Two weeks ago I gave you a rundown of the structure of the 401(k) plan and how to use it to help you prepare for retirement. I said then that I would be giving you an update soon on some of the 2006 changes to the laws governing 401(k)s.
The new bill was signed on August 6, 2006, just about one year ago, and was hailed as the most sweeping reforms experienced by the U.S. retirement system. Without a doubt, it did clearly mark the recognition of the "end" of the defined benefit retirement programs offered by corporations over the last 60 or years.
In its place, employees (as well as employers) now see that the 401(k) plan has been brought to front and center by Congress as the retirement plan of the future for virtually every one. So, we better get used to how to make our 401(k) work for us. The August 2006 bill is likely to be just the beginning of "adjustments" that will be made over the next 20-30 years.
Everyone seems to agree that there were four or five important new features in the bill (some say even six to seven, depending on one's interpretation, I guess). Those features all seem aimed at putting more of the responsibility on you, the plan owner, when it comes to selecting and managing your investment retirement plan.
Now, this is not meant as a political comment, but if this is the direction things are going, how far behind can demands for some individual control of one's social security portion of retirement funds be?
Well, anyway, let's look more closely at what Congress has served up this time around. I will first list the important changes I see and follow with some comments on each one. Here are the five changes that directly affect you:
Finally, the "Saver's Credit" tax deduction, like the Section 529 feature, was also scheduled to expire in 2010, but is now a permanent deduction and can save lower wage earner a bundle on their owed taxes, so long as their income stays below $52,000.
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There were many other features in the bill, of course, but these are the ones that I believe reach into your billfold the deepest. I think you will agree.
Comments On The Five Changes
As a beginning comment, in all cases where I tell you of the 2007 contribution rates for the 401(k) plans, Congress, in every case, also set in place an automatic escalator using the Cost-of-Living Index to raise contribution levels year to year after 2007. Now, some expanded comments on each of the five features.
Plan Enrollment Required — In the past, the participation in 401(k) plans has struggled to get over the 35 percent-40 percent mark nationwide. That will likely change drastically. Employers will automatically enroll you in a 401(k) plan now. You do have the option to say no.
The idea is quite simple. Congress is intent on raising the savings rate of the country and this could have profound implications in that direction. By using "automatic" enrollment, it is believed by the bills sponsors that, while a few employees may opt out, the percentage of employees using the 401(k) will climb to over the 90 percent mark in less than 5 years. And they are probably right.
And not only will employees be automatically enrolled, but they will find the employer is able to offer them investment advice. This will be done, most likely, by the company hiring outside "experts" to counsel the employees. Already, less than a year into the new rules, companies are springing up to do just this as their specialty.
This is a radical departure from the past and one that will surely attract more attention from legislatures over time. I expect that somewhere along the way, some plan participants will not like the advice given by the employer and will sue the company. So, in five years or so look for some Congressional modifications here, most likely in the employer liability side of the equation.
Also, if you find your plan offers outside advisors, I advise to closely check the fees your plan is charged. They could be as low as 0.1 percent to as high as 1.5 percent and the higher levels could truly adversely impact your plans assets. (Do you notice how more of the responsibility for your future is being put on your shoulders? Interesting.)
Contributions and Plan Management — The contribution allowed for a 401(k) are quite generous. There are basically three types of plans: (1) Traditional (2) Safe Harbor and (3) SIMPLE 401(k) plan.
The rules for the SIMPLE are more restrictive (roughly only 2/3rds of the annual contribution allowed for the Traditional and Safe-Harbor plans contribution is permitted).
But, the rules are quite specific on the combined contributions of the employer AND employee Total contributions cannot exceed $45,000 for 2007 (or if your income is less than $45,000 per year, the yearly salary becomes the limit).
In addition, if the employee is over 50 years of age, an additional $5,000 can be added from before tax earnings. For the employee, the maximum amount allowed for the SIMPLE 401(k) is $10,500 for 2007 while the maximum to be put into the Traditional and Safe-Harbor 401(k) in 2007 is $15,500, with the same $5,000 additional allowed for employees over 50 years of age.
By any measure, this is quite a generous allowance when compared to the IRA plans. But, I caution you again, there are some quite specific restrictions, depending on the type of plan your employer offers, so be sure to find out exactly what your employer's plan offers before you proceed.
