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529 Plan Benefits Made Permanent by the Pension Protection Act

Volume 1, Issue 2

Whether your client is a parent with future educational obligations for young ones, or perhaps a loving aunt, uncle, grandparent, or stepparent, now more than ever 529 plans are an attractive tool for the escalating costs of education, as well as for income and estate planning purposes. This is because one of the hidden gems of the new Pension Protection Act of 2006 (signed into law on August 17, 2006) is a provision that makes permanent the income tax-free growth of Section 529 plans used for qualified higher education expenses. Prior to this new law, these provisions would have expired December 31, 2010.

Planning Tip:  The new Pension Protection Act makes permanent the income tax-free growth of 529 plans, but only for withdrawals used for qualified higher education expenses. Funds used for other expenses are tax deferred (like an IRA) and subject to a 10% penalty.

Most wealth planning professionals (and clients for that matter) understand the value of investing in 529 plans. 529 plans are by far the most popular college savings vehicle, but they’ve just become even more popular. According to a recent survey, 54% of parents with young children who do not currently own a 529 account are more likely to open one now, due to the new law, and 36% who already own a 529 plan say they are now more likely to increase the amount they contribute to existing plans. And another recent survey confirmed that older clients may want to learn more about college savings.

Income Tax Benefits

While many clients understand the educational savings benefits, many do not understand the benefits of investing in 529 plans for income tax purposes. Just like with an IRA, the power of tax-deferred growth makes 529 plans worthwhile even if not used for educational expenses. The ability to frontload up to five years of annual exclusion gifts, or $60,000 per beneficiary ($120,000 per beneficiary for married couples), without paying gift tax creates the ability to grow a significant amount of money tax free. In addition, many states offer residents a state income tax deduction for an investment in their state’s 529 plan. Planning Tip: Clients should consider an investment in a 529 plan even if it is not anticipated that the funds will be used for educational purposes. The income tax benefits alone of 529 plans make these very worthwhile investments.

Estate Planning Tax Benefits

529 plans are unique in that you can invest in a 529 plan, retain absolute control over the assets, and yet remove those assets from your estate for estate tax purposes. This type of control typically means that the asset would be subject to estate tax at a 46% rate (in 2006) at death, but not with a 529 plan. Thus, clients can invest up to $60,000 per beneficiary ($120,000 per beneficiary for married couples) without paying gift tax and, if the client lives for at least five years, all of these assets will not be subject to estate tax. More importantly for many clients, a 529 plan allows them to use the 529 plan assets in a financial emergency.

Planning Tip:  Clients should also consider 529 plans for estate planning purposes to remove significant wealth from the estate tax while retaining the ability to use the assets in a financial emergency.

Educational Trusts

Many 529 plans permit a trust to be the owner and beneficiary of accounts set up under that state’s plan. A 529 plan combined with an Educational Trust may provide more flexibility to ensure that the 529 meets the client’s objectives by, for example, moving assets between siblings or providing a smooth transition should the client become incapacitated or die.

This combination of 529 plans and specially designed trusts can also provide divorce and creditor protections, even for those states’ 529 plans that do not provide their own asset protection; for example, to ensure that the 529 plan’s assets do not end up in the hands of a former son-in-law or daughter-in-law. And the client still retains the ability to use the funds in a financial emergency.

Planning Tip:  Consider combining 529 plans with Educational Trusts to provide the greatest flexibility and to ensure that the 529 plan assets meet each client’s particular planning objectives.

Conclusion

Now more than ever, clients should consider 529 plans for educational savings, income tax benefits and estate tax benefits; and when combined with a carefully-crafted Educational Trust, they will provide added flexibility to control this asset and to ensure that it meets the client’s planning objectives.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer’s particular circumstances.

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The Pension Protection Act: New Opportunities for Retirement Planning

Volume 1, Issue 1

The new Pension Protection Act of 2006 (signed into law on August 17, 2006) creates significant planning opportunities for advisors and their clients who understand it. This newsletter focuses on two key provisions: (1) non-spousal rollovers from a qualified plan to an inherited IRA and (2) charitable contributions of IRAs during lifetime.

Non-Spousal Rollovers from Qualified Plans

In the past, only a surviving spouse could roll over a qualified plan (for example, a 401(k)) to an IRA after the plan owner’s death. Once rolled over, it is as if the surviving spouse created the IRAÑhe or she can defer required minimum distributions from the IRA until reaching age 70 1/2 and can withdraw these required minimum distributions over his or her lifetime.

Planning Tip:  The new law does not impact spousal rollovers; a spouse can still rollover a qualified plan to his or her own IRA after the death of the owner.

Alternatively, a beneficiary other than a surviving spouse (for example, a child or unmarried partner) has been forced to withdraw the qualified plan in full – and pay income tax on this amount – over the period set forth in the plan agreement, typically within one to five years of the plan owner’s death. Thus, a non-spouse beneficiary could not defer income tax by “stretching out” distributions over his or her life expectancy.

Beginning January 1, 2007, a non-spouse beneficiary can roll over a qualified plan to an “Inherited IRA” after the plan owner’s death. If the owner names a trust as beneficiary of the qualified plan, the trustee of that trust can roll over the qualified plan to an inherited IRA for the benefit of the trust beneficiary.

