On August 17, 2006, President Bush signed into law the Pension Protection Act of 2006 (the "Act"). The Act had passed in both the United States Senate and House of Representatives by wide margins. While the Act deals mostly with defined benefit pension plans, it also contains some major provisions that impact estate and wealth preservation planning.
Non-Spousal Rollovers of Inherited Qualified Retirement Plans
Prior to the Act, if someone other than a participant's surviving spouse was named as a beneficiary of a qualified plan (like a 401(k)), those nonspousal beneficiaries were stuck with the often inflexible distribution options provided in the qualified plan document. The nonspousal beneficiaries often could only defer distribution for five years after the death of the employee, at which time the entire plan benefit would need to be distributed and be subject to income tax upon distribution.
To contrast the treatment of spousal versus nonspousal beneficiaries, it is beneficial to review the special treatment
accorded plan distributions when the employee names a spouse as primary beneficiary (which is unaffected by the Act). If a surviving spouse is named as the sole beneficiary of an employee's plan, the spouse has two options: 1) treat the benefit as an inherited IRA, with distributions commencing in the later of the year the employee would have attained age 70 ½ or the year the spouse attains 70 ½; or 2) take a lump sum distribution from the plan (if the plan allows lump sum distributions) and then rollover the distribution to the spouse's own new IRA. Assuming the spouse opts for a rollover, the spouse would commence distributions in the year he or she attains 70 ½. The spouse may also name new beneficiaries on the rollover IRA, so when the spouse dies, the benefits would be paid out over the life expectancies of the spouse's named beneficiaries. Assuming the spouse names children with differing ages, after the death of spouse, the benefits would be paid out over each child's remaining life expectancy. A trust for each child could also be named as the beneficiary under the spouse's IRA, and, if the trust is structured properly, each child could still use their own life expectancy as the distribution period. These were the options available to a surviving spouse prior to the Act and they continue to be available options after the Act.
As a result of the Act, nonspousal beneficiaries, including trusts, now may take the distribution from a qualified plan account and "rollover" that distribution into an inherited IRA. They must still commence distributions in the year of the rollover, but those distributions may now be taken from the inherited IRA over the nonspousal beneficiary's remaining life expectancy. In the case of a properly drafted trust, the life expectancy of the oldest beneficiary would be used to determine the distribution period. The extended distribution period authorized by the Act will allow continued tax free growth of the undistributed amounts. While the provisions in the Act do not give the nonspousal beneficiaries the ability to defer distributions as effectively as a surviving spouse, the Act does remove the inflexibilty related to distributions upon death of an employee that had existed in many qualified retirement plans.
For example, a 40 year old unmarried individual names a trust for the sole benefit of his 4 year old niece as the primary beneficiary of his 401(k). His company's qualified plan document says that nonspousal beneficiaries must take the entire balance out of the qualified plan after a participant's death either in a lump sum or no later than 5 years after the participant's death. Under the rules prior to the Act, if the participant died on January 1, 2007, the trust for his niece would have the recognize all the income on or before December 31, 2011, at the latest. Under the new provisions created by the Act, the account can now be rolled over into an inherited IRA, with distributions made to the niece's trust over her remaining life expectancy. The deferral of income tax on the account is thus extended from no more than 5 years to 78.7 years (the remaining life expectancy of a 4 year old).
Tax-Free Distributions from IRAs for Charitable Purposes
Another provision allows taxpayers to "roll over" an individual retirement account (IRA) to charity in a tax favorable way. Prior to the Act, if a taxpayer wanted to contribute an IRA to a charity, the taxpayer had to first withdraw the monies from the IRA, recognize the income in the year withdrawn, and then receive a charitable deduction for amounts given to the charity. As a result of income tax contribution base limitations, taxpayers often were not able to offset 100% of the income recognized on withdrawal by the charitable deduction. The new provision in the Act eliminates this potential gap and allows tax-free contributions of IRA's directly to qualifying charities.
