Year-End IRA Opportunities And Strategies

The closing of this year brings some important opportunities to IRA owners. Don’t put this issue aside until you have read this article and decided whether you need to take action by Dec. 31.

• Those of you who converted a regular IRA to a Roth IRA this year have a decision to make.
  When a regular IRA is converted to a Roth, income taxes are due as though the converted amount had been distributed. The taxes are based on the value of the account as of the day of the conversion. If you converted early in the year, the value of the account likely was much higher than it is now. You will pay income taxes on wealth that no longer exists.

Fortunately, a conversion to a Roth IRA can be reversed any time (known as a recharacterization) before the tax return for the year is due, including extensions. If you file for all the extensions possible, the decision doesn’t have to be made until Oct. 15. If your IRA declined after a conversion, consider a recharacterization.  You won’t owe taxes on wealth that no longer exists, and you’ll be back to owning a regular IRA. A recharacterization is done on Form 8606 and by contacting the IRA custodian.

After doing a recharacterization, the traditional IRA can be converted into a Roth again only after the later of the next tax year or 30 days after the recharacterization.

• The second IRA opportunity is available to two groups: Those who have large IRAs and those who are taking required minimum distributions that exceed their spending needs.In past visits I have described situations in which owners of large IRAs should consider withdrawing more money than they need or are required to. (See the April 2001 issue or the Tax Watch section of the web site Archive.) As one ages, the required distribution rules require larger and larger annual distributions, which are taxed as ordinary income. Lifetime taxes might be reduced if money is taken out of the IRA now and taxes paid at the current value. Then future income and gains are out of the IRA, the owner has control over when taxes are paid on gains, and the owner can give away some of the wealth now instead of waiting.

  The bear market gives special reason for these IRA owners and others to consider emptying their IRAs or taking out significantly more than they are required to.

  The value of your IRA might be much lower than it was earlier in the year or a couple of years ago. Now, the value also is likely to be at or near the low point for this market cycle. In a few years, the IRA could be worth more than it is now, perhaps significantly more. This year presents a unique opportunity to empty the IRA at a lower tax cost than was possible in the past or might be possible after a year or two has passed. Consider getting money out of the IRA now and having future income and gains taxed outside of the IRA.

   

• In another opportunity, the IRS changed the rules to help some of you, if you act by the end of the year.
  People who take money out of an IRA or other qualified retirement plan before age 59 1/2 pay a 10% early withdrawal penalty in addition to income taxes. The penalty can be avoided if the distributions are made on a schedule that consists of a series of substantially equal payments over the taxpayer’s life expectancy.

Obviously, there are people who began such distributions before this year when their IRAs were more valuable than they are now. Because of the market decline, some IRAs won’t last much longer if the payments continue on the current schedule.

To help these taxpayers, the IRS recently announced a break. Those who based their payment schedules on a fixed value of the IRA can make a one-time election to a method that bases the payments on the value of the account each year. The switch would put the accounts on a system that is similar to that for computing required minimum distributions.

The basic rules for determining the substantially equal payments are in IRS notice 89-25. The IRS announcement detailed rules for making the change in Revenue Ruling 2002-62. Remember that this change applies only to taxpayers who began a series of substantially equal payments before age 59 1/2 in order to avoid the 10% early distribution penalty.

• Those who own multiple IRAs and have to take a required minimum distribution face two decisions.
  The law requires that all the IRAs be grouped to compute one RMD. Then you are allowed to take the RMD from the accounts in any way that you want. Take it all from one account, or take it equally from each of the accounts. Or take it in some other formula. If one account has stocks or funds you don’t want to sell or has a back-end load or redemption fee, take the entire distribution from another account. You probably should drop a letter to the custodians that your RMD for the year is being taken from one account.

Another decision is in what form to take the distribution. RMDs do not have to be in cash. If you want to hold your specific stocks or mutual funds and avoid transaction costs, have the shares transferred to a taxable account. Most funds and brokers will do this free if you meet the minimum balance requirement. The value of the investments on the date of the transfer will be the RMD for the year and will be included in gross income.

Keep records of this transfer if you distribute property. The tax basis of the investments in the taxable account is the value that was included in gross income, not the original cost of the investment in the IRA. When the investments eventually are sold from the taxable account, only appreciation that occurs after the date of the distribution should face capital gains taxes. If you don’t keep track of the tax basis, you will pay taxes twice on some of the gains.