Did you know that you are not required to take an IRA or pension distribution during 2009? Did you find out too late, and wish you could “undo” it?  Those of you who did know and opted to withdraw funds anyway, are you aware that you may save taxes by receiving a distribution that isn’t required?    

Last year, the Worker, Retiree, and Employer Recovery Act of 2008 (the “Act”) was signed into law, waiving – only for 2009 – the normal required minimum distribution (RMD) rules.  The RMD rules are designed to prevent deferral of taxation, and they accomplish this by forcing retirees to receive and be subject to tax on minimum annual distributions from retirement plans (IRAs, 401(k)s, etc.).  The Act produced some planning opportunities that may benefit certain taxpayers who opt for a distribution (full or reduced) in spite of the waiver. Also, beneficiaries who already took 2009 distributions but wish they had not done so may be able to “reverse” those distributions pursuant to the recently-issued IRS Notice 2009-82.

Background

In general, the RMD rules apply to traditional IRAs (not including Roth IRAs) and defined contribution plans sponsored by employers (such as “401(k) plans”). With a few exceptions, distributions must begin by April 1 following the year the account owner turns 70 ½, and continue on an annual basis over the owner’s expected lifetime.  The amount of each year’s distribution is based on the value of the plan’s holdings at the end of the prior year.  In response to the 2008 stock market decline, the Act was passed to prevent taxpayers from potentially having to cash out holdings at a steep loss to meet required withdrawals that were calculated on stronger holdings.

Example: If an IRA is worth $480,000 on 12/31/08 and the owner’s life expectancy is 12 years, a 2009 RMD of $40,000 (8%) would be payable.  However, if during 2009 the IRA had decreased in value to $240,000, the same $40,000 RMD would result in a 17% depletion of the IRA.

The Act allows withdrawal of any amount for 2009, down to and including $0.  Because a distribution can be taken as late as 12/31/09, with good tax planning, retirement plan owners should be in a great position to determine what distribution amount will produce the best outcome on their 2009 tax returns.  Although the funds generally are taxable whenever withdrawn, some deductions or other scenarios may be lurking, ready to neutralize that income. Let’s look at some examples.

When Distributions Should Be Taken

Low income taxpayer receiving Social Security payments:
If income is low enough (joint filers and single/head-of-household filers with modified adjusted gross income (“AGI”) below $32,000 and $25,000), Social Security payments are not taxable.  A taxpayer with some wiggle room left under these thresholds – especially if income is not typically that low and is expected to improve the following year – should consider withdrawing only enough from an IRA in 2009 that AGI remains under these levels.  The distribution itself will of course produce additional income whenever withdrawn.  However, if the IRA distribution is planned properly, Social Security payments (already paid at fixed amounts) can remain immune to taxation.

Net operating losses:
Net operating losses (generally business losses that exceed income) can be carried forward to future tax years to offset income, or can be carried back to prior profitable years to produce a refund via amended returns.  However, if a net operating loss is expected in 2009, account owners should consider withdrawing IRA or pension funds that in this case will be shielded from income by offsetting the operating loss.

High medical expenses:
Medical expenses can be deducted as an itemized deduction to the extent they exceed 7.5% of a taxpayer’s adjusted gross income.  Unlike net operating losses, unused medical expenses cannot be carried over to other years, but instead are lost forever as deductions. If a taxpayer’s high medical expenses, combined with exemptions and other itemized deductions, exceed adjusted gross income, a beneficiary should consider withdrawing enough from an IRA to eliminate this excess loss and produce taxable income closer to $0.  Although a small portion of the medical deduction may be diminished by the increased income (7.5% of the additional AGI), netting the IRA withdrawal with the excess medical costs generates permanent tax savings.

Excess charitable contributions:
Some very generous taxpayers can be subject to limits on charitable contributions. In general, contributions in a given year are limited to a percentage of a taxpayer’s AGI.  Any excess may be carried over, subject to the same limitations, to each of the next five year’s tax returns.  Any remaining excess is permanently lost.  A taxpayer whose contributions will expire after 2009 should consider increasing their income with IRA or pension distributions. Netting the two amounts can shelter the IRA distribution from taxability while avoiding permanent loss of the contribution deduction.

Tax rates:
In general, a taxpayer who is in a lower tax bracket than usual may want to withdraw IRA funds now rather than later to generate tax at the lower rates.

When Distributions Should Be Avoided

Certain Social Security recipients:
As mentioned above, Social Security payments escape taxation for recipients whose income is low enough.  However, if modified AGI is between $25,000 and $34,000 for single/head of household filers or $32,000 and $44,000 for joint filers, Social Security payments are phased into income at increasing rates, with as much as 85% of the payments included in taxable income.  Taxpayers in these ranges should avoid IRA and pension distributions if possible because this phase-in of Social Security payments will cause their income to increase by more than the incremental pension withdrawals.

High-income taxpayers/others:
Taxpayers whose relatively high income level subjects them to itemized deduction/exemption phaseouts likely should avoid IRA/pension withdrawals because the impact on taxable income will be greater than the amount distributed.  In general, beneficiaries at any income level who will not benefit from a tax-savings scenario like the ones described above should consider taking advantage of the Act’s provisions because doing so will defer payment of tax.

Corrective Action

What if you were not aware that you could forgo them until you already had taken distributions in 2009?  Recently-issued IRS Notice 2009-82 provides some relief, but it provides less favorable treatment for IRAs than it does for participants in employer-sponsored plans such as 401(k)s.  Plan participants have until the later of November 30, 2009 or 60 days following the dates of 2009 distributions to “roll over” the amounts received into the same or another qualified plan.  IRA beneficiaries may do the same, but unfortunately may do so only with one distribution made during 2009.  Obviously this is of limited use for someone who withdrew a series of payments from an IRA in 2009, but it provides tremendous flexibility for participants in other plans.

Conclusion

Some folks cannot take advantage of the RMD “holiday” because they need the funds for routine living expenses.  Arguably, those who least need assistance from Congress to ride out tough economic times are in the best position to benefit from these rules, and in most cases they should avoid 2009 RMDs as temporarily allowed.  However, as explained above, some retirement plan owners may find that some unique tax planning can produce tax savings through selection of a specific distribution amount, and the “mulligan” provided by IRS Notice 2009-82 may help them too.

NOTE: This article is provided for information purposes only and should not be relied upon for legal or financial advice. We would be happy to discuss how the Recovery Act of 2008 or Notice 2009-82 may help you.  For more details about this matter, please contact Stan Rose or your BNN tax professional at 800.244.7444

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Pursuant to requirements imposed by the Internal Revenue Service, any tax advice contained in this communication (including any attachments) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any tax-related matter. Please contact us if you wish to have formal written advice on this matter.