As individuals try to reclaim some of the losses to their retirement portfolios, many tax advisors have become active participants in growing those accounts. With significant percentage gains and losses occurring from month to month, techniques to deal with this unfamiliar territory have become necessary. Some have already been tested by case law, while many others can be evaluated, at least for the time being, only through what's been said in private letter rulings or on the Internal Revenue Service's Web site in informal advice.
TAKING BACK IRA CONTRIBUTIONS
Prior to the economic downturn, the general expectation was that a dollar contributed to a retirement plan at any time during the year grew in value from that date. One outgrowth of that trend was the advice to contribute the maximum to a retirement plan as early in the year as possible to maximize tax-free or tax-deferred appreciation. When contributions decrease in value, however, a different strategy may be warranted.
Whether regular or excess contributions, the deadline for returning the contribution generally is the due date (with extensions) of the return filed for the year of the contribution. Any income earned on the contribution (regular or excess) must also be distributed and will be taxable (and subject to the 10 percent penalty, if applicable; for example, if the account holder is under age 59-1/2). All gains are ordinary income.
Excess contributions can instead be taken as an allowable contribution in the subsequent year, if contributions in the later year are less than the limit for that year. Or excess contributions can be returned after the return's due date if the total contributions did not exceed $5,000 and no deduction was taken for the amount being withdrawn.
* Loss strategies. Any losses on the contribution will reduce the amount that must be distributed, but will not be deductible on an interim basis. Losses can only be deducted when the entire account balance is distributed, provided the total distributions are less than the account's basis. (The basis is the amount of any nondeductible contributions.) The loss can only be taken as a miscellaneous itemized deduction, subject to the floor of 2 percent of adjusted gross income.
One consolation in having the value of an early contribution to a traditional IRA decrease during the year is that the full amount of the original contribution continues to be the amount deductible against ordinary income. In a sense, that full deduction makes any market-based loss immediately deductible. Those account holders in need of cash, therefore, should weigh carefully whether a take-back of contributions would be the best source for those funds.
On the Roth side of the equation, however, taking back an initial contribution that has decreased in value may make sense if the goal is to maximize the annual contribution limit (currently, $5,000 plus any over-50 catch-up contributions). For example, if a $5,000 Roth contribution made on Jan. 2, 2009, is now valued at $3,000, the account holder can take back the $3,000 and recontribute the full $5,000 once again for the 2009 tax year.
UNDOING ROTH CONVERSIONS
Many taxpayers who have converted from traditional IRAs to Roths in 2008 or early 2009 have seen their Roth balances drop significantly. Nevertheless, they must recognize taxable income on these conversions based upon the value of the account on the date of conversion ... unless they undo it in time.
The conversion can be undone if the amount contributed to the Roth is transferred back to the traditional IRA. Earnings (or losses) on the contribution also must be transferred. Unfortunately, the treatment of losses here is the same as when current contributions are taken back: The amount transferred is reduced by the losses on the contribution, but the losses are not deductible.
Most important in today's market, however, a recharacterization may be made by the due date (including extensions) of the return that would reflect the initial conversion. This deadline is Oct. 15, 2009, for most taxpayers with initial 2008 conversions.
Once a Roth IRA has been recharacterized back to a (new) traditional IRA, the (new) traditional IRA can be reconverted to a Roth IRA, provided the taxpayer meets the eligibility requirements in the reconversion year. Generally, the taxpayer may not reconvert that amount from the traditional IRA to a Roth IRA before the beginning of the tax year following the tax year in which the amount was converted to a Roth IRA or, if later, the end of the 30-day period beginning on the day on which the IRA owner transfers the amount from the Roth IRA back to a traditional IRA by means of a recharacterization.
* 2010 kicker. Under TRRA '06, the $100,000 AGI limit on the conversion of a traditional IRA to a Roth IRA is eliminated effective for tax years beginning after Dec. 31, 2009. For conversions in 2010, taxpayers also can recognize conversion income ratably in 2011 and 2012. For conversions after 2010, all of the conversion income has to be recognized in the year of conversion. Due to the probability that those in the highest tax brackets will be paying more after 2010, however, the two-year tax deferral option may not be best for everyone. In any event, this option will soon be available for traditional-to-Roth-to-traditional-to-Roth conversions and may be worth delaying the final traditional-to-Roth leg of this strategy until January to take advantage of the new rules.
RMD RELIEF
Billed in the Worker, Retiree and Employer Recovery Act of 2008 as a provision designed to help retirees build up their accounts a little faster, required minimum distribution rules do not apply to IRAs for 2009. This waiver applies to IRA owners and beneficiaries. An owner who is age 70-1/2 or older can skip the RMD for 2009. An owner under age 70-1/2 is not affected.
