Little-Known Facts About the New Tax Act
Fidelity Investments


Last summer's passage of the Pension Protection Act of 2006 may go a long way toward helping Americans build a secure retirement for themselves.

Some of the law's provisions, such as making higher contribution limits for IRAs and 401(k)s permanent, have been well publicized. Buried within the Act's 900 pages, however, are several additional changes that may have a direct impact on your ability to sock away money for retirement, save for college, or donate IRA assets to charity.

Here's how you may be able to take advantage of these lesser-known opportunities.

Deposit federal tax refunds directly into an IRA. Effective January 1, you will be able to instruct the Internal Revenue Service to deposit your federal tax refund directly into an existing IRA. If the amount of your refund exceeds the 2006 or 2007 contribution limit of $4,000, you can instruct the IRS to split the refund and deposit a portion to another non-retirement account. This change may help you build the discipline to fully fund your IRA each year, rather than spend your tax refund.

Tax relief for non-spouse beneficiaries. Under the old rules, non-spouse beneficiaries of a qualified retirement plan (such as a 401(k) or an IRA) could not transfer any assets they inherited into an IRA in their own name. Rather than preserving the tax-deferred status of inherited retirement assets, non-spouse heirs were required to take a lump-sum distribution and pay ordinary income tax on it. The Act provides a remedy. Beginning January 1, non-spouse beneficiaries can complete a direct trustee-to-trustee transfer of inherited retirement assets. By stretching out minimum required distributions over their lifetime, many beneficiaries will be able to reduce the tax bite and keep that money growing tax-deferred.

Action Step: Review or update your IRA beneficiary information.

More diversification for 401(k) plan savers. If your employer offers matching contributions of publicly traded company stock as part of your compensation plan, the Act gives you the right to sell those shares after three years of service. You can sell shares that you bought with your contributions at any time. The Act prohibits companies from forcing employees to invest any of their own retirement savings contributions in company stock. Employer-sponsored retirement plans are also required to offer at least three investment options other than company stock. These investments must each offer materially different risk and return characteristics.

529 college savings permanently federal income tax-free. One of the knocks on 529 College Savings Plans had been that one of their key benefits—-the ability to take federal income tax-free distributions to pay for qualified higher education expenses—-was due to expire on December 31, 2010. Thanks to the Pension Protection Act, however, the tax benefits of investing in a 529 plan have been made permanent.

Action Step: Learn more about 529 College Saving Plans.

Donate IRA savings to charity. If you are 70 1/2 or older, you may now donate up to $100,000 in IRA assets directly to a qualified charity, but only in 2006 and 2007. The distribution must be transferred directly to a qualifying charity from the IRA custodian. SEP IRAs and SIMPLE IRAs are ineligible, and distributions to donor-advised funds, supporting organizations, and private foundations are not considered qualified charities.

Charitable distributions from an IRA will not be treated as taxable income. Therefore, if you are subject to minimum required distributions from you IRA, you may be able to meet your requirement without incurring taxable income. Simply send the amount of your minimum required distribution to a qualified charity. "Even for a modest account where your required distribution is only $2,000 a year, you may be better off giving that money to charity," says Ed Slott, a Long Island, New York-based CPA and the author of Parlay Your IRA Into a Family Fortune (Penguin Books, 2005). "You won't have to report the income or pay tax on the distribution."

Donations of cash and goods get more scrutiny. While the Pension Protection Act makes it easier to donate IRA assets to charity, it also makes it a bit tougher for individuals to claim tax deductions for contributions of cash, clothing, and household goods. Starting with the 2007 tax year, you must now have a canceled check or a written statement from a charity to claim deductions for cash contributions. If you normally throw a few dollars in the church collection basket, you will need a receipt to claim that amount on your federal tax return. Donations of clothing or household goods, including furniture, appliances, etc., must be in "good" condition or better to qualify for an income tax deduction. However, if you donate an item that has been appraised at more than $500, you can still deduct that amount, even if it is not in good condition. You may be subject to penalties if the IRS determines that you have made inflated claims about the appraised value of items donated to charity.

Help for military reservists. Qualified reservists and members of the National Guard can take early withdrawals from an IRA without having to pay the 10% early withdrawal penalty. This provision applies to reservists who served more than 179 days of active duty between September 11, 2001, and December 31, 2007. However, any early withdrawals must be repaid within two years. Reservists who took early withdrawals prior to passage of the Act have until August 17, 2008, to repay them.

Incentives for low-income savers. The Saver's Credit, which was due to expire at the end of this year, has been made permanent. This provision gives a tax credit of up to $2,000 to low-income earners who contribute to an employer-sponsored retirement savings plan or an IRA. Single filers must have an adjusted gross income (AGI) of less than $25,000 to qualify; the AGI limit for married couples who file a joint tax return is $50,000. Starting in 2007, the income limits that determine whether taxpayers qualify for the Saver's Credit will be indexed to inflation.

Action Step: Open an IRA.

The Pension Protection Act includes additional provisions that require companies to fully fund their pension plan obligations within seven years. It also allows companies to automatically enroll employees in a 401(k) plan and automatically increase the percentage of each employee's annual salary deferral. Taken together, these new rules should go a long way toward improving the average American's retirement readiness.