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Monday, January 12, 2009

New 2009 Rules on IRA Distributions

New 2009 Rules on IRA Distributions For Those Over Age 70 ½:
Required Minimum Distribution (RMD) Relief

January 8, 2009. A 2008 tax law change gives retirees and beneficiaries some much needed flexibility in managing their personal finances for 2009. A key provision in the recently passed Worker, Retiree, and Employer Recovery Act of 2008 provides relief to retirees and others by allowing them to temporarily suspend their Required Distributions from their IRAs during 2009. The The Act provides relief only for 2009 distributions. Here's a summary of this new provision:

Required Minimum Distributions Basics. Under the required minimum distribution (RMD) rules, participants in individual retirement accounts (IRAs) are generally required to begin taking distributions no later than April 1 of the year after they attain age 70½. The amount of the RMD each year generally is measured by dividing the account balance as of the end of the prior year by a distribution factor (generally, a life expectancy factor from the Uniform Lifetime Table published by the IRS). If an individual dies while taking an RMD, the beneficiary of the individual's retirement plans and IRAs is also required to take distributions measured by dividing the account balance as of the end of the prior year by a distribution factor. The distribution period is generally equal to the remaining years of the beneficiary's life expectancy from the IRS chart. If the surviving spouse is the designated beneficiary, distributions can be continued under the greater of the spouse’s life expectancy (again from the IRS table), or the life expectancy of the individual receiving RMDs. If the beneficiary is a non-spouse, then the amount must be distributed over the remaining life expectancy of the beneficiary or the life expectancy of the beneficiary, whichever is greater. You can always take more than the RMD; however, taking less results in severe penalties.

Roth IRAs are not subject to the RMD rules during the IRA owner's lifetime. If a spouse inherits a Roth IRA they may elect to treat the Roth IRA as their own and are not required to take distributions. However, Roth IRAs are subject to the post-death minimum distribution rules applied to traditional IRAs for non-spouse beneficiaries. For Roth IRAs, the IRA owner is treated as having died before the individual's required beginning date. So, the non-spouse beneficiary has the option of taking distributions over their life expectancy or to take the full amount out of the Roth by December 31 of the fifth year following the year the Roth IRA owner dies.

Failure to take an RMD triggers an ugly 50 percent excise tax (which we fondly call the ‘Alzheimer’s tax’, since you usually don’t forget it more than twice), payable by the individual or the individual's beneficiary.

New Law. The 2008 Recovery Act provides a one year suspension of the RMD rules for 2009. Specifically, no required minimum distribution is required for the calendar year 2009 from Individual Retirement Accounts and defined contribution retirement plans (such as §401(k) plans). The exemption also applies to §457(b) eligible Deferred Compensation plans maintained by a state, a political subdivision of a state, or any agency or instrumentality of a state or political subdivision of a state. Thus, any annual minimum distribution for 2009 from these plans is not required to be made. The next RMD will be for calendar year 2010. This relief (referred to as the "2009 RMD waiver") applies to lifetime distributions to employees and IRA owners and after-death distributions to beneficiaries.

The 2008 Recovery Act's relief provides that a taxpayer who attained age 70 ½ in 2008 but chose to wait until Apr. 1, 2009, to receive their first RMD (for 2008) would still have to make that first RMD by April 1, 2009. However, they would not have to make the otherwise-required RMD for 2009.

For beneficiaries who are otherwise required to take RMDs using the five-year rule, the five-year period under that rule is determined without regard to calendar year 2009. Thus, for example, for an account with respect to an individual who died in 2007, the five-year period ends in 2013, instead of 2012.

The 2008 Recovery Act's suspension of RMDs for 2009 helps retired taxpayers who don’t need to rely on RMDs to meet living expenses. By not taking the RMD for 2009 (or withdrawing less than the RMD) from their qualified plan accounts and/or IRAs, they will wind up with less taxable income for 2009. This bracket shift can be substantial for someone with a pension, Social Security and an IRA RMD. For example, for a couple with taxable income over $78,850 is in a 25% or higher bracket; not taking the RMD can substantially reduce the current tax burden. In addition, not taking an RMD can avoid (or mitigate the effect of) AGI-based phaseouts of tax breaks. Some of these phaseouts include:

