Sound Mind Investing : More Help for Savers in New Pension Law

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More Help for Savers in New Pension Law

By Mark Dodge, MBA, AAMS, CWA

In 2001, Congress passed tax legislation which was designed to encourage Americans to step up their savings efforts. Enhancements in the tax incentives associated with IRAs, 401(k)s, and 529 savings plans were welcome, but they came with a hitch—Congress included a "sunset provision" in the law so that they all expired after 2010. However, in August, President Bush signed the Pension Protection Act of 2006 which made many of middle-class America's favorite tax breaks permanent. To be specific:

• IRA and 401(k) contribution limits. You may be one of the millions of investors who are putting the maximum contributions allowable into your retirement accounts—$4,000 for IRAs and $15,000 into your 401(k). If you're over the age of 50, perhaps you have even been able to take advantage of the "catch-up" provision which allows you to put in additional amounts as you approach retirement ($1,000 extra in IRAs and $5,000 extra in 401(k)s). These favorable higher contribution limits have now been extended indefinitely.

• 529 plan distributions tax-deductibility. Many parents jumped on board when 529 plans were first introduced, and they've been gaining in popularity ever since. These plans offer tax-free savings for college along with other useful benefits. A major drawback to 529 plans was the uncertainty surrounding the tax-free nature of the plans' earnings beyond 2010. Under the 2001 law, the distributions were scheduled to revert to being taxable to the student when received. Due to the new legislation, this risk has now been eliminated.

• Roth 401(k)s. We first wrote about the new Roth 401(k) back in Introducing the Roth 401(k). Since the rollout, several companies expressed concerns as to whether Congress was going to renew the Roth 401(k) beyond 2010. Accordingly, most decided to take a wait and see approach before offering it to their employees. The pension bill addresses those reservations by making the Roth 401(k) permanent. With the uncertainty out of the way, rapid growth in Roth 401(k) offerings is expected in the near future.

In addition, the Act addresses the gradual shift in pension benefits offered by corporate America that has been underway over the past 25 years. Prior to the 1980s, most people planned for retirement income in an indirect fashion via the company pension plan. Today, most employees save directly for retirement through employer plans like 401(k)s, with most expecting they won't receive a traditional pension. Over time, many of the rules governing company-sponsored retirement plans hadn't kept up with this changing reality. The new legislation dramatically updates the nation's retirement savings laws. Here are some of the highlights:

• Automatic 401(k) enrollment. It's well documented that many employees aren't saving enough in their company retirement plans, and others fail to even enroll in them. While most companies liked the idea of automatically enrolling employees, many feared this violated state laws prohibiting withholding employees' wages without their consent. The Act makes it clear that automatic enrollment does not violate these state laws. The effect of this change could be dramatic. Currently, only about half of all eligible workers sign up for their company retirement plan. By implementing automatic enrollment, companies expect to increase employees' participation to 85-90%.

• Investment advice. Many employees don't understand the basic principles that would help them make wise investment decisions within their retirement plan. Unfortunately, many of them blindly guess which funds to choose and how to allocate their money among the funds offered. Not surprisingly, it's common for employees to load up on their company stock, often times putting them in a riskier position than they realize. The Act encourages plan sponsors to hire outside financial advisors who can provide investment advice to the employees. Among other things, these financial advisors will be able to help employees determine their risk tolerance levels, explain the importance of diversifying, and help calculate how much the employee should try to contribute each month.

Furthermore, before this pension bill, when an employee didn't choose specific investments, the money in their retirement account generally defaulted to a cash account. Under the Act, the default investment is likely going to be a target-fund or life-cycle fund. These funds are designed to automatically adjust the investor's money between equity and fixed income on an ongoing basis, becoming more conservative as the investor moves closer to retirement. The potential for growth in these funds is far superior to what can be expected in a cash account.

• Distribution option. With a pension, an employee receives an income stream for life upon retirement. Under the Act, companies are being encouraged to offer an annuity distribution option when the employee reaches retirement. If an employee opts for the annuity option, the result would be similar to the traditional pension by providing a monthly income check for life.

• Gifting. The Act allows taxpayers to donate money (up to $100,000 per year) to charity directly from their IRA account. The donations will come out tax-free and not be subject to the penalty on early withdrawals. However, since the distribution will not be taxed, the donor will not be able to claim a tax deduction for the contribution.

Mark Dodge is the Associate Editor of Sound Mind Investing. He is an Accredited Asset Management Specialist and a Chartered Wealth Advisor. Mark has worked in both the securities and accounting industries and taught finance courses at the university level.