Editor: Anthony S. Bakale, CPA, M. Tax.
In late 2008, President Bush signed into law the Worker, Retiree, and Employer Recovery Act of 2008, P.L. 110-458 (the act). The act waives, for 2009 only, the required minimum distribution (RMD) rules applicable to retirement plan withdrawals, thereby allowing retirees to forgo a year’s distributions. The benefit of this suspension may seem obvious: It enables the beneficiary to defer taxable income and hopefully allows the holdings—likely battered over the past year—to recover before being further depleted. However, before blindly forgoing the distribution, beneficiaries should consider some planning opportunities before the suspension expires at the end of this year.
The RMD rules are found in Sec. 401(a)(9) and related regulations. In general, the rules apply to various traditional IRAs (not including Roth IRAs) and defined contribution plans sponsored by employers. Holdings cannot remain in these plans to sidestep the government’s tax coffers indefinitely; the RMD rules call for distributions to commence by April 1 of the year following the calendar year in which the beneficiary turns 70½ years of age or, if later, April 1 of the year following the year of retirement in the case of an employer-sponsored plan if the recipient owns less than 5% of the sponsoring entity. Subsequent distributions are paid by the end of each plan year.
Generally, the rules call for distributions to be paid in annual installments over the account owner’s expected lifetime. For nonspousal beneficiaries of inherited plans, annual distributions generally are paid over a five-year period or in certain cases over the life expectancy of the designated beneficiary. Each distribution is based on the value of the holdings at the end of the previous year. A 50% penalty may be imposed on RMDs that are not paid.
The act’s provisions make sense in light of the mathematics behind the RMD rules:
Example: Retiree R has IRA holdings valued at $200,000 on December 31, 2007, and a life expectancy of 10 years. Her RMD would be $20,000 (10% of the value). Also assume R withdrew her 2008 distribution late in 2008 following a 35% market decline that left the value of her holdings at $130,000. R’s $20,000 distribution now represents 15% of her holdings.The one-year RMD waiver provided by the act will allow such a disparity to be avoided during 2009.
The act provides some flexibility, the benefits of which should not be overlooked. Forgoing the distribution is optional, and it is not an all-or-nothing provision. This allows the recipient to withdraw any amount, down to and including $0. Because a plan participant may take a distribution as late as the last day of the year, the participant is in a good position to select a distribution amount that will optimize his or her tax savings. The rest of this item looks at some examples of what can be done.
When Distributions Should Be Taken
High medical expenses: If a taxpayer has unusually high medical expenses, much of the income resulting from an IRA distribution may be shielded from tax. Excess medical expenses cannot be carried over to another tax year, so the deduction will be lost if not offset. The IRA distributions, on the other hand, are taxable at some point when withdrawn, so forgoing the distribution is merely deferring the tax. Although a small portion of the medical deduction will be lost due to the increased income (7.5% of the incremental AGI), netting these two amounts may produce permanent tax savings.
Expiring charitable contributions: An individual with charitable contribution carryovers that will soon expire may wish to take an IRA distribution to avoid permanently losing the deduction.
Existence of NOLs: Unlike medical expenses, net operating losses (unfortunately common for 2008 and possibly 2009) can be carried over, but they too can partially or fully offset otherwise taxable income resulting from a pension distribution.
Low income/drawing Social Security: A taxpayer whose modified AGI is below the level requiring taxability of Social Security payments may consider withdrawing IRA distributions only to the level that would allow the Social Security payments to continue escaping taxation. This would benefit joint filers and single/ head-of-household filers with modified AGI below $32,000 and $25,000, respectively. The IRA distribution itself will be taxable, but if planned properly the Social Security payments will not.
Rollover to Roth IRA: 2009 may be a particularly good year to convert regular IRAs to Roth IRAs. Although conversions create taxable income, market values have taken such a beating that a taxpayer can convert a much larger percentage of IRA holdings to a Roth IRA for each dollar of income generated from the conversion. This conversion is available for 2009 only to taxpayers with modified adjusted gross income of $100,000 or less. Action in 2009 should be taken only after considering that a conversion taking place during 2010 will not be subject to the $100,000 income limit, and the income resulting from a 2010 conversion may be deferred by being spread equally between 2011 and 2012 (Sec. 408A(d)(3)(A)(iii)).
Tax rates: Taxpayers may find 2009 to be a year in which they are subject to maximum tax brackets lower than they are accustomed to due to any number of reasons, including capital losses and diminished interest and dividend income. Although tax rates may change in the future, taxpayers who believe they will be taxed in a higher bracket the following year (25% vs. 15%, for instance) may want to take otherwise deferrable RMDs in the current year to trigger tax at the lowest rates.
When Distributions Should Not Be Taken
Some retirees drawing Social Security: A taxpayer who is drawing Social Security payments but has not yet reached the full 85% taxability should consider avoiding IRA distributions. Joint filers with modified AGI between $32,000 and $44,000 and single/head of household filers with modified AGI between $25,000 and $34,000 would find their AGI increasing by more than the amount of the IRA distributions as an increasing portion of Social Security earnings became taxable.
High-income taxpayers/others: Ironically, it seems the individuals who least need help from Congress to survive the economic downturn are the ones who benefit most by this provision of the act. While many taxpayers rely on IRA distributions for routine living expenses, high-income/wealthy individuals can draw from other sources and take full advantage of the RMD hiatus. Forgoing distributions makes sense for most taxpayers who are subject to the various phaseouts based on income (itemized deductions, exemptions, etc.). It also makes sense for taxpayers at any income level who would not realize a benefit such as those described above. For them, the distribution would only accelerate tax that they could defer.
Obviously, regardless of income level, those who will incur current incremental tax will want a compelling reason for taking distributions that are not necessary, and many people will gladly forgo the 2009 distribution for this reason. With a little luck, they will see the value of their holdings increase before making part of the decline in value permanent by taking a distribution. But for others, the Worker, Retiree, and Employer Recovery Act’s RMD holiday has created a unique opportunity for some unusual tax planning; practitioners should make sure clients take advantage of it before the waiver expires at the end of 2009.
Anthony Bakale is with Cohen & Company, Ltd., Baker Tilly International, Cleveland, OH.
Unless otherwise noted, contributors are members of or associated with Baker Tilly International.
For additional information about these items, contact Mr. Bakale at (216) 579-1040 or firstname.lastname@example.org.