  • The threshold of taxation of Social Security benefits at income above $25-$32,000 ($25,000 for single, $32,000 for married). Suppose a person has interest of $5,200, Social Security benefits of $21,000, and the balance of their income is an RMD of $25,000. Assuming they took the RMD and took a standard deduction, their tax would be about $4,250. Without the RMD, their tax would be zero.
  • The threshold for college credits and deductions (you may be old and have kids in college, though I hope not) is:
    • HOPE and Lifelong Learning credit: $50,000 ($100,000 for joint filers) of modified Adjusted Gross Income (AGI) for qualifying education expenses for the HOPE credit.
    • Student Loan Interest: $60,000 ($120,000 for joint filers) of modified Adjusted Gross Income (AGI) for qualifying student loan interest.
    • Education expenses: $65,000 ($130,000 for joint filers) of modified Adjusted Gross Income (AGI) for qualifying tuition and related expenses.
  • AGI floors. There are certain deductions that have ‘floors’ based on adjusted gross income. Reducing income reduces the floor and increases the deduction. For example, there’s a ‘floor’ of 7 ½ % of AGI for medical expenses. Suppose a taxpayer has some Medicare premiums, a Medigap policy and some significant dental expenses to the total tune of $8,200, and they have other itemized deductions totaling $7,000. They have a projected 2009 AGI of $125,000, which includes a projected RMD of $36,000. If they take the RMD, they will not be able to deduct any of the medical expenses. However, by not taking the RMD, they not only reduce their income by $36,000 (which saves about $10,000 of state and federal tax), but they also get to deduct $1,525 of medical expenses, which further reduces their taxes by about $400. Some of the AGI limits for deductions are:
    • Medical expenses, at 7 ½ % of AGI;
    • Casualty losses, at 10% of AGI;
    • Miscellaneous Itemized deductions (like investment expenses) at 2% of AGI.
  • Michigan’s pension tax. The state of Michigan taxes pension income on private pensions (from a company or an IRA) if the total private pension income exceeds $43,440 for single and $86,880 for joint (these are 2008 numbers). The RMD counts as a private pension. So if a person were taking a pension from their company (say Ford or GM) and the pension income exceeded the threshold, suspending the RMD would save 4.35% Michigan tax.
  • Personal Exemptions phaseout. Your personal exemptions start getting phased out at $166,800 ($250,200 for joint filers). If the RMD puts you above the phase-out, you get an additional benefit from suspending the RMD and using your exemptions.
  • Itemized deduction phaseout. Itemized deductions in total start getting phased out at $166,800 for single and joint filers. If the RMD puts you above the phase-out, you get an additional benefit from suspending the RMD and increasing deductions.
  • Roth IRA conversion threshold. One thing we really like to see in this down market is Roth IRA conversions. When the market recovers, any dollars converted to Roth IRAs will appreciate tax-free. Money left in a conventional IRA will have any market appreciation taxed as ordinary income. The income threshold for Roth conversion is $100,000 for single or married persons. If suspending the RMD puts income below this threshold, we feel it presents an excellent opportunity for a Roth conversion. In addition, in 2010, the income limit is suspended, but making a partial conversion in 2009 would allow a ‘splitting’ of the conversion into two separate tax years (not to mention getting the Roth tax-free advantage for any 2009 appreciation)

There are other considerations, ranging from the passive income loss limitations to the dreaded AMT. Needless to say, the ability to suspend an RMD may mean significant tax dollar savings in terms of phaseouts and tax deductions, as well as tax brackets.

Another point worth noting is that Medicare Part B premiums are increased for single taxpayers with AGI over $85,000 and married taxpayers with AGI over $170,000. Not taking a RMD to keep your AGI under the thresholds may save you significant dollars in the following year for the Part B Premiums. The base rate of $96.40 can go as high as $308.30 a month. This can save $2,500 per year for a single person and over $5,000 for a married couple. Not taking the RMD also allows the IRA owner to leave more to their beneficiaries. Older recipients will benefit the most, because their (short) table-life expectancy factors would otherwise compel them to take large RMD payouts in 2009.

For some taxpayers with large estates, taking the RMD (or more) reduces the taxable estate by the amount of the income taxes paid on the RMD. (Sounds strange, doesn’t it: pay taxes to save taxes?)

From a nontax standpoint, those taxpayers that can afford to forgo their 2009 RMD will have an opportunity to allow their investments to recover (if the market rebounds over the next 12 to 24 months) before having to sell assets in order to make withdrawals.

Update on charitable contributions for IRA’s. The IRS has also extended through the Pension Protection Act through 2009 the ability to make a tax-free donation of up to $100,000 to a charitable organization of your choice directly from your IRA. That donation does not get included in your taxable income for 2009. In addition to the potential benefits listed above from lowering your taxable income, you may actually get an additional benefit if you do not itemize your taxes or if you are near the standard deduction of $11,400 Married/Joint or $5,700 Single. As an example, if you normally take the standard deduction and you fall in the 25% tax bracket then you would save 25 cents for every dollar you donate to charity when normally you would have gotten no benefit. To take advantage of this benefit you must direct your IRA custodian to send and make the check out directly to the charity. If those rules are not followed it will not qualify for the deduction.

The new rules provide some excellent tax-planning opportunities. However, the benefit of suspending your RMD requires a case-by-case analysis and we suggest an individual review of your situation. Contact your financial and tax advisor (or us) for a review.

LJPR, LLC is an independent fee-only advisory firm in Troy, MI. LJPR specializes in independent wealth management for retirees and their families. Our staff performs comprehensive analysis of financial situations, including investment management, tax analysis and estate review.