Thursday, March 31, 2011

Tips for dealing with mandatory IRA distributions

By Sandra Block, USA TODAY

We all know that Dec.31 is the deadline for completing certain fiscal errands, such as depleting flexible spending accounts and making charitable contributions. April15 — actually, April18 this year — is the deadline for filing your federal income taxes. But April1? That’s a day associated with whoopee cushions and snakes-in-a-can, not financial responsibilities.

For the estimated 1million Americans who turned 70½ last year, though, April Fool’s Day is as serious as a heart attack. The reason: It’s the deadline for taking a mandatory distribution from your individual retirement account.

Ordinarily, IRA holders who are 70½ or older must take their withdrawal by Dec.31. For those who are taking a distribution for the first time, though, the deadline is extended until April1 of the following year. The amount of the withdrawal is based on your life expectancy and the value of your IRA.

Fidelity Investments says more than a third of its IRA account holders who turned 70½ last year hadn’t taken their first withdrawal by Dec.31. Some may be deliberately waiting as long as possible to withdraw the money, thus giving it more time to grow tax-deferred. But a more worrisome possibility is that some of these IRA holders don’t realize they have to start taking money out of their accounts.

That’s a costly oversight, because where mandatory withdrawals are concerned, the IRS has no sense of humor. Miss the deadline, and you’ll have to forfeit 50% of the amount you should have withdrawn, says Ken Hevert, vice president of retirement products for Fidelity.

Retirees who delay their first distribution until April1 are still required to take another distribution in the same calendar year, Hevert says. The first withdrawal represents your 2010 distribution and is based on the value of your IRA at the end of 2009. The second, which must be taken by Dec.31, will be based on the value of your IRA at the end of 2010.

Depending on the size of your IRA, taking two distributions in one year could push you into a higher tax bracket, Hevert says.

If you turned 70½ last year, or will hit that milestone in 2011, it’s time to start thinking about how you’re going to manage this annual ritual. If you need the money for living expenses, you probably won’t have to worry about withdrawing less than the minimum required.

Don’t need the money to pay bills? Consider these tax-saving strategies:

• Convert to a Roth IRA. Once you convert your IRA to a Roth, you’re no longer required to take minimum withdrawals. In the past, there were income restrictions on conversions, but a law that took effect last year allows all IRA owners to convert to a Roth.

When you convert, though, you must pay taxes on all pretax contributions and earnings. For that reason, this strategy primarily makes sense for IRA owners who want to leave the money to their children, says Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research.

Your heirs will be required to take distributions from the Roth, but they won’t have to pay taxes on the money, Spiegelman says.

“A Roth conversion can be a really nifty estate-planning tool,” he says. “You’re doing your heirs a big favor by leaving them a tax-free account.”

You’re allowed to convert to a Roth after you turn 70½, but you must take your minimum distribution — and pay taxes on that money — before you convert, Hevert says.

You don’t have to convert your entire IRA to a Roth in one year, Spiegelman adds. You can convert just part of your IRA, which will reduce the tax you’ll owe on the transaction.

• Donate money from your IRA to charity. In 2011, seniors who are 70½ or older can contribute up to $100,000 from their IRAs directly to charity and have it counted toward their minimum distribution, Hevert says. The contribution isn’t deductible, but the money won’t be included in your adjusted gross income (AGI), Spiegelman says.

Reducing your AGI could benefit you in several ways: It could reduce taxes on your Social Security benefits, for example, or make you eligible for tax breaks that are tied to AGI. In addition, the contribution will reduce the overall balance in your IRA, which will reduce the size of future mandatory distributions, Hevert says.

You can find more information about IRA withdrawal requirements in IRS Publication 590, available at www.irs.gov. Your IRA provider should also be able to help.

“Get as educated as you can on this stuff,” Spiegelman says. “The last thing you want to do is lose 50 cents on the dollar because you missed a deadline.”

Sandra Block covers personal finance for USA TODAY. Her Your Money column appears Tuesdays.

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