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401(k) ... 457 ... 403(b) ... 529 ... Yes, It's All in the Numbers
To those who ask about highlights of the new Pension Protection Act that was recently signed into law, here's what you need to know:
The Pension Protection Act of 2006 that was signed into law this past Aug. 17 focuses primarily on pension plans, but also includes provisions affecting IRAs, 529 plans and defined contribution plans.
In particular, the new law affects several provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, which were slated to expire after 2010.
Here are some of the specific points of the new law:
Individual Retirement Accounts
· The phased-in increases of regular and catch-up (for those age 50 and above) contribution limits introduced in EGTRRA are now permanent.
· For the 2006 and 2007 tax years only, an IRA owner age 70 or older can make a tax-free donation of up to $100,000 to a charity instead of taking a Required Minimum Distribution.
· Effective in 2007, nonspousal beneficiaries of qualified retirement plans, 457 or 403(b) plans can now roll their distributions into an inherited IRA, instead of having to take a lump-sum payment.
· Effective in 2008, retirement-plan participants who retire or leave their employer can roll their account balance directly into a Roth IRA without having to roll it into a traditional IRA first.
529 College Savings Plans
· Federally tax-free withdrawals from 529 plans for qualified education expenses introduced in EGTRRA will not expire in 2010, as previously scheduled.
Defined Contribution Plans
· The phased increases of contribution limits introduced in EGTRRA will not expire in 2010.
· Plan sponsors can now offer Roth 401(k) or 403(b) plans, which feature tax-free withdrawals, without worrying that these plans might expire after 2010.
· Effective in 2008, plan sponsors will have the ability to automatically enroll employees in their plan at a specified contribution rate.
· Effective in 2007, employer non-elective contributions must vest on a six-year graded schedule or completely after three years of service.
· Effective in 2007, plans must allow elective deferrals and after-tax contributions in employer stock to be diversified at the time of purchase.
The Pension Protection Act of 2006 makes the Roth 401(k) permanent, removing the 12/31/10 expiration date that previously was in force. The Roth 401(k) can be a boom for high-income individuals who haven't been able to contribute to a Roth IRA because of the income restrictions. (Eligibility phases out between $95,000 and $110,000 for single filers, and $150,000 to $160,000 for those who are married and file jointly). There are no income stipulations for Roth 401(k)s.
Some companies and nonprofit organizations are now offering their employees the opportunity to save for retirement with Roth after-tax contributions. Roth contributions can be accepted by 401(k) and 403(b) plans. It's worth taking a close look at how they can benefit you and to see if your company can now offer it.
The Roth contributions allow you to save money from your paycheck that has already been taxed. That means you don't have to pay taxes on the money or its earnings when you withdraw it for retirement -- as long as the account has been open five years or more, and you are age 59 or older. You are, in effect, prepaying your federal income taxes on your contributions, so you will have more in retirement.
Traditional 401(k) and 403(b) contributions allow you to make contributions with pretax dollars, which reduces your taxable income today. Any withdrawals you take in retirement are taxable as ordinary income. If a participant in a traditional 401(k) or 403(b) plan decides to make a large withdrawal of pretax savings in retirement, the result would be higher taxable income and possibly a shift into a higher, unexpected tax bracket.
If you expect your tax rate to be the same or higher in retirement than it is now, you might be better off with a Roth 401(k). This is likely to be the case with young people who are just starting their careers and expect their income to increase in the future.
For those who are in the 15 percent or 25 percent tax bracket, it may not be a bad idea to pay those taxes now and never have to worry about what tax brackets might become in the future. If you're in your peak earning years, on the other hand, and you figure your tax bracket will be lower in retirement, then you'll benefit from continuing with traditional 401(k) contributions.
Roth contributions are advantageous for investors because they will be able to save more money for retirement. Again, it is particularly advantageous for young people who have a long time to invest.
Employees who are currently contributing at their plan's maximum rate should consider splitting their new contributions this year between the Roth and the traditional or pretax options as a hedge against higher income taxes later.
Employees can contribute $15,000 in 2006 or $20,000 into a Roth 401(k) or 403(b) if they are age 50 or older. With the Roth IRA, they can only contribute $4,000 or $5,000 if 50 or older.
The Roth accumulation from a 401(k) or 403(b) can also be rolled into a Roth IRA, effectively creating a way to transfer assets to heirs free from federal income taxes. In addition, while the 401(k) or 403(b) contributions impose a requirement that certain sums begin to be distributed at age 70, whether the retiree needs the money or not, the Roth IRA has no such rule.
It's important to discuss this approach with your accountant and estate-planning attorney to determine your individual advantages or disadvantages.
Craig Langweiler is president of the Langweiler Financial Group, in Newtown. He can be reached at 215-860-8088 or at: firstname.lastname@example.org.