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On July 28,2006, the U.S. House of Representatives passed the Pension Protection Act of 2006. The U. S. Senate passed identical legislation on August 3, 2006 and President Bush signed the measure into law on August 17, 2006.
The Pension Protection Act contains many beneficial changes for both defined contribution and defined benefit plans. This Summary provides an overview of the provisions of the Act relating to 401(k) and other defined contribution plans we believe are most relevant to plan administration.
For information on other provisions of the Act including those provisions that impact defined benefit plans, you should consult with your legal or tax advisers. The Summary organizes the changes made by the Act into groups of related issues and does not necessarily follow the structure of the Act. For each change made by the Act, we have provided a short synopsis of the current law, where applicable, followed by an overview of the new law and the effective date of the change.
Current Law: The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") made numerous changes affecting defined contribution retirement plans. Under existing law, these provisions sunset (expire) after 2010.
The provisions that would expire after 2010 and either revert back to their pre-EGTRRA definitions or be eliminated altogether include increases to the contribution limits for 401(k) plans, catch-up contributions for plan participants age 50 and older, Roth 401(k) contributions, changes to the top heavy rules, rollover portability, and various other important provisions.
New Pension Law: The Act makes permanent all provisions of EGTRRA that relate to retirement plans and IRAs.
Current Law: The Saver's Credit is a non-refundable tax credit available to eligible taxpayers who satisfy certain adjusted gross income limits and make contributions to a defined contribution plan or IRA. The Saver's Credit is scheduled to expire at the end of 2006.
New Pension Law: The Act makes the Saver's Credit permanent. The Saver's Credit income limits will be indexed for inflation after 2006.
Current Law: In general, 401(k) plans must satisfy annual nondiscrimination tests that compare the rates of deferrals and matching contributions made on account of highly compensated employees to the rates of deferrals and matching contributions made on account of non-highly compensated employees (the ADP and ACP tests). 401(k) plans are also subject to other nondiscrimination requirements that ensure that owners and key employees do not disproportionately benefit under the plan (the top-heavy test). Current law provides employers with the ability to satisfy these nondiscrimination requirements under a "safe harbor contribution" arrangement in which the 401(k) plan must satisfy certain contribution, notice, and vesting requirements.
New Pension Law: The Act provides for a new nondiscrimination safe harbor for plans with a "qualified automatic enrollment feature. In general, an automatic enrollment program is designed to have an employee automatically defer to the plan a certain stated percentage of his or her compensation unless the employee affirmatively elects a different percentage or elects to forgo withholding altogether. Under the Act, plans that satisfy the new automatic enrollment safe harbor (1) would be deemed to satisfy the ADP and ACP tests, and (2) would not be subject to the top-heavy plan rules.
The Act provides that in order to satisfy the automatic enrollment safe harbor, the plan must provide for an initial automatic deferral rate of between 3% and l0%, unless the employee affirmatively elects otherwise. In addition, the automatic deferral rate for employees must increase to at least the following percentages of compensation by the second through the fourth year of participation:
Deferral rate must be at least:
3% - first year of participation
4% - second year
5% - third year
6% - fourth year and thereafter
Current employees on the date the arrangement is implemented would be exempt from the automatic enrollment requirements if they have already made a deferral election or elected not to participate. However, a plan sponsor could elect to cover such existing employees under a new automatic enrollment program.
Safe Harbor Contributions and Vesting. To qualify for the automatic enrollment safe harbor, an employer must make either (i) a nonelective contribution of at least 3% of compensation on behalf of all eligible NHCEs or (ii) a 100% match on non-HCE elective contributions up to 1% plus a 50% match on non-HCE elective contributions that exceed 1% up to 6% of compensation. In addition, the safe harbor contributions must vest within two years.
Notice Requirement. Similar to existing safe harbor plans, a notice to participants must be provided on an annual basis for plans wishing to qualify as automatic enrollment safe harbor plans. Effective Date: Plan years beginning after December 31,2007.
Effective Date: Plan years beginning after December 31, 2007
Current Law: With limited exceptions, current law prohibits in-service distributions from 401(k) plans and 403(b) arrangements for amounts attributable to elective deferrals.
New Pension Law: Plans with an eligible automatic enrollment arrangement may allow employees to elect during the first go days after the start of automatic contributions to receive a corrective distribution in an amount equal to the automatic elective contributions (plus earnings). The amounts distributed would be exempt from the 10% penalty tax and not included in the ADP test. Any matching contributions made on the amount withdrawn must be forfeited. These amounts would need to be distributed by April 15 of the following year.
Effective Date: Plan years beginning after December 31, 2007.
Current Law: Employers are subject to a l0% excise tax on distributions made to participants from a 401(k) plan as a refund to correct failed ADP or ACP non-discrimination tests if made more than 2 1/2 months after the end of the plan year.
