New IRA Strategies for 2009

Congress did IRA owners a favor by suspending most requir-ed minimum distribu-tions for 2009. Yet, the change has confused some IRA owners because there are some exceptions and not all the details are clear. There also are planning opportunities created by the law and by the markets IRA owners should consider.

First, we will review the basic rules.

IRA owners who are older than age 70½ are required to take minimum distributions from their IRAs each year (RMDs). Heirs who inherited IRAs also are required to take RMDs. The penalty for failing to take an RMD is 50% of the amount that was supposed to be distributed.

An RMD is computed by taking the IRA balance on Dec. 31 of the preceding year and dividing it by a factor contained in tables issued by the IRS. The tables are in Publication 590, and the factor depends on the owner’s age. The RMD rule applies to most defined contribution qualified retirement plans in addition to IRAs, such as 401(k) plans.

The RMDs are suspended for 2009. More properly put, Congress suspended the penalty for failing to take the 2009 RMD. But there are some fine points, traps, and planning opportunities in the law that the IRS is fleshing out. Here are points you should know.

2009 distributions only. The penalty is suspended only for 2009 RMDs. That is tricky for those who turned 70½ in 2008, as we discussed in past visits. If you turned 70½ in 2008, you had until April 1, 2009, to take that first RMD. Though not due until 2009, the RMD was for 2008. The law gives you a grace period of three months to take that first RMD. Under the new law, the penalty is not suspended for that first RMD if it was for 2008, though the deadline was not until April 1, 2009.

Those who turn 70½ in 2009 do not have to take their first RMDs in 2009. They also do not have to take a distribution by April 1, 2010. Their first RMD is for the year 2010 and must be taken by Dec. 31, 2010.

Inherited IRAs. The RMD penalty also is suspended for 2009 for inherited IRAs, for both traditional and Roth IRAs. But those heirs who recently inherited IRAs cannot sit back and relax. They still need to take actions this year if they want to maximize tax deferral from the inherited IRAs.

When multiple heirs inherit an IRA, they can split it into separate IRAs for each heir. A split allows each heir to take RMDs based on his or her age. If a split is not made, RMDs from the IRA must be made based on the age of the oldest beneficiary. Though the RMD rules are suspended for 2009, the deadline for splitting a jointly inherited IRA is unchanged. The split must occur by the end of the year following the year of the original owner’s death or it is invalid.

Suppose an IRA was left to the estate. In that case the IRA must be distributed within five years. There are a few other instances when an IRA must be distributed within five years. In each of those cases, the 2009 payout is not required, and the heirs or estate have six years to distribute the IRA.

Automatic distributions. Many people who face RMDs set up automatic distribution schedules with their IRA custodians. The custodian calculates the correct RMD and sends monthly, quarterly, or annual distributions. You might want to cancel the automatic payout for 2009 if you do not need the full distribution and the custodian allows a cancellation at this point.

If you are not able to cancel the automatic distributions, you might be able to roll them back to the IRA within 60 days of receipt. The distribution will not be included in gross income for the year if you do a rollover. An easy way to do a rollover is to write a check to the IRA custodian for the same amount as the distribution.

Here’s where it can get tricky. Normally you cannot roll an RMD back to an IRA, but the IRS will allow it for this year. Also, there is a one-a-year limit on rollovers for an IRA. The IRS is likely to suspend that rule for 2009 for those receiving RMDs. It has not done so yet, but IRA custodians are asking it to.

Some custodians automatically suspended automatic payments. Others waited for IRA owners to request suspension. If your automatic distributions are suspended, ask if you need to make another request later this year to have them resume in 2010.

Annuities. Some people buy annuities through IRAs, then annuitize. That means they receive fixed payments monthly, quarterly, or annually. These payments must continue under the law despite the RMD suspension.

Under age 59½. Suppose you began receiving regular payments while under age 59½. You took advantage of the exception to the 10% early distribution penalty by scheduling a series of substantially equal payments. These payments must continue in 2009 for you to avoid the 10% penalty. They are unrelated to RMDs and not affected by the new law.

Take the RMD anyway. The idea behind suspending the RMD penalty is IRA owners who don’t need the cash should be allowed to let the money compound so it can benefit from any improvement in returns. That would help speed the recovery of the IRA balance.

But it might be better for you to take the RMD amount in 2009 anyway. Certainly if you need the money to meet expenses and do not have other income sources, take a distribution of the amount you need.

Also, if you are likely to need the cash in the next few years, it might make sense to spread the distributions over several years instead of bunching them in one year, which might push you into a higher tax bracket. You also might want to take the distribution if you expect tax law changes to put you in a higher bracket in another year or two.

Determining the right move depends on making assumptions about your future tax rates and cash needs. You might need to meet with your accountant or make some calculations yourself. A distribution you take from an IRA in 2009 still is included in gross income the same as in any other year.

Convert to a Roth. Converting a traditional IRA to a Roth IRA could be an unprecedented opportunity in 2009.

A conversion can be a good idea if you have sufficient assets outside the IRA to meet living expenses and plan to leave the IRA to the children or grandchildren. A conversion also can be profitable if you won’t need distributions from the IRA for 10 years or so after the conversion. In that case, the compounding and future tax-free income more than make up for paying the taxes on the conversion.

We have discussed the benefits of converting to a Roth IRA in past visits. These are available in the web site Archive and Back Issues sections. Two benefits are worth emphasizing now. The original owner of a Roth IRA does not face future RMDs. Also, distributions from the Roth are tax free, whether received by the original owner or an heir.

Of course, you pay a price to convert to a Roth IRA. You treat the converted amount as if it had been distributed by including it in gross income, and you pay income taxes on that amount. With stock indexes down 50% and more, you convert today at a substantial discount from the value of only a year ago and perhaps at a discount to future value. The suspension of RMDs also is a help. Normally someone over age 70½ cannot avoid an RMD by converting to a Roth IRA. The RMD for the year of the conversion still must be taken. If you are over age 70½, this could be the only year you are able to convert to a Roth IRA without having to take an RMD.

In addition, you get two bites at the apple. Suppose you convert today, and the IRA’s value continues to decline. You can decide to reverse the conversion as late as Oct. 15, 2010. Then, you will have an opportunity to convert again. There are incentives to convert to Roth IRAs beginning in 2010, but today’s low value might be an incentive to convert now.

A conversion is allowed in 2009 only if your adjusted gross income is not more than $100,000. In 2010 and later, taxpayers at any income level will be able to convert to Roth IRAs as the law stands today. In addition, those who convert in 2010 are allowed to defer taxes on the conversion over two years and not owe any interest on the deferral. Details about this opportunity also are on the web site.

Consider charity. Congress also extended the tax break for charitable contributions made from an IRA for those over age 70½. Under the rule, a transfer directly from the IRA to a charity is not treated as a distribution. So, it is not included in the owner’s gross income. (In a year when there are RMDs, the transfer counts as part of the RMD.) There is no deduction for the gift, but that is not a problem if you do not itemize deductions. The transfer from the IRA also does not face the charitable contribution limit of 50% of AGI that is imposed on charitable gifts deducted as itemized expenses. The IRA charitable gift rollover is limited to $100,000 for the year and currently is available only through Dec. 31, 2009. RW April 2009.