Retirement Benefits Planning Update

 Retirement Benefits Planning Update Editor: Harvey B. Wallace II, Berry Moorman PC, The Buhl Building, 535 Griswold Avenue, Suite 1900, Detroit, MI 48228–3679,hwallace@berrymoorman.com.

 Retirement Benefits Planning Update provides information on developments in the field of retirement benefits law. The editors of Probate & Property welcome information and suggestions from readers.

Pension Protection Act of 2006 Highlights

Most of the Pension Protection Act (PPA) of 2006, Pub. L. No. 109-280, 120 Stat. 780, enacted on August 17, 2006, is devoted to new rules for the funding and administration of defined benefit pension plans and to the investment of 401(k) plan assets. This column highlights provisions that affect IRAs, distribution planning, and defined contribution plans generally.

The Sun Never Sets on EGTRRA’s Pension Provisions

The provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Pub. L. No. 107-16, 115 Stat. 38, made significant changes to the limits on contributions to (and deductions for contributions to) qualified plans and IRAs, introduced catch-up contributions for participants age 50 and older, provided for Roth 401(k) accounts, liberalized plan-to-plan rollover rules, and allowed for hardship relief on violations of the 60-day rollover requirement. The provisions introduced by the Act were scheduled to expire at the end of 2010 under the sunset rule of EGTRRA § 910, at which time all of the amended Internal Revenue Code provisions were to revert to pre-EGTRRA law. Although the elimination of the increased contribution limits as well as the increased rate of cost-of-living adjustments to those limits would have substantially slowed the amount of retirement savings, the sunset would most dramatically have affected structural changes made in plans in reliance on EGTRRA’s provisions, such as the elimination of money purchase pension plans (in light of the increased 25% defined contribution plan contribution limit) and the adoption of Roth 401(k) programs. Section 811 of PPA 2006 makes permanent the pension and IRA provisions of EGTRRA, effective on the enactment of PPA 2006. This provision, together with the provision described below allowing for inherited IRAs under which the payment of benefits may be deferred for nonspouse designated beneficiaries of plan participants whose benefits are payable in the form of lump sum distributions, may well stimulate the adoption of Roth 401(k) provisions.

Increased Income Limits for IRA Contributions

Section 833(b) and (c) of PPA 2006 amend Code §§ 219(g)(8) and 408A(c)(3)(C) to provide for cost-of-living adjustments (using a 2005 base year) to the modified adjusted gross income (MAGI) limits within which contributions can be made by a qualified individual to a traditional IRA or by any individual to a Roth IRA, beginning with the 2007 year. For an individual who is an active participant in a qualified plan, the maximum contribution of $4,000 per year ($5,000, if age 50 or older) may be made for 2007 if MAGI is less than $52,000 and a partial contribution if MAGI is under $62,000 (in each case, up $2,000 from the 2006 limits). In the case of contributions made to a traditional IRA by an individual whose spouse is an active participant in a qualified plan and who files a joint return, the maximum contribution may be made for 2007 if MAGI is less than $83,000 and a partial contribution if MAGI is less than $103,000. This compares to the 2006 phase-out range of $75,000 to $95,000. The cost-of-living provision further increases the previously scheduled increase for 2007 to a range of $80,000 to $100,000 by $3,000.

For a Roth IRA, the maximum $4,000 (or $5,000) nondeductible contribution (reduced by any amount contributed to a traditional IRA) is subject to MAGI limits for 2007 of:

 Single—$99,000 to $114,000

Married—$156,000 to $166,000

 up from 2006 levels by a cost-of-living adjustment of $4,000 in the case of single individuals and $6,000 in the case of married individuals. Cost of living increases in future years will occur in increments of $1,000, each adjustment rounded to the nearest $1,000. Code §§ 219(g)(8) and 408A(c)(3)(C).

