October 6, 2006

The Pension Protection Act of 2006

Holland & Knight Alert
Robert J. Friedman

Congress recently passed, and the President has signed into law, the Pension Protection Act of 2006 (the Act), that amends several sections of the Internal Revenue Code (the Code) and the Employee Retirement Income Security Act of 1974 (ERISA). The Act affects many retirement plans and programs currently sponsored by employers for their employees.

This is the second in a series of alerts from Holland & Knight that summarize those provisions of the Act that will have a substantial impact on employers that sponsor retirement plans, both with regard to new compliance requirements affecting their current retirement plan documents, as well as to changes affecting the ongoing administration and operation of their plans.

Described below are key provisions of Title VIII and other sections of the Act.

Increase in Deduction Limit for Single-Employer Pension Plans

For plan years beginning in 2006 and 2007, the Act amends Code Section 404(a) to increase the deduction limit for employer contributions to single-employer pension plans from 100 percent to 150 percent of the plan’s current liabilities.

For plan years beginning after December 31, 2007, the deduction limit for employer contributions to such plans is an amount equal to the excess of the sum of (i) the plan’s funding target for the plan year; (ii) the plan’s targeted normal costs for the plan year; and (iii) a “cushion” amount for the plan year equal to the sum of (a) 50 percent of the plan’s funding target for the plan year and (b) the amount by which the plan’s funding target for the plan year would increase if the plan were to take into account anticipated increases in compensation in succeeding plan years, over the value of plan assets as of the valuation date. In no event will the employer deduction limit be less than the plan’s minimum required employer contribution for the plan year.

Special rules apply to (i) plans with 100 or fewer participants (for the purpose of determining the “cushion,” certain increases in the compensation of highly-compensated employees are disregarded); (ii) terminating plans (deduction limit shall not be less than the amount required to fully fund the plan’s benefit liabilities in the year of termination); and (iii) multiple employer plans (the deduction limit for plan years beginning after December 31, 2007, is increased to the excess of 140 percent of the plan’s current liabilities for the plan year over the value of the plan assets as of the valuation date).

Provisions Previously Set to Expire Made Permanent

The pension and individual retirement account provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) that otherwise were set to expire after 2010 are made permanent by the Act, including all of the following:

  • the higher contribution limit for IRA contributions ($4,000 in 2006)
  • the higher contribution limit for defined contribution plans ($44,000 in 2006)
  • the higher elective deferral contribution limit ($15,000 in 2006)
  • the increase in the annual benefit limit under a defined benefit plan ($175,000 in 2006)
  • the availability of catch-up contributions for workers age 50 and older ($5,000, for 401(k) plans in 2006)

In addition, the Saver’s Credit will no longer expire at the end of 2006. The Saver’s Credit is a tax credit equal to the applicable percentage (determined by income) of up to $2,000 of an eligible individual’s “qualified retirement savings contribution.” The applicable percentage is 10 percent, 20 percent, or 50 percent, depending on the individual’s adjusted gross income.

Modification to Hardship Rules

Under the Act, the Secretary of the Treasury is instructed to issue rules modifying the current hardship distribution and unforeseeable emergency withdrawal rules to provide that if an event, including the incurrence of a medical expense, would constitute a hardship or unforeseeable emergency if it occurred with respect to a participant’s spouse or dependent (as defined in Code Section 152) then, to the extent permissible under the terms of the plan, it would also constitute a hardship or unforeseeable emergency if it occurs with respect to a beneficiary of the participant under the plan.

Corporate-Owned Life Insurance Rules

The Act incorporates, effective as of August 17, 2006, a new provision into the Code providing specific rules with regard to corporate-owned life insurance (COLI). Under the new provision, which is generally a codification of the current “best practices” in the industry, the death benefit under a COLI arrangement, to the extent not in excess of the total amount of premiums and other amounts paid, is exempt from taxation. There are certain exceptions to this rule, such as in the case of amounts paid to an employee’s heirs (including family members, designated beneficiaries, the estate of the employee, a trust, etc.), to individuals who were employees at any time within 12 months of death or to individuals who were directors or highly-compensated employees/individuals at the time of policy issue. The Act also contains reporting and record-keeping requirements for COLI arrangements.

Transfer of Excess Pension Assets to Retiree Health Accounts

The Act provides that defined benefit pension plans with assets in excess of 120 percent of the plan’s current liability (or funding target) may transfer excess assets equaling two or more years of estimated retiree medical costs to a health account under the pension plan. The health account, known as a Code Section 401(h) account, is established within the defined benefit pension plan and is used to pay the costs for retiree health expenses for retirees, other than key employees, covered by the pension plan.

The employer must elect the transfer period for transferring the excess assets to the health account, which is a period of not less then two taxable years and not more than 10 taxable years starting with the year of the transfer. The limit on the amount transferred to the account is the amount the employer reasonably estimates the plan will pay out of the health account during the taxable year of the transfer for qualified current retiree health liabilities plus, for the additional years in the transfer period, the sum of the reasonably estimated qualified current retiree health liabilities for those additional years.

To take advantage of these transfers, the employer must maintain the 120 percent funding level by making contributions to the pension plan or transferring assets back from the health account to the pension plan.

Long-Term Care Added to Annuities and Life Insurance

Under the Act, long-term care riders are now permitted for annuities and life insurance contracts. The Act also provides for favorable tax treatment of long-term care life insurance contracts, including the use of the cash surrender value to pay for the long-term care benefits.

Spousal Pension Protection

Qualified Domestic Relations Orders

The Act provides that the Department of Labor must issue regulations within one year to clarify that a qualified domestic relations order will not fail to be treated as “qualified” solely because: (1) the order is issued after, or revises, another domestic relations order or qualified domestic relations order, or (2) the time at which the order is issued. These orders will be subject to the same protections and requirements that apply to qualified domestic relations orders under the Internal Revenue Code and ERISA

New Qualified Optional Survivor Annuity

For plan years beginning after December 31, 2007, a participant may elect a qualified optional survivor annuity as long as the participant waives the qualified joint and survivor annuity under the plan. Qualified plans are required to provide a written explanation to participants of the qualified optional survivor annuity.

A qualified optional survivor annuity is the actuarial equivalent of the single annuity for the life of the participant. It is an annuity for the life of the participant with a survivor annuity for the life of the spouse which is equal to the “applicable percentage” of the amount of the annuity that is payable during the joint lives of the participant and spouse. If the survivor annuity percentage is less than 75 percent, then the applicable percentage is 75 percent. If the survivor annuity percentage is equal to or greater than 75 percent, then the applicable percentage is 50 percent. The survivor annuity percentage means the percentage which the survivor annuity (under the plan’s qualified joint and survivor annuity) bears to the annuity payable during the joint lives of the participant and the spouse.

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