On the mildly negative side, the bill made employers responsible for the plan's proper management. If they do it themselves or hire outside help, the job of monitoring will get a bit heavy for the company and that is already leading some companies to limit the types of investments that are offered to plan owners to use (fewer stocks, a more limited menu of mutual funds, etc.). That could put a damper on the more sophisticated investor's plans for making profits.
There is a way around this potential limitation if you want greater latitude in the type of investments you want to make. It is called a "broker's window." This allows you to go directly to any broker you chose and do your investing.
There are a number of ramification here, so first, find out if your employer offers this option and, if not, ask that he add it to his plan rules. If you need help, most any broker will go to bat for you at the employer level on this one — and why not!?!
College Tax Free Plan Made Permanent — If you have college bound kids, you must look into the Section 529 (its real name is "Qualified Tuition Plan") that allows you to place post-tax money into an earnings tax sheltered plan and then withdraw these funds with no tax liability incurred when you need the money for school expenses.
This plan was scheduled for expiration in 2010, as I said earlier, but making it a permanent part of the landscape is truly a gift to the middle class already burdened by expenses of all sorts in raising a family.
The funds put into this plan cannot exceed the cost that may be incurred in the education of the plans beneficiary (usually your child by name). The state where you reside or the university or school where your child may go are the only ones allowed to establish these plans, so check with them to see if a plan is available that you can join.
The rules governing these plans are usually quite specific, so careful reading of them is important. The funds to be used can be added in a lump sum or payments each month. But listen up! Do get this plan set up for your kids as soon as you can. Expenses for college are not going to go down and you need as much head start as you can get. It is found money!
New Designated Roth 401(K) Plan — The so-called Designated Roth 401(k) is a creature unto itself and the rules are quite long and specific, but I will give you a few points of importance and then send you to the IRS for publication #4530 for a more detailed description.
First of all, the Designated Roth 401(k) can only be funded by post-tax dollars. The contribution levels are comparable to the pre-tax 401(k) plan levels shown in the Contributions section above. But, it is a requirement that if the 401(k) plan is going to offer this Designated Roth 401(k) as part of its resources, the rule says the plan must also offer the pre-tax 401(k) plan.
Congress didn't want employers to limit the 401(k) solely to the Designated Roth 401(k) and have the employee lose the benefit of increasing the earning power of their 401(k) from the use of pre-tax dollars placed in a regular 401(k) plan.
Withdrawals are allowed tax free after a five year waiting period from the date of the first contribution into the Designated Roth 401(k) plan and under the three following conditions: (1) On or after the owner reaches the age of 59 1/2; (2) if the plan owner becomes disabled; and (3) in the event of the death of the plan owner (usually in the form of a distribution to the beneficiaries).
Additionally, the contributions you have contributed from pre-tax contributions to your "regular" 401(k) cannot, repeat cannot, be rolled into a Designated Roth plan for obvious tax reasons. (The IRS won on that one, it appears.).
Saver's Tax Credit Left Middle America A Bit Short — Finally, the one part of the new rules that, in my opinion, short-changed the middle class just a bit was the Saver's Tax Credit. Simply stated, this is a feature for lower income earners and allows them to reduce their income tax due to the IRS quite substantially.
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Forgive me, but again, I won't go into all the details or we will be here all night. Essentially, if you earn an adjusted Gross Income of less than $52, 000, as joint filers, or $39,000 as a head of household, you are eligible to use the Saver's Credit. At its best (under $31,000 for joint filers, you can deduct $.50 from each dollar of tax you owe to the IRS for each dollar you put into your 401(k) plan.
This percentage diminishes as you approach $52,000 and this is where the Congress could have done a better job of giving incentive to plan owners to save. The maximum level might have been raised to, say, $75,000 and really been a major addition to the tax landscape. Maybe next time.
Well, that is where we stand nearly one year after the historic landmark changes of 2006.
Clearly, individuals will never again be able to ignore managing their retirement plans. They have been made part of the equation and, hopefully, what Congress did will have a twofold effect: (1) it will increase the entire country's saving rate, and (2) it will force plan owners to educate themselves about what is happening to their retirement money.
The days of the old-fashion defined benefit pension plan have ended and the days of individual responsibility have arrived. It should be a fascinating flower to watch unfold.
So, that's it for this week. Hope this bare-bones review was some help to you. And I hope your coming investment week will be a profitable one. In the meantime, you keep in touch. I do! See you next week.
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