If the owner dies before RMDs have begun, the beneficiary must take the entire interest within five years. With the waiver, the beneficiary can take the payments over six years (or take the entire balance in the sixth year). If payments have not begun, a surviving spouse does not have to begin distributions until the owner would have turned age 70-1/2 (or when the survivor turns 70-1/2 when the survivor treats the IRA as their own).
The five-year rule does not apply if distributions begin within one year of the owner's death and are payable over the life or life expectancy of the beneficiary. If the owner dies after payments have begun, they must continue to the beneficiary at least as rapidly as the distribution method chosen by the owner.
The lifting of RMDs for 2009 also has an indirect advantage in rollover situations. Rollover of an RMD is prohibited. An individual who has attained at least age 70-1/2 by the end of a calendar year may not convert an amount distributed from a non-Roth IRA during that year to a Roth IRA before receiving his RMD with respect to the non-Roth IRA for the year of the conversion. In order to be eligible for a conversion, an amount first must be eligible to be rolled over. This pitfall is therefore removed in 2009 by the temporary lifting of RMDs.
PERIODIC-PAYOUT IRA ROLLOVERS
A recent letter ruling that effectively prevents movement of certain IRA funds to a safer investment has some practitioners scratching their heads. While the IRS's position may change, caution dictates steering clear of identical fact situations until the IRS issues more definitive guidance. In the ruling (LTR 200925044), the taxpayer had been taking equal periodic payments that avoided the early-withdrawal penalty. The institution in which the IRA was deposited, however, did not offer the safety of CDs. As a result, the taxpayer pulled part of his money out of that IRA and redeposited it in a trustee-to-trustee transfer to a bank that set up an IRA CD. Presumably to get a higher rate on the CD, the taxpayer also transferred his entire balance in a second IRA into the new IRA CD.
The IRS determined that the transfer of the partial amount from the equity IRA to the new CD IRA was a modification of the original series of substantially equal periodic payments that, under controlling Rev. Rul. 2002-62, could not be corrected by transferring the amount back to the equity IRA. While the IRS has previously been more forgiving in allowing corrective retransfers in situations involving mistakes made by a financial institution in following directions, apparently a blunder made directly by the taxpayer, whether with or without tax advice, triggers recapture of the early-withdrawal penalty irrespective of efforts to make amends.
"LOANS," HARDSHIP WITHDRAWALS
Once the deadline for taking back a contribution made during a tax year passes, withdrawing funds from an IRA without penalty may be done only under specified circumstances. Some strategies include:
1. Short-term "loans" through 60-day rollover window. The amount distributed from an IRA is not included in the recipient's income if the distribution is transferred to another eligible IRA within 60 days after it is received. While some taxpayers have used this as a method to acquire a short-term loan, the consequences of not redepositing the funds within 60 days can be onerous, typically requiring both income recognition and an early-withdrawal penalty. While the IRS is permitted to waive the 60-day rule for hardship cases, it generally does not encourage the use of the provisions for short-term loans.
2. Hardship withdrawals. Financial hardship per se does not excuse an early-withdrawal penalty for IRAs. The concept of "hardship withdrawals" based on financial need for purposes of allowed distributions from 401(k), 403(b), 457 and 409A plans does not carry over to IRA withdrawals. Instead, certain events or expenses - whether or not they precipitate financial hardship for the particular individual - qualify for lifting the penalty. They include:
* Disability (a person is disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or to be of continuing and indefinite duration);
* Qualified higher education expenses;
* Qualified first-time home purchases (capped at $10,000);
* Medical expenses that exceed 7.5 percent of AGI; Payment of health insurance premiums by certain unemployed individuals;
* Satisfaction of an IRS levy;
* Reservists called to active duty for more than 179 days or an indefinite period; and,
* A one-time rollover distribution to a health savings account.
Once a permitted withdrawal is taken and 60 days have passed (or two years in the case of a reservist), it cannot be recontributed as an additional contribution after the account holder gets back on their feet. The tax-deferred growth of those assets is lost.
CONCLUSION
Coping with the immediate economic downturn while preserving capital for retirement at a future date is a challenge that is reshaping conventional wisdom. Rather than a traditional "set it and forget it" strategy for IRAs, looking to maximize the benefits from every contribution, conversion or withdrawal opportunity has become the new paradigm for many taxpayers and their advisors. Especially with the prospects of an increased income tax rate structure and at least continued short-term volatility in the markets, awareness of the finer points - with all their variables - can make a significant difference in a client's overall long-term financial health.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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