October 2006
   
How to Make the Most of New Tax Law

Viewed as the most sweeping reform of America's pension laws in over 30 years, the new tax act gives you plenty of ways to save on your income taxes, and put aside money for retirement and college. One message is clear—if you make the effort to save, the federal government will give you a hand, in the form of tax advantages.

Saving more at work

The tax act is good news if you work for an employer who offers a retirement savings plan such as a 401(k), 403(b), 457(b), or SIMPLE IRA. Now you may be able to take advantage of the higher annual pretax contributions made permanent by the new law to increase your savings. And, because these pretax contributions can effectively reduce your current taxable income (thereby lowering your overall income tax bill), you've got an even greater incentive to contribute more to your plan.

What's more, if you're age 50 or older and your plan allows it, you can make additional catch-up contributions. If made on a pretax basis, these extra contributions can usually lower your tax bill as well. The table below summarizes the limits for individual contributions to most retirement plans.

Workplace Roth 401(k) and Roth 403(b) features become permanent
 
Your employer may currently include a Roth 401(k) or Roth 403(b) feature in your plan. If you have this choice, you can direct part of your paycheck to the plan's Roth account. This allows you to make salary reduction contributions to your workplace plan with after-tax dollars, similar to a Roth IRA.

The advantage of a Roth 401(k) or Roth 403(b) feature is that you can withdraw assets later on (generally after age 59 1/2 and after meeting certain other requirements), free from federal income taxes. You may find this particularly appealing if you expect to be in a higher tax bracket during your retirement years than you are now.

It's important to remember that although Roth contributions to a 401(k) or 403(b) are withheld from your current salary, they are made with after-tax dollars, so they won't reduce your current taxable compensation. In contrast, traditional pretax contributions to a 401(k) plan or 403(b) plan effectively reduce your current taxable compensation and may lower the amount of income taxes you'll pay in that year.

Automatic enrollment eliminates savings inertia

Most workplace retirement plans today require you to actively enroll in a plan and then choose your own contribution amounts. So, if you don't elect to join or don't select appropriate investment options, the result may be low (or no) retirement savings.

But, for plan years beginning after 2007, the new tax law will provide more specific guidelines for employers who want to automatically enroll their employees in retirement plans—in effect, permitting you to ''opt out'' rather than asking you to ''opt in'' to contributing to your plan.

Qualified plan rollovers to Roth IRAs simplified

Under previous tax rules, it took two steps to convert workplace retirement plan assets to a Roth IRA. First, you had to roll your distribution over into a Traditional IRA and then you had to convert that account into a Roth IRA. Thanks to the new tax law, this two-step procedure will no longer be necessary, although you will generally still owe federal taxes on the amount converted.

Beginning in 2008, if you're eligible to make a Roth IRA conversion, the new law will allow you to arrange for a direct (trustee-to-trustee) rollover from your retirement plan into a Roth IRA. This Roth ''conversion'' opportunity will be available for assets from qualified retirement plans such as 401(k), 403(b), and governmental 457(b) plans.

Income limits for Roth rollovers gone in 2010

Thanks to tax law changes passed in early 2006,2 retirement savers with more than $100,000 in modified adjusted gross income will soon be able to take advantage of the direct Roth roll-over/conversion rule too. Starting in 2010, the income limit for Roth conversions will be eliminated, allowing savers to take advantage of the Roth rollover/conversion opportunity regardless of income level.

What's more, if you decide to convert any assets in 2010, your federal income tax bill can be spread out over two years in 2011 and 2012 unless you elect otherwise. (For conversions after 2010, the conversion tax bill can't be stretched out.)

Guidelines for giving investment advice

Starting in 2007, you may find there are more opportunities than ever to get the advice and guidance you may need to evaluate your retirement portfolio and to be more confident about making investment choices. Why? Because under the new tax law, the government will be creating new guidelines for providing access to professional investment advice for both your workplace and personal retirement plan accounts.

The new tax law also includes:

Saver's tax credit of up to $1,000. For individuals with modest incomes who contribute to IRAs, 401(k)s, and certain other plans, the credit is now permanent. This could be especially valuable to young workers who are just beginning to save.

Faster diversification out of employer stock. If your workplace savings plan includes publicly traded company stock, you may be able to diversify sooner to protect your assets.

Eased hardship distribution rules. Under certain circumstances, new rules allow for early withdrawals of retirement plan assets.

Military early withdrawal option. Qualified reservists may take early withdrawals from retirement accounts without paying the usual 10% penalty. If you served, or will serve, on active duty between September 11, 2001 and December 31, 2007, you are eligible to withdraw from your Roth or Traditional IRA or your workplace plan. The tax relief is retroactive, so if you've already paid the penalty you can claim a refund from the IRS.

Action step

Take advantage of all the workplace retirement savings options your employer offers.