Direct IRA Charitable Distributions in 2006 and 2007

Code § 408(d)(8), as amended by PPA 2006 § 1201(a), permits qualified charitable distributions of up to $100,000 per year (for 2006 and 2007 only) to be made directly by the trustee of a traditional IRA or a Roth IRA to certain charities on or after the IRA owner attains age 70¹/_2.. Eligible recipient charities are public charities described in Code § 170(b)(1)(A), other than supporting organizations described in Code § 509(a)(3) or donor-advised funds maintained by a public charity described in Code § 4966(d)(2). Nonpublic charities, such as private foundations (other than private operating foundations), are ineligible. Charitable distributions within the $100,000 per year limit are not included in the IRA owner’s gross income (as would be the case if a distribution were made to the IRA owner from a traditional IRA or within the five-year period following a Roth IRA’s establishment) and, accordingly, no charitable deduction may be claimed by the owner for the direct transfer from the IRA to the charity. Qualified charitable contributions from traditional IRAs are deemed to count toward satisfying the minimum required distribution requirement for the year of transfer under Code § 401(a)(9). Technical Explanation of H.R. 4, Joint Comm. on Taxation JCX-38-06 (Aug. 3, 2006), at 266, available at www.house.gov/jct/pubs06.html.

The transfer from an IRA to a qualified charity is treated as a qualified charitable distribution only if the transferred amount would have been included in the IRA owner’s gross income if it were instead distributed to the IRA owner. The usual income tax treatment of distributions from an IRA, a portion of the assets of which are attributable to nondeductible contributions, requires that pro rata portions of each distribution consist of a taxable amount and an amount representing the return of the account owner’s tax cost basis. By contrast, a direct charitable distribution from an IRA is considered to be made first from the portion of the IRA that would be includable in gross income. Code § 408(d)(8)(B). To constitute a qualified charitable distribution, the entire distribution amount must be deductible under Code § 170, ignoring, for this purpose, the Code § 170(b) percentage of adjusted gross income limits. Code § 408(d)(8)(C). Accordingly, if any benefit is received by the IRA (or IRA owner) in exchange for the charitable distribution, the entire transfer is disqualified. A similar all-or-nothing result occurs if any portion of the transfer would not be deductible because of insufficient substantiation for the gift. The gross income exclusion is not available for distributions made from Code § 408(b) simplified employee pension plans or Code § 408(p) simple IRAs. Code § 408(d)(8)(B).

As compared to the withdrawal of IRA funds by the IRA owner followed by a charitable contribution, the direct charitable distribution from the IRA reduces the IRA owner’s adjusted gross income (AGI) for the year of the gift and thus may avoid cutbacks in the amounts of personal exemptions, prevent an increased tax on Social Security benefits, or avoid reductions in deductions for medical benefits that would otherwise be triggered by increased AGI. Because the transfer does not involve an itemized charitable deduction, it is available to non-itemizers. For taxpayers who itemize, the transfer is not subject to (and does not affect the otherwise available) limits on charitable deductions as a percent of AGI for the year of transfer and the transferred amount is not subject to the 2% “haircut” on itemized deductions. IRA account owners in states that do not permit (or limit) charitable deductions for state income tax purposes (Indiana, Michigan, Ohio, and Massachusetts) may gain even greater benefits from direct charitable distributions.

Inherited IRAs for Nonspouse Qualified Plan Beneficiaries

To avoid the administrative cost of providing for the deferred payment of retirement plan death benefits, many qualified plans require that a participant’s death benefits be paid to a deceased participant’s designated beneficiaries in the form of a lump sum distribution. Under pre-PPA 2006 law (which continues in effect), a participant’s surviving spouse has the power to roll a lump sum distribution over to the spouse’s own IRA (either by a direct trustee-to-trustee rollover or by the rollover of a plan distribution within 60 days) and receive IRA distributions, beginning with the spouse’s required beginning date, over the spouse’s “recalculated” life expectancy (that is, using the Uniform Lifetime Table factors for the spouse’s attained age, year by year, over the spouse’s lifetime). Unless the participant was able to roll the plan account over to an IRA before death, nonspouse designated beneficiaries had no alternative to the receipt of a lump-sum distribution foreclosing the stretch-out of benefit payments and resulting in immediate income taxation of the distributed benefits except in the case of an at least five-year-old Roth 401(k) account.