New Pension Law: Plans with an eligible automatic enrollment arrangement may make ADP or ACP corrective distributions up to six months after the end of the plan year without incurring the l0% excise tax.
Effective Date: Plan years beginning after December 31, 2007.
Current Law: Certain states have existing wage garnishment/labor laws that require employers to receive affirmative consent from employees before withholding amounts from employee wages. It is unclear under existing law to what extent these state wage laws are preempted by ERISA. This uncertainty has made it difficult for employers in these states to implement an automatic enrollment Program in their 401(k) plans.
New Pension Law: Preempts any state law that would prohibit or restrict the inclusion of an automatic enrollment feature, provided that the plan provides notice to affected employees within a reasonable period before each year, including an explanation of (1) an employee's right to opt out of the automatic enrollment feature and (2) how contributions made under the arrangement will be invested. Preemption of state garnishment laws is limited to plans that are covered by ERISA.
Effective Date: Date of enactment.
Current Law: Under ERISA, plan fiduciaries are required to prudently select and monitor the investment of plan assets. ERISA section 404(c) provides relief to fiduciaries to the extent participants or beneficiaries exercise control of the investment of their own accounts under the plan. Section 404(c) does not provide relief from fiduciary responsibility for the investment of plan assets where a participant or beneficiary does not exercise control of his or her account and is invested in the plan's "default" investment as a result.
New Pension Law: Under the new law, the Department of Labor is directed to issue regulations providing safe harbor guidance on the designation of default investments under ERISA section 404(c). The default investments should include "a mix of asset classes consistent with capital preservation or long-term capital appreciation, or a blend of both."
A participant shall be treated as having elected to have the plan sponsor invest his or her account in the plan's default fund if the participant receives a annual notice explaining the employee's right under the plan to make investment elections and explaining how contributions will be invested in the absence of an election. The plan sponsor must provide the participant with a reasonable period after the receipt of the notice and before the beginning of the year to make a change.
Effective Date: Plan years beginning after December 31, 2006
Current Law: ERISA restricts fiduciaries from entering into specific "prohibited transactions" as provided under ERISA. Under current law, it is difficult for a party to provide investment advice to a plan participant regarding asset allocation without violating one or more of ERISA's prohibited transactions if the adviser receives varying amounts of payments depending on which investment alternatives are selected.
New Pension Law: The new law provides an exemption to ERISA's prohibited transaction rules for advice provided by a "fiduciary adviser" under an "eligible investment advice arrangement." The exemption covers advice provided to a participant in the plan, but not advice to the plan. In order to qualify for the exemption, the eligible arrangement must either (1) provide that the fees or other compensation received by the fiduciary adviser do not vary depending on the investment option chosen or (2) use a computer model under an investment advice program meeting certain criteria modeled after the DOL's Advisory Opinion 2001-09A. An independent fiduciary would need to approve the arrangement.
The adviser also would be required to provide advice in a format designed to be reasonably understood by the average investor.
The Definition of a "fiduciary adviser." The advice would have to be provided by a "fiduciary adviser," which may include a registered broker-dealer, a registered investment adviser under the Investment Adviser Act of 1940, a bank or similar financial institution, or an insurance company. The bill defines an "adviser" to include all affiliates or registered representatives of the fiduciary adviser.
In addition, the fiduciary adviser must specifically acknowledge in writing that it is a fiduciary of the plan with respect to the provision of the advice. The plan sponsor (and/or other plan fiduciary) would still be subject to general fiduciary requirements on the prudent selection and periodic review of a fiduciary adviser. However, the plan sponsor would not have a duty to monitor the specific advice given by the fiduciary adviser to any particular participant, as the adviser would be acting as a fiduciary with regard to the specific investment advice given.
Effective Date: Applies to investment advice provided after December 31, 2006
Current Law: A participant's spouse is eligible to roll over their spouse's account balance into an IRA or other eligible retirement plan in the event the participant dies. Non-spouse beneficiaries are not permitted to rollover such distributions and, as a result, may incur an immediate tax liability upon distribution.
New Pension Law: Under the new law, a non-spouse beneficiary may roll over the benefits they receive from a retirement plan to an IRA. The IRA should be treated as an inherited IRA and subject to the minimum distribution rules that apply to inherited IRA's
Effective Date: Distributions after December 31, 2006
Current Law: Only the Roth portion of a participant's 401(k) account may be rolled over to a Roth IRA.
New Pension Law: Plan participants may roll over both the Roth and non-Roth portions of their retirement plan accounts directly into Roth IRAs. The taxable portion of the rollover distribution will be taxed at the time of the rollover. The Roth rollover distributions would be subject to the Roth IRA conversion eligibility rules including the current income restrictions.
