) plan. While companies have been establishing automatic enrollment plans, under which employees are automatically enrolled unless they file a request to opt-out, there was concern on the part of employers that they could be held liable if the investments to which the employees’ contributions were directed went down in value. Under the Pension Protection Act, employers won’t have this concern as long as they invest the deferrals in required default investment funds and meet participant notice and other requirements. Employers will have to wait until 2008 for this protection from fiduciary liability. However, the Act does immediately prevent the application of state garnishment law from interfering with the adoption of automatic enrollment plans. “Some employers will still move forward with automatic enrollment just knowing that the rules have become clearer,” said Sulzer, cautioning that if a company does adopt such an arrangement, they must inform employees and give them adequate time to opt out. “However, many companies may continue to be reluctant to implement the plans because of added administrative costs,’’ Sulzer noted. Accordingly, employees cannot assume that merely because their employer sponsors a 401(k) plan, they will be automatically enrolled in the plan. Lighting the Way: Professional Investment Advice AvailableOne aspect of the changed structure of employer-provided benefits has been that employees have been required to take greater responsibility for investing their retirement accounts, perhaps without being prepared to do so. “Many employees, intimidated by a surfeit of sometimes confusing information from employers and outside sources, may merely give in to inertia and not change investment allocations over time, effectively diversify or otherwise manage their accounts,’’ Sulzer explains. Compounding the problem, Sulzer adds, was that employers have been reluctant to provide specific investment advice to participants, beyond general investment education, because of concerns with fiduciary liability for failed investments. The Pension Protection Act addresses this concern, effective for investment advice provided after 2006, by allowing fiduciary advisers to provide individual investment advice for a fee to 401(k) plan participants and beneficiaries. A potentially troubling feature of the new law is that fiduciary advisers may be affiliated with investment funds offered under the plan. However, the Pension Act imposes safeguard measures, such as annual audit, fee disclosure and record maintenance requirements that are designed to prevent self-dealing and generally protect the interests of plan participants. The upside of the new law is that employees will now have access to much-needed professional individualized investment advice. The benefit to employers is that they will not be liable for the investment advice provided by the fiduciary adviser or required to monitor the advice that has been provided. However, employers will remain subject to their fiduciary obligation to prudently select and monitor the fiduciary advisers. Higher Ceiling Allows for Greater DeferralsA major concern is that 401(k) plan participants do not defer amounts that will be sufficient to preserve their lifestyles in retirement. For 2007, employees can contribute up to $15,500 of their pre-tax dollars to a 401(k) plan and $5,000 more as a catch-up contribution if they are 50 years of age or older. These ceilings are beyond the reach of most employees participating in 401(k) plans. However, automatic enrollment, increased portability and investment education should lead employees to at least an awareness of the need to contribute more to their accounts. Adding to Retirement through the Saver’s CreditOne way lower and middle income taxpayers can get more bang for their retirement buck is by taking advantage of the Saver’s Credit. The Saver’s Credit is a nonrefundable tax credit that allows participants with an annual adjusted gross income (AGI) below specified threshold levels to use plan contributions (up to $2,000) to reduce their federal income tax on a dollar-for-dollar basis. The credit, which had been set to expire in 2007 and has now been permanently extended under the Pension Protection Act, is available (up to $1,000 per year for each eligible individual) to married couples filing jointly whose AGI in 2007 is $52,000 or less and single filers whose income is $26,000 or less. Depending upon income, the credit ranges from 10 percent to 50 percent with lower income taxpayers being eligible for a higher credit. For example, a married individual filing jointly with a combined AGI of $30,000 making a $1,000 contribution to a 401(k) plan could be eligible for a 50-percent credit, or $500. By contrast, a married individual filing jointly with a combined AGI of $48,000 making a $1,000 contribution could be eligible for a 10-percent credit or $100. The Saver’s Credit also applies to contributions to IRAs, Roth IRAs, SIMPLE plans and other qualified retirement plans. Roth 401(k) Plans Attract Interest of Young Workers and Wealthy Soon to RetireRoth 401(k) plans (and Roth 403(b) plans), which came into being as a result of the Economic Growth & Tax Relief Reconciliation Act of 2001 (EGTRRA), were first offered for the 2006 tax year. However, given that these plans were set to expire in 2010, there was limited interest as employers did not want to make the extra effort to set up a short-lived program. The Pension Protection Act has now made Roth 401(k) (and Roth 403(b)) plans permanent. Like Roth IRAs, these plans allow contributions to be made on an after-tax basis with subsequent qualified distributions and earnings realized tax-free. As with traditional 401(k) and 403(b) plans, the maximum after-tax contribution level for 2007 for Roth 401(k) and 403(b) plans is $15,500, with participants age 50 or older allowed to contribute an additional $5,000 in catch-up contributions. Employees who may benefit most from Roth 401(k) plans are generally on the extreme ends of the earning spectrum: either they’re low-earning workers who are in a lower tax bracket today than they believe they will be at the time they retire, or they’re very highly compensated individuals who are not eligible to participate in IRAs or invest in other retirement options given their income level and who, because of accumulated retirement assets, do not expect to be in a lower tax bracket at retirement. “Roth 401(k) plans enable taxpayers to reduce their tax burden in retirement, as distributions are not taxed, and also allow individuals to pass on their savings, without burdening their heirs with onerous tax consequences,’’ Sulzer noted. Roth 401(k) contributions are subject to the required minimum distribution rules, thus, a Roth 401(k) plan participant will be required to begin making