New Code § 402(c)(11) added by PPA 2006 effective for lump sum distributions made after December 31, 2006, permits a designated beneficiary who is not the participant’s surviving spouse to transfer, by direct (trustee-to-trustee) rollover only, a benefit from a qualified plan, Code § 403(b) plan, or a Code § 457 plan to a separate inherited IRA. An inherited IRA must be established in the name of the deceased participant for the benefit of the designated beneficiary. The Code § 401(a)(9) minimum required distribution rules will permit the distribution of IRA benefits to be made, beginning in the year following the participant’s death, over the fixed single life expectancy of the designated beneficiary (that is, based upon the factor shown in the single life expectancy table for the age attained by the designated beneficiary in the year following the participant’s death, reduced by one year for each subsequent year). In the case of a participant who dies before the participant’s required beginning date, the single life expectancy factor for the age attained (or that would have been attained) by the participant in the year of the participant’s death will instead be used if a longer payout period results. Unlike a spousal rollover, an inherited IRA does not provide the potential of deferring the commencement of benefits until the year in which the beneficiary attains age 70¹/₂ or permit the slower rate of distribution under the recalculated Uniform Lifetime Table—but, compared to an immediate distribution, the deferral is extremely beneficial (particularly in the case of younger designated beneficiaries).

It is not clear how this relief provision is to be implemented from the employer plan point of view. Presumably, a plan amendment authorizing the direct rollover to an inherited IRA would need to be adopted at the election of the employer. When implemented, the current pressure (particularly for unmarried participants) to roll over qualified plan benefits to an IRA (and, in some cases, to sacrifice creditor protection in doing so) to assure that the deferred benefit payment of death benefits is available would be alleviated. Finally, new Code § 402(c)(11)(B) provides that, to the extent provided in Treasury Regulations, a trust maintained for the benefit of one or more designated beneficiaries must be treated the same way as a trust designated beneficiary. Although it would appear that a trust designated as beneficiary that qualifies as a see-through trust and has a designated beneficiary would pass muster, under the wording of the Code section, there is some risk to naming trusts as beneficiaries of plan benefits when an inherited nonspouse IRA might be established until regulations have been issued.

Direct Rollovers—Qualified Plan to Roth IRA After 2007

Under current law, the conversion of tax deferred benefits (by including the converted benefits in the account owner’s gross income for the years of conversion) can only occur by the conversion of a traditional IRA to a Roth IRA in a year in which the account owner’s adjusted gross income does not exceed $100,000. To “convert” qualified plan benefits, plan benefits must first be rolled over to a temporary traditional IRA. Beginning in 2008, a plan participant who meets the AGI requirements may roll qualified plan benefits, Code § 403(b) annuities, or Code § 457 plan benefits over to a Roth IRA, accomplishing a one-step conversion. PPA 2006 § 824, amending Code §§ 408A(e), 408A(c)(3)(B), and 408A(d)(3).

Employer-owned Life Insurance

Contrary to the general rule of Code § 101, PPA 2006 § 863(a) amends Code § 101(j) to provide that, unless certain requirements are met, proceeds received by an employer from a life insurance policy on the life of an employee issued after August 17, 2006, are includable in the employer’s gross income to the extent the proceeds exceed the policy premiums paid. If, however, the notice and consent requirements described below are met, the entire amount of proceeds is excludable (as under pre-PPA 2006 law) if (1) the insured was employed at any time during the 12-month period preceding death; (2) the insured was a director, highly compensated employee, or a highly compensated individual at the time the contract was issued; (3) the proceeds are payable to a member of the insured’s family, a beneficiary designated by the insured, a trust for the benefit of the insured’s family or a designated beneficiary, or the insured’s estate; or (4) the insurance proceeds are used to purchase an equity interest in the employer from a family member, beneficiary, trust, or estate. For this purpose, a highly compensated employee is an employee defined in Code § 414(q) without reference to any election made by the employer to include the employee in the top paid group of employees for the previous year under Code § 414(q)(1)(B)(ii) and a highly compensated individual is an individual defined in Code § 105(h)(5) except that “35%” must be substituted for “25%” in calculating the Code § 105(h)(5)(C) highest paid percentage.

To satisfy the notice and consent requirements so that insurance proceeds are excludable from gross income if the foregoing circumstances are met, before the insurance contract is issued, the employee must be notified in writing that the employer (or a related person) intends to insure the employee’s life and of the maximum face amount for which the employee could be insured at the time the contract was issued. Second, the employee must give advance written consent to being insured under the contract and to the continuance of coverage after employment terminates. Finally, the employee must be informed in writing that the employer (or a related person) will be a beneficiary of the insurance proceeds. Code § 101(j)(4). Under Code § 6039I(a) and (b) annual reporting and record-keeping requirements apply.