Under the new rules, taxpayers do not have to report the amount of the contribution in their taxable income in the year of withdrawal, but they also do not receive a charitable deduction for the contribution. In order to take advantage of the new provisions, the contributions must be made prior to December 31, 2007. The contributions must come from an IRA (not from a 401(k) or SEP), and are limited to $100,000 per year. Only individuals who have attained age 70 ½ or older may make the contributions, and the contributions must be made to public charities or private conduit foundations. Contributions to donor-advised funds and supporting organizations do not qualify for the beneficial treatment. The amount of the contribution also will count against the taxpayer's minimum required distribution for the tax year. The new provision will benefit taxpayers who are charitably inclined, but who otherwise may have contributions limited due to income levels, or those who do not itemize deductions.
Other Major Charitable Provisions
Basis Adjustment to Stock of S Corporation Contributing Property: If an S corporation contributes property to a charity, an S corporation shareholder need only reduce his basis in S corporation stock by his pro rata share of the adjusted basis of the contributed property. This provision is effective for tax years 2006 and 2007. Previously, the basis reduction was equal to the fair market value of the charitable contribution.
Qualified Conservation Contributions. The charitable deduction limitation for qualified conversation contributions is raised from 30% to 50% of adjusted gross income, so long as the donated land is not prevented from being used for farming or ranching purposes. Unused deductions may be carried over for up to 15 years, but the provision is only effective for contributions in 2006 and 2007.
Excise Taxes. Most excise taxes for certain activities related to entities taxed as private foundations are doubled.
Donor Advised Funds. Prior to the Act, donor advised funds were not subject to many of the stringent rules that apply to private foundations. The Act now provides new code sections to define donor advised funds, impose excise taxes for taxable distributions, distributions that provide more than an incidental benefit to a disqualified person (the donor and his/her family) and excess business holdings. These new provisions also apply to some types of supporting organizations as well. Finally, the Act instructs the Treasury Department to conduct a study of donor advised funds to determine if the deductions that are being allowed for taxpayers are appropriate in light of the powers retained by the donor with respect to the fund.
Recordkeeping Requirements for Certain Charitable Contributions. Effective for donations made in taxable years beginning after August 17, 2006, a provision in the Act provides that in the case of a charitable contribution of money, the donor must maintain a cancelled check, bank record or receipt from the organization, regardless of the amount. As a result, taxpayers will no longer be able to claim a charitable deduction for cash they put in the basket at church or in the Salvation Army kettle. Look for an increase in registration at your local places of worship.
Distributions from Qualified State Tuition Programs (529 Plans)
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) contained a provision that made distributions from a qualified state tuition program (QSTP) for educational expenses exempt from federal income tax. Like all of the other provisions of EGTRRA, unless made permanent through further Congressional action, this tax break for students was set to expire in 2011. The Act contained a provision that makes permanent the provision that distributions from QSTPs for qualifying educational expenses will not be included in income for federal income tax purposes.
Another Development: Failure to Pass Permanent Estate Tax Changes
Although it was not part of the Pension Protection Act, an attempt to increase the applicable estate tax exclusion amount to $5,000,000 per person, with a carryover of any unused portion being allocated to a surviving spouse, and to also lower estate tax rates, failed as part of the so-called "trifecta bill." As an incentive to get more votes, an increase in the minimum wage and some long-sought after tax extenders were also included in the bill. Due to the sunset provisions of the 2001 tax act, the trifecta bill needed 60 votes to pass, and the final yeas were 4 short at 56. Congress did not reintroduce this bill prior adjourning in advance of the mid-term elections in November. What this means for taxpayers is that, unless Congress takes further action to change the law, the applicable exclusion amount of $2,000,000 remains through 2008, increases to $3,500,000 in 2009, the estate tax is repealed in 2010, but then the applicable exclusion amount reverts to pre-2001 Tax Act levels of $1,000,000 in 2011.
For more information, please contact Bradley J. Kalscheur at 414.225.2763 or firstname.lastname@example.org.