Key IRA Decisions for 2007

IRA owners can squeeze significant additional after-tax dollars out of their accounts – if they plan carefully. In addition to the usual planning strategies, there are new IRA opportunities available in the next few years.

The Pension Plan Protection Act of 2006 created a charitable giving opportunity for some IRA owners. We covered this after the law was enacted in 2006 and will review the basics again.

IRA owners who are age 70½ or older can make charitable contributions directly from their IRAs. The amount of the contribution will not be included in gross income as a distribution. The IRA owner also cannot take a deduction for the contribution. This provision applies only to contributions up to $100,000 annually and is set to expire at the end of 2007. Additional requirements to qualify are in the September 2006 issue and in the Tax Watch section of the web site Archive.

This strategy should be considered by someone who is inclined to make charitable contributions and whose IRA and other assets exceed the amount likely needed for lifetime living expenses. Giving through the IRA avoids having to use after-tax cash to make a contribution and risk losing part of the deduction because of the itemized deduction reduction for high income taxpayers. Giving through the IRA also avoids having to take the cash from the IRA in the future as a required minimum distribution to be taxed at ordinary income tax rates. The charitable contribution made from the IRA can count toward the required minimum distribution for the year the contribution is made.

Higher income taxpayers also might want to consider increasing IRA contributions or making contributions that they have avoided in recent years. Many high income taxpayers do not contribute to IRAs because they do not receive deductions, and the income and gains will be taxed as ordinary income when withdrawn. They probably are better off investing for long-term gains and dividends through taxable accounts.

But after 2010 the income ceiling on converting a traditional IRA to a Roth IRA expires. Taxpayers with any level of income will be able to convert their IRAs to Roth IRAs.

This change is an incentive for higher-income taxpayers to bulk up their traditional IRAs and perhaps even 401(k)s now. Remember that when an IRA is converted, taxes are due only on the amount that would be taxable if distributed. Since higher income taxpayers will be making nondeductible contributions, converting those amounts will not be taxable. Only the income and gains earned between now and 2010 will be taxable when converted, so most of the IRA will be converted tax free. After the conversion and qualifying period, income and gains withdrawn from the Roth IRA will be tax free. A Roth IRA also is not subject to required minimum distributions.

Maximizing 401(k) contributions also can be beneficial if the taxpayer will retire or leave the job in a few years. Then, the account can be rolled over into a traditional IRA, and subsequently converted to a Roth IRA.

A special incentive to prepare now for a conversion is that in 2010 only, the entire converted amount need not be included in gross income that year. Instead, half the taxable converted amount can be included in gross income in 2011 and half in 2012. In effect, the taxpayer gets an interest-free loan from the government. High income taxpayers should consider bulking up their IRAs now and keeping enough cash available in taxable accounts to pay the conversion taxes.

Each year all taxpayers should consider whether to convert their traditional IRAs to Roth IRAs.
In the year of the conversion, the converted amount is taxed as though it were distributed from the IRA. After the rollover, income and gains compound in the Roth tax free. There is no required minimum distribution requirement for the original Roth owner. And distributions that are taken at least five years after the Roth IRA was created are tax free. In addition, contributions or rolled over amounts can be withdrawn at any time tax free.

We have discussed when to consider IRA conversions in detail in past visits, and also in my book, The New Rules of Retirement. A conversion is a good idea when the taxpayer has cash from other sources that can be used to pay the income taxes, so that the entire IRA can remain intact and maximize the income and gains that will compound. In addition, the IRA should be left alone for 10 years or longer so that the compounding can make up for the taxes paid on the conversion.

An IRA can be converted in whole or in part. Owners of multiple IRAs can convert one IRA in whole or in part, and leave the others alone. Or the IRAs can be converted in any combination the owner desires. The only limit would be imposed by the IRA custodian and the ability to pay taxes.

Once a conversion is made, it can be reversed, known as a recharacterization. The IRA owner has until the tax return is due for the year of the conversion to do the recharacterization. The owner would want to reverse the conversion if the value of the assets declined after the conversion. The conversion is taxed based on the value on the date of the conversion. The recharacterization allows the owner to avoid paying taxes on wealth that has disappeared and consider converting again in the future.

In past visits, I have encouraged well-off taxpayers to consider emptying their IRAs early, either in part or in total. The potential to convert to a Roth IRA in 2010 or later is more attractive than emptying the IRA now, but higher income taxpayers should consider one of these avenues.

The reason to consider action is that when an IRA plus other assets exceed the lifetime spending needs of an individual, the IRA becomes something of a liability. Distributions are taxed as ordinary income. As one gets older, the required minimum distributions increase far beyond spending needs. The distributions increase the annual tax bill and can cause the loss of tax write offs.

Leaving the IRA to heirs is not tax efficient. The entire IRA will be included in the gross estate. In addition, heirs do not increase the tax basis of the IRS. They pay ordinary income taxes on distributions just as the original owner would have.

My number-crunching has shown that paying taxes now can be better in the long term than holding on to an “Excess IRA.” While waiting until 2010 or later to convert to a Roth IRA is more attractive, some taxpayers might want to distribute some or all of their IRAs and pay taxes now.

IRA owners over age 70½ need to take required minimum distributions from their traditional IRAs (as well as other qualified retirement plans). The first RMD must be taken by April 1 of the year after the owner turns age 70½. Subsequent RMDs must be taken by Dec. 31 of each year, including the year that the first RMD was required by April 1. The owner always can take distributions exceeding the RMD. Instructions for computing the RMDs are in IRS Publication 590, Individual Retirement Arrangements, available on the IRS web site at www.irs.gov.

It might be best to take the first RMD in the calendar year before it is required. Instead of waiting until the April 1 deadline, take by the previous Dec. 31. That avoids having two RMDs on one year’s tax return.

Otherwise, it is best to take an RMD late in the year. That allows the tax-deferred compounding to work as long as possible. The exception is a year when the portfolio declines. If you can anticipate that all or part of the portfolio will decline during the year, take the RMD early in the year, converting the investments into cash. An RMD does not need to be taken in a lump sum. Periodic distributions can be taken during the year as long as the total by Dec. 31 equals or exceeds the RMD.

When an owner has multiple IRAs, they are aggregated to determine the total RMD for the year. Then, the owner can choose to take the total from the IRAs in any combination. All the RMD can be taken from one IRA, equal amounts from each, or different amounts from different IRAs. This flexibility can be used to help rebalance the total portfolio, to sell the most highly valued assets, or to reach other goals of the owner.

RMDs do not have to be in cash. Most IRA custodians allow you to set up a taxable account. Then, you can have specific shares transferred from the IRA to the taxable account to satisfy the RMD. You still will owe taxes on the distribution as though it had been made in cash. But you won’t have to liquidate an investment you like or incur expenses to buy and sell an investment just to make the RMD.