Managing IRAs for the Latest Changes

IRAs and other retirement accounts were changed by Congress’s last minute laws in December 2010. The changes included the extension of the Bush tax cuts and some other provisions and generally are positive for IRA owners.

? Among the provisions that were extended is the special treatment of charitable contributions from some IRAs. The provision that expired at the end of 2009 was extended for 2010 and 2011 (not for 2012). IRA owners ages 70½ and older can have charitable contributions made directly from their IRAs to charities. When they do, the amount is not included in their gross income. They also don’t take a deduction for the contribution. The charitable distribution counts toward the required minimum distribution for the year. This special treatment is limited to $100,000 annually per IRA owner.

A new rule allows the IRA owner elect to have a qualified IRA charitable distribution that is made in January 2011 to be treated as if it were made on Dec. 31, 2010. This allows people who didn’t get their contributions done by the end of 2010 because Congress passed the law late to make a contribution that qualifies for the 2010 limit and do another for 2011, taking full advantage of the $100,000 limit in both 2010 and 2011.

But it doesn’t work the other way. Many taxpayers stopped waiting for Congress to take action in 2010, so they took regular required minimum distributions before the end of 2010. What some wanted to do was return the RMDs to their IRAs in January and make a charitable contribution from the IRA that qualifies for the RMD. The IRS says the law doesn’t allow the distributions to be returned to the IRAs, so those people were stuck.

? The extension of the Bush tax cuts for two years has an indirect effect on those who converted traditional IRAs into Roth IRAs in 2010. Existing law gives them the option of including the converted amount in gross income in 2010 and paying the taxes then, or the converted amount can be split equally between gross income in 2011 and 2012.

We had a lot of discussion previously about how to make that decision. We were hampered in the analysis, because we didn’t know what the 2011 and 2012 tax rates would be. With the 2010 tax rates now prevailing through the end of 2012, there isn’t much of a decision for most people. Since the tax rates are the same, there’s little reason to pay taxes on the conversion with your 2010 return when you can hold onto the money, invest it longer, and pay the same taxes in 2011 and 2012. Actually you might pay a little less in 2011 and 2012 because the tax tables are indexed for inflation each year.

Paying the taxes in 2010 should be considered when you anticipate that income will rise or deductions will fall for you in 2011 or 2012, triggering a higher tax bracket in either or both of those years.

Another reason not to defer the taxes is to avoid triggering higher Medicare Part B premiums, income taxes on your Social Security benefits, or other effects of higher gross income in 2011 and 2012. When you’re in a tax bracket that could trigger these tax increases, you might prefer to take the full tax hit for only one year instead of spreading these higher taxes over a couple of years.

? The estate tax changes also indirectly affect the IRA conversion decision. The higher estate exemption amount means more IRAs will avoid estate taxes. By converting a traditional IRA to a Roth IRA, you create an asset that is completely tax-free to your heirs: no estate taxes and no income taxes.

? The Small Business Jobs Act, enacted in September 2010, allows employees to transfer traditional 401(k) accounts to Roth 401(k) accounts in the same plan. The IRS issued rules on these transfers in late 2010. The rules are very similar to those for IRA conversions. The converted amount must be included in gross income. When such conversions were made by the end of 2010, employees have the same option IRA owners do to either pay the conversion taxes in 2010 or defer the gross income to 2011 and 2012.

An employee’s own contributions to the 401(k) can be converted only after age 59½. Employer contributions can be converted two years after they are made or when the employee has been a plan member for five years or more.

A big difference from IRA conversions is that 401(k) conversions can’t be recharacterized later. Once you’ve made the conversion, you’re stuck with it. The 401(k) conversions are possible only if the employer plan allows them, and many large employers report they won’t change their plan documents to allow such conversions before 2012.

An alternative to 401(k) conversions is an “in-service distribution” when the plan allows it. You roll over 401(k) assets to a traditional IRA, and then convert the IRA to a Roth IRA.

RW February 2011.