taxable withdrawals from their account at age 70½, unless the amounts are rolled over. However, Sulzer explains, Roth IRAs are not subject to the required minimum distribution rules during the owner’s lifetime and, thus, present a very attractive rollover option for taxpayers. For example, a Roth 401(k) participant, by rolling over funds to a Roth IRA may allow his beneficiaries to stretch required distributions from the account over their lifetimes, thereby significantly reducing potential tax liability. Despite the potentially attractive tax advantages to some employees, distributions from Roth 401(k) plans also come with some restrictions. Money can’t be withdrawn from a Roth 401(k) until the individual reaches age 59½, becomes disabled or dies. Contributions must also have been kept in the Roth 401(k) account for at least five years in order to qualify for tax-free treatment upon distribution. In addition, although 401(k) plan participants may roll distributions over to a Roth IRA, distributions from traditional 401(k) plans may not be rolled over to a Roth 401(k) plan. Thus, if an employee terminates employment with a company that maintains a Roth 401(k) plan in which he participated, he may: (1) roll over the account to the Roth 401(k) of his new employer, or (2) roll the account over to his own Roth IRA. The employee may not, however, roll the distribution to the traditional 401(k) plan of his new employer. For an employer, the plans also are harder to administer than traditional 401(k) plans and require additional educational costs as employees need to be informed about all their retirement plan options. The primary challenge for both employers and Roth 401(k) participants will be complying with the requirement to maintain separate accounts with separate tracking and reporting mechanisms for pre-tax contributions to traditional 401(k) plans and after-tax contributions to Roth 401(k) plans. Depending upon how much flexibility an employer allows, employees may be able to designate how they want to allocate their 401(k) investments between pre- and post-tax plans, meaning employees may be contributing to both types of plans throughout a given year – something that many employees’ payroll systems are simply not up to handling. After an employee leaves a job and goes to roll-over the 401(k) funds, he or she needs to continue to keep pre- and after-tax funds in separate accounts. Solo 401(k) Plans Provide Option for Maximum Savings by Self-employedOne of the major challenges for self-employed individuals with the means to save for retirement has been finding a plan that allows them to make contributions sufficient to adequately prepare for retirement. Income restrictions for IRAs preclude many successful entrepreneurs from saving even the minimum in traditional deductible IRAs and SEP plans restrict contributions to 25 percent of compensation. However, changes in the contribution and deduction limits that were enacted, effective in 2002, and which have now been permanently extended by the Pension Protection Act, have allowed for the emergence of Solo 401(k) plans. Also known as one-person plans, Solo 401(k) plans allow sole owners (and the owner’s spouse) to make greater tax deferred and deductible contributions than would be permitted under an IRA, SEP, SIMPLE plan or even a profit-sharing plan, while avoiding both the complex nondiscrimination tests associated with larger 401(k) plans and the expense of maintaining a money purchase plan. Here is an example of how an entrepreneur can save more in a Solo 401(k) than just a SEP. Suppose Jane is the sole shareholder and employee of an S corporation. She has $100,000 of W-2 wages for 2007. If the company adopts a profit-sharing plan or a SEP, it will be able to make an employer contribution of up to $25,000 (25 percent multiplied by $100,000) towards Jane’s retirement. Alternatively, if her company adopts a 401(k) plan with a profit-sharing feature, Jane will be permitted to make an elective deferral of up to $15,500 for 2007 and the company will be able to make an employer contribution of $25,000. Thus, with the 401(k) plan, $40,000 could be contributed to the plan on her behalf, compared to $25,000 for a profit-sharing-only or SEP plan. Note, if Jane were age 50 or older she would also be eligible to make a catch-up contribution to the plan. Jane is subject to employment taxes on the elective deferral, but her company may deduct the contributions to the plan. Solo 401(k) plans are subject to annual contribution and deduction limits and many of the other requirements applicable to qualified 401(k) plans, such as annual reporting. However, the administrative requirements are substantially less than those under a traditional 401(k) plan. In addition, as with traditional 401(k) plans, earnings grow on a tax-deferred basis and are not subject to income tax until distribution. Solo 401(k) plans may allow for participant loans (unlike IRAs) and enable an owner to consolidate retirement assets by rolling over funds from IRAs, SEPs and traditional 401(k) plans. However, Sulzer cautions that entrepreneurs need to be very careful with Solo 401(k) plans because as soon as they hire an employee, their plan likely won’t meet the discrimination rules governing contributions. Plans with only highly paid employees are deemed to satisfy the applicable nondiscrimination tests. However, employers that maintain plans that also cover nonhighly compensated employees (i.e., those earning less than $100,000 per year) may be required to make additional matching and nonelective contributions to enable the plan to satisfy the nondiscrimination requirements and thereby maintain its qualified status. What's Up First: When 401(k) Changes Take Effect
About CCH, a Wolters Kluwer businessCCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax and accounting law information, software and services. It has served tax, accounting and business professionals and their clients since 1913. Among its market-leading products are The ProSystem fx® Office, CCH® Tax Research Network™, Accounting Research Manager® and the U.S. Master Tax Guide®. CCH is based in Riverwoods, Ill. Wolters Kluwer is a leading global information services and publishing company. The company provides products and services for professionals in the health, tax, accounting, corporate, financial services, legal and regulatory, and education sectors. Wolters Kluwer has annual revenues (2005) of €3.4 billion, employs approximately 18,400 people worldwide and maintains operations across Europe, North America, and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. Its shares are quoted on the Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices. For more information, visit www.wolterskluwer.com. -- ### -- nb-07-29
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