Tax Changes: Part One

For the next two weeks, we're going to turn to the subject of the changes included in two recent tax laws. For help on that complicated topic, I've called on my friend and colleague, Bob Leins, a certified public accountant and fellow seminar presenter.

The recently passed laws involve changes to employer-sponsored retirement plans. Their provisions will need to be separately applied to the government's 401(k)-style Thrift Savings Plan.

This week, we'll look at the Pension Protection Act of 2006 (H.R. 4), a massive new law with a host of changes. If the measure, which President Bush signed into law on Thursday, had not been enacted, some of the benefits related to retirement savings that we have become accustomed to would end on Dec. 31, 2010. The law will permanently extend some of these provisions that have been taken for granted, and offer some additional benefits to make saving for retirement easier.

Tax Break for Beneficiaries

After you die, your federal retirement savings are paid to your beneficiary in a lump sum. Most beneficiaries don't want to pay income tax on this inheritance if they don't have to. The new law doesn't allow beneficiaries to avoid the tax entirely, but allows them to spread the burden over a longer period of time.

Currently, surviving spouses can transfer their deceased spouses' retirement savings into their own IRAs. Spousal beneficiaries of TSP account holders have this same benefit. The surviving spouse is not taxed when the transfer takes place. Instead, the taxes are incurred as normal distributions are taken.

The new tax law extends this special treatment to nonspouse beneficiaries. That means that your brother, your children or your best friend can inherit your retirement savings and reinvest the inheritance into an IRA. Those funds will be taxable only when distributions are received. Your beneficiary won't have to report the entire account as taxable income in a single year. This is good news for estate planning as well as retirement planning.

Direct Transfers to Roth IRAs

Effective for distributions after Dec. 31, 2007, the new law allows transfers from a qualified retirement plan, tax-sheltered annuity or governmental plan directly to a Roth IRA. Such transfers will be treated as a Roth conversion if all other conversion qualifications are met.

The primary conversion qualification is a limit on your adjusted gross income of $100,000. That limit will be waived in 2010.

You may be wondering if you will be able to transfer your TSP to a Roth IRA after retirement-or why you might want to. We'll cover that next week.

Penalty-Free Distribution

The new law will make it easier to make hardship withdrawals from retirement savings. The law allows for withdrawals for "unforeseen financial emergencies for any person who is listed as a beneficiary under the 401(k) plan" -- not just spouses.

The TSP is not technically a 401(k) plan, but in many respects it has been granted the same tax treatment as such plans. While we think Congress will extend the new 401(k) provisions to the TSP, it is not certain that will happen.

Indexed Income Limits for IRAs

Currently, income limits restrict some taxpayers' contributions to deductible IRAs and Roth IRAs. The new law will provide relief by increasing these ceilings somewhat.

Permanent Changes

Under current law, many enhanced retirement savings incentives would have ended after Dec. 31, 2010. For example, without the Pension Protection Act, IRA contribution limits would have reverted to the 2001 level of $2,000 per year and the ability to make catch-up contributions would have ended. The new law repeals "sunset" provisions regarding these incentives, and they will continue. That makes long-range retirement planning easier.

Charitable Contribution Limits

While loosening some restrictions that would have gone into effect, the new law imposes others. For example, under the law, no deduction will be allowed for any charitable contribution of cash, check or other monetary gift unless the donor can show proof of the contribution. Such evidence, which can be in the form of a bank record or a written communication from the charity, must indicate the amount of the contribution, the date the contribution was made and the name of the charity.

Previously, donations under $250 did not require documentation.

The new recordkeeping requirements appear to give taxpayers no leeway. Cash donations, regardless of the amount, must be substantiated either by a canceled check or a bank record. Donations made by debit or credit card can be substantiated by the taxpayer's bank statement.

The law also prohibits taxpayers who don't itemize their deductions from making deductions for charitable contributions. Also, no deductions are allowed for used clothing and household items unless the items are in "good" condition -- but the law doesn't define that term. Household items include furniture, furnishings, electronics, appliances, linens and similar items. Food, paintings, antiques, objects of art, jewelry, gems and collectibles are not household items under the law.

Other provisions of the Pension Protection Act include:

• Limits on IRA contributions of $4,000 in 2006 and 2007, and $5,000 in 2008. The limits will be adjusted for inflation after that.
• Permanent higher dollar limits on tax-deferred contributions from your pay. The elective deferral limit for TSP plan contributions in 2006 is $15,000.
• Permanent provisions allowing catch-up contributions to retirement plans for those 50 or older. For the TSP and 401(k) plans, $5,000 in such contributions currently are allowed.