Your 401(k) Just Got Better

While much of the country tried to keep cool during a brutal August heat wave, Congress enjoyed a burst of energy and passed the most sweeping changes to 401(k) rules since these tax-deferred savings plans debuted 25 years ago. It's a good thing, too, because traditional pensions continue to disappear, shifting the burden of saving for retirement from employers to workers. The new law makes it easier for you to sock away more money for retirement and, beginning next year, to get personal advice from your plan provider on how to invest it.

Automatic contributions. To increase 401(k) participation and protect procrastinators from themselves, the new law encourages companies to enroll workers automatically in their 401(k) plans. You can opt out, but why would you? This change should mitigate the inertia associated with retirement savings. According to the Employee Benefit Research Institute, automatic enrollment will increase 401(k) participation from about 66% of eligible workers to more than 90%.

Beginning in 2008, if you are automatically enrolled in your company retirement plan, your employer may deposit 3% of your pay in your 401(k) account to start and increase your automatic contributions each year until the set-aside reaches 6%. Again, you can just say no, but that wouldn't be wise. Many retirement-plan providers recommend saving at least 15% of your pay (including any employer matching contributions) to accumulate adequate retirement savings.

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The U.S. Labor Department is expected to issue guidelines making target-date retirement funds -- which invest in balanced portfolios of mutual funds that grow more conservative as you near retirement -- a default investment that's preferable to more-conservative money-market and stable-value funds. That way, even investors who never select an investment strategy on their own will be on the right track.

Higher savings limits. The new law makes permanent the higher contribution levels for IRAs and 401(k)s that were scheduled to disappear after 2010. Higher limits also apply to other workplace-based retirement plans, such as 403(b)s for teachers and 457 plans for government workers.

The annual contribution limit for an IRA, $4,000 in 2006, will rise to $5,000 in 2008 and be indexed to inflation after that. Meanwhile, contributions to 401(k) plans, currently limited to $15,000, had been scheduled to drop back to $14,000 after 2010. Now the higher level will remain until inflation triggers future increases.

Catch-up contributions if you're age 50 or older are also here to stay. If you qualify, you can continue to add an extra $1,000 to your IRAs and an additional $5,000 to your 401(k) plans.

The new Roth 401(k), which allows you to contribute after-tax dollars in exchange for tax-free withdrawals in retirement, is expected to catch on more quickly. Employers had been slow to adopt the Roth 401(k), introduced in 2006, for fear it would disappear after 2010. Now that it's permanent, there's no excuse for foot-dragging. The Roth 401(k) is a great option for young workers who will benefit from decades of tax-free growth or for anyone who believes taxes will be higher in the future as retiring baby-boomers increase the demand on Medicare and other federal programs.

The law also permanently extends the Saver's Tax Credit that was due to expire at the end of this year. Low- and moderate-income workers get a tax credit of up to $1,000 for contributing either to an IRA or a 401(k). Although teens under 18 and full-time students can't take advantage of the credit, it could reduce or wipe out the tax bill for many entry-level workers and retirees who work part-time. You'll also be permitted to designate that all or part of your tax refund be deposited directly into an IRA.

Investment advice. Employees are often bewildered about how to invest their 401(k) money. Starting next year, you can get specific answers. In one of the law's most controversial provisions, plan providers, including mutual fund companies, will be authorized to offer in-person investment advice. To ensure that the advice is unbiased and in your best interest, it must be based either on a computer model or offered by a financial adviser who charges a flat fee that's not tied to the recommended investment products.

In response to the Enron disaster, the new law also requires that your company allow you to diversify out of company stock and into other investments within your retirement plan. EBRI president Dallas Salisbury says that the combination of personalized investment advice and liberalized rules on company stock should go a long way toward reducing the high concentration of stock held by some employees -- often well in excess of the 10% of total investments normally recommended by financial advisers.

Breaks for beneficiaries. The law also changes some rules on distributions from your IRAs and 401(k) plans. Previously, only a surviving spouse could transfer an inherited 401(k) account into an IRA. Other beneficiaries were often required to take immediate distributions that were fully taxable. The new law allows children, grandchildren, siblings and other beneficiaries to transfer an inherited 401(k) to an IRA and stretch out distributions -- and taxes -- over their lifetimes.

But you have to handle the paperwork carefully or risk losing this generous tax break, warns Ed Slott, a CPA in Rockville Centre, N.Y. Beginning next year, it must be done as a trustee-to-trustee transfer and properly titled as an inherited IRA. You can't roll over the account into your own IRA or make annual contributions to it.

There is also a significant, albeit temporary, change for older IRA owners. If you're at least 70#189;, in 2006 and 2007 you can take a distribution from an IRA and transfer it directly to a charity. The donation will satisfy the rules for required minimum distributions, and donated amounts won't be taxed or included in your adjusted gross income.

Traditional pensions. Ironically, the new law, officially called the Pension Protection Act, may not accomplish its main purpose, which is to shore up the traditional pension system through tougher funding requirements. Alicia Munnell, director of the Center for Retirement Research at Boston College, thinks the law may actually accelerate the demise of traditional pensions as more employers freeze their plans in response to higher costs.

But another type of pension may get a boost. The law clears the way for broader adoption of so-called cash-balance plans. Employers fund these hybrids as they would fund pension plans, but the money is held in separate accounts for employees, much like 401(k)s. Cash-balance plans will also be helped by a recent court ruling that rejected allegations of age bias.