Planning Tip:  Clients who name a trust as designated beneficiary can protect the assets from creditors (including former spouses of the beneficiary) and spendthrift beneficiaries, who often withdraw far more than the required minimum distributions. Naming a trust also allows the owner’s financial advisor to continue to manage the assets as the owner desired.

With an Inherited IRA, a non-spouse beneficiary can use his or her own life expectancy to determine required minimum distributions. This significantly reduces the amount that the beneficiary must withdraw each year, thereby deferring income tax and allowing the account balance to continue to grow income tax free.

Planning Tip:  A non-spouse beneficiary must begin taking required minimum distributions from the Inherited IRA by December 31st of the year following the year of the owner’s death. This is different from a spousal rollover, where the surviving spouse can defer required minimum distributions until attaining 70 1/2.

A rollover to a non-spouse beneficiary must be directly from the trustee of the qualified plan to the trustee of the Inherited IRA (a trustee-to-trustee transfer). In addition, and unlike a spousal rollover, the IRA must remain in the name of the deceased owner.

Planning Tip:  Avoid re-titling the qualified plan in the name of the non-spouse beneficiary. Also avoid transferring the qualified plan to an existing IRA in the non-spouse beneficiary’s name. Both constitute a taxable distribution of the entire account. The Inherited IRA should be titled like this: Susan Participant, deceased, IRA f/b/o Emily Participant (beneficiary).
Planning Tip:  Any distribution to a non-spouse beneficiary is a taxable distribution, subject to income tax. Therefore, the check should be made payable directly to the Inherited IRA.

Until January 1, 2007, a non-spouse beneficiary must continue to use the payout schedule dictated by the qualified plan agreement. Thus, if the plan agreement provides that all funds must be distributed within three years of the owner’s death, the beneficiary must withdraw, and therefore pay income tax on, the entire plan balance within three years, thereby eliminating potentially significant growth through income tax deferral.

Planning Tip:  If possible, delay post-death distributions from a qualified plan to a non-spouse beneficiary until after December 31, 2006 to take advantage of these new provisions.

Example

On October 1, 2006, Susan Participant dies having named a trust for her daughter Emily’s benefit as the death beneficiary with her 401(k) plan. Anytime after December 31, 2006, the trustee of Emily’s trust can request a trustee-to-trustee transfer of the 401(k) to an inherited IRA for Emily’s trust’s benefit, using Emily’s life expectancy to determine the required minimum distributions from the inherited IRA.

Clients Impacted by This Change

All clients with qualified plans and clients named as the beneficiary of a qualified plan will potentially benefit from this new provision.

Charitable Contribution of IRA During Lifetime

In 2006 and 2007 only, a taxpayer who is at least 70 1/2 years old can contribute to charity up to $100,000 per year from one or more Individual Retirement Accounts (IRAs).

Planning Tip:  Distributions from a SEP IRA, SIMPLE IRA or qualified plan do not qualify because they are not distributions from an IRA. Consider rolling out qualified plan assets into an IRA where appropriate to take advantage of this opportunity.

If the contribution is made by direct transfer from the IRA custodian to a “public” charity, the taxpayer need not report the distribution as taxable income. In other words, unlike a typical IRA distribution, the distribution will not appear as taxable income on the taxpayer’s income tax return. Because the distribution does not appear as income, the taxpayer does not get an offsetting charitable income tax deduction to reduce the income created by the IRA distribution.

Planning Tip:  The check must be made payable to the charity. If the check is made payable to the IRA owner who endorses it to the charity, the owner must report the distribution as taxable income.
Planning Tip:  Public charities include religious organization, schools, etc. Unfortunately, Donor Advised Funds, Supporting Organizations and Charitable Remainder Trusts are not public charities, and therefore distributions to these types of charities do not qualify.

Significantly, charitable contributions that meet these requirements satisfy the taxpayer’s required minimum distributions for the year of distribution.

Clients Impacted by This Change

There are two critical questions: (1) Does the client have IRAs from which they can make direct contributions to charity or, alternatively, can the client roll out of a qualified plan into an IRA; and (2) Is the client currently making or contemplating charitable gifts. Consider the following classes of clients who will benefit from this provision.

  1. Clients Who Claim the Standard Federal Income Tax Deduction
    For clients who do not itemize, this new law provides the equivalent of an unlimited federal charitable income tax deduction for up to $100,000 of the charitable gifts that they make from an IRA.
  2. Clients Who Would Lose Phased-Out Deductions with Increased Income
    Under the new law, a direct contribution of an IRA up to $100,000 does not increase the taxpayer’s Adjustable Gross Income (AGI). Correspondingly, it does not impact other deductions.
  3. Clients Who Are Subject to the 50% Limitation on AGI
    A direct contribution to charity of up to $100,000 is not subject to the typical 50% of AGI cap for cash contributions to a public charity.
  4. Clients Who Live in States That Do Not Permit State Income Tax Charitable Deductions
    For clients in Indiana, Michigan, New Jersey, Ohio and Massachusetts, direct contributions from IRAs will result in the highest possible net state tax savings.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer’s particular circumstances.

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