Effective Date: This provision will be effective for distributions after December 31, 2007
Current Law: The ability to take distributions under a 401(k) plan is generally limited to the occurrence of specific events, but may include the ability to withdraw 401(k) contributions on account of hardship. A distribution is considered made on account of a hardship if it is made in response to an immediate and heavy financial need and it is made in an amount necessary to satisfy that need and is generally limited to hardships incurred by the participant or his or her dependents.
New Pension Law: The Act requires the IRS to issue regulations permitting hardship withdrawals on account of hardships or unforeseeable emergencies of a person who is designated as the participant's beneficiary under the plan, even if that beneficiary is not the participant's spouse or dependent.
Current Law: In general, the ability to take distributions from a 401(k) plan is limited to the occurrence of specific events. In addition, distributions taken from a retirement plan prior to age 59 1/2 are subject to a 10% federal excise tax (with limited exceptions).
New Pension Law: Under the Pension Protection Act, 401(k) plans and IRAs would be able to make distributions to Qualified Reservists provided such persons were called up to active duty for a minimum period between September 11, 2001 and December 31, 2007. Distributions to Qualified Reservists under this rule would not be subject to the 10% premature distribution penalty tax. A two-year window for rollover distributions would apply following the end of the active duty period.
Current Law: With limited exceptions, distributions taken from a retirement plan prior to age 59 1/2 are subject to a 10% federal penalty tax. The 10% penalty tax does not apply to distributions made to participants over age 55 who have separated from service.
New Pension Law: Distributions made to Public Safety Employee (defined generally as a state or local employee who provides police, firefighting, or emergency medical services) who has attained age 50 and has separated from service will not be subject to the 10% premature distribution penalty tax.
Effective Date: Distributions after date of enactment.
New Pension Law: The Department of Labor will be required to display 5500 information in an electronic form within 90 days of receipt. In addition, plan sponsors that maintain an Intranet Web Site that is used to communicate with employees will need to display the plan's Form 5500 on that Intranet site.
Effective Date: Plan years beginning after December 31, 2007.
Current Law: A plan administrator must provide participants or beneficiaries with a benefit statement upon request, but only once during any 12-month period.
New Pension Law: Participants or beneficiaries who have the right to direct their investments in a defined contribution plan must be provided benefit statements on a quarterly basis. For participants or beneficiaries who do not have the right to direct their investments, a benefit statement must be provided on an annual basis.
The Department of Labor is directed to issue model benefit statements that will satisfy these requirements. The model will include language that advises participants of the risk of investing more than 20 percent of his or her account in the securities of any single entity (such as employer securities).
Effective Date: Plan years beginning after December 31, 2006, subject to a delay of up to two years for collectively bargained plans.
Current Law: Employer contributions (with the exception of matching contributions) made to participant accounts in a defined contribution plan must become 100% vested on either a five-year cliff or seven-year graded vesting schedule (100% after five years or 20% for each year of service beginning with the third year of service). Matching contributions must become 100% vested on either a three-year cliff or six-year graded vesting schedule (100% after three years or 20% for each year of service beginning with the second year of service).
New Pension Law: All employer contributions must now become 100% vested on either a three-year cliff or six-year graded vesting schedule (100% after three years or 20% for each year of service beginning with the second year of service). These changes are identical to the current top heavy vesting requirements.
Effective Date: The provision would effectively apply for contributions made for plan years beginning after December 31, 2006, provided the employee has at least one hour of service after the effective date. There is a separate later effective date for collectively bargained plans and certain employee stock ownership plans.
Current Law: Under ERISA, plan fiduciaries are required to prudently select and monitor the investment of plan assets. ERISA section 404(c) provides relief to fiduciaries to the extent participants or beneficiaries exercise control of the investment of their own accounts under the plans
New Pension Law: The Act would provide ERISA 404(c) relief to a plan fiduciary during a plan's "blackout period," if certain conditions prescribed by the Department of Labor are met. The relief will be provided for a "qualified change" includes the investing of a participant account in one or more existing or new investment options reasonably similar in characteristics to the prior options, provided that the participant receives notice of the change at least 30 days and no more than 60 days prior to the change, the participant has not provided affirmative instruction to the contrary of the change, and the investments chosen by the participant or beneficiary prior to the change are the result of the participant's or beneficiary's control over his or her account.
Effective Date: Applies to plan years beginning after December 31, 2007. There is a delayed effective date for collectively bargained plans.
The views expressed in this article are those of MFS and are subject to change at any time.
MFS does not provide legal, tax or accounting advice. Any statement contained in this communication (including any attachments) concerning U.S. tax matters, was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code. This communication was written to support the promotion or marketing of the transaction(s) addressed. Clients of MFS should obtain their own independent tax and legal advice based on their particular circumstances.