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Year-End IRA Tax Tips

Natalie Choate addresses investors' dilemmas in light of today's tax code uncertainty.

Natalie Choate, 09/14/2012

2012 is drawing to a close, and no one knows what tax rates and rules will prevail in 2013. Is there anything clients can do, now, with their retirement benefits that might help minimize taxes?

Question: Steve is over age 70½ and owns an IRA. For the last several years, he has used his required minimum distribution (his will be about $40,000 this year) to fund a charitable gift via direct transfer from the IRA to our city's Community Foundation. However, these so-called "qualified charitable distributions" (QCDs) are no longer part of the Tax Code, since the applicable section (allowing direct IRA-to-charity transfers of up to $100,000 for individuals over age 70½) expired at the end of 2011.

Steve is waiting to see whether Congress will renew QCDs again for 2012, but he is getting nervous about missing his required 2012 distribution. He doesn't want to owe the IRS a 50% penalty (for failing to take the minimum required distribution--that would happen if he waits too long to take his 2012 distribution), but he also does not want to waste a tax-planning opportunity by taking his required distribution in cash, and then finding out if he had waited just a little longer, he could have satisfied the RMD with a QCD if Congress decides to renew that provision at the last minute--as they did in 2010, for example. What should he do?

Answer: I would recommend that Steve instruct his IRA provider, right now, to send the $40,000 2012 minimum distribution amount directly from the IRA to the Community Foundation. By doing so he will have satisfied his 2012 required minimum distribution, so he can stop worrying about incurring a penalty.

If Congress does finally renew the QCD option for 2012 very late in the year, they will almost certainly make it retroactive to the beginning of the year, as they did when they originally created QCDs in 2006, and again when they renewed them in 2008 and 2010. Assuming Congress does renew the QCD option and make it retroactive, Steve will be in good shape because he has already done his QCD for the year.

If Congress does not extend QCDs for 2012, then Steve is no worse off than if he had withdrawn the funds and then contributed them to the Community Foundation: He will have a taxable distribution of $40,000 plus a charitable contribution of the same amount that should be at least partly deductible, subject to the usual rules and limitations regarding charitable contributions.

Question: Vinny is very concerned that tax rates are going to increase substantially after 2012. He is retired, with a large IRA, and has over $250,000 a year of investment income in addition to taxable minimum required distributions that he doesn't need for his living expenses, but that, of course, he receives anyway from his substantial IRA. He is looking for a way to keep his income under $250,000 a year for future years in view of the potentially higher tax brackets that may well apply to income over that amount. But just when he thinks he should "pull the trigger" and do something to accelerate distribution of his IRA into the 2012 year (when at least he knows what the taxes will be), he gets cold feet thinking about the fact that Congress might roll back all the expected tax increases and let today's rates continue for another year or even longer. What can he do to get out of this dilemma?

Answer: This sounds like an ideal situation for a Roth conversion of Vinny's entire IRA in 2012:

Converting now would accelerate all the income into 2012, when tax rates are known and (though not the lowest they've ever been) lower than they will be next year if expected tax increases take effect.

Converting would put an end to Vinny's unwanted required minimum distributions from the account. These are the distributions he must take annually from his traditional IRA, even though he doesn't need the money for living expenses or want it for any other purpose right now. Roth IRAs do not have required minimum distributions during the owner's lifetime. Suppose Vinny converts his entire IRA to a Roth in 2012. For 2013 and later years (until Vinny's death), there would be no further required distributions from the account, so post-conversion his only income will be the income from his taxable investment account.

Paying the income tax on the Roth conversion, using funds from his taxable investment account, should reduce Vinny's future income from that account, thus helping to keep his taxable income under the $250,000 level that would be the starting point for higher "surtax" brackets on investment income.

Finally, the best thing about a Roth conversion is that the converter can change his mind and undo the whole thing right up until Oct. 15 of the year after the year of the conversion. That option is extremely rare in the Tax Code, but it's right there to help Vinny deal with the uncertainty of 2012–2013. If he files his 2012 tax return by April 15, 2013 (or by the extended due date, if he gets an extension), then he has until Oct. 15, 2013, to undo (recharacterize) all or part of the Roth conversion. Thus, if we get halfway through 2013 and find out that the 2012 tax rates will be extended through 2013, Vinny can unwind his 2012 Roth conversion if he wants to.

So Vinny should convert the whole IRA to a Roth right now, then sit back and see what happens. A Roth conversion may be the only way an individual can get so much choice about what year to realize income in--with the option to undo the deal if tax rates don't, in fact, go up next year.

Natalie Choate will be speaking at a location near you if you live in Boston (11/19/12) or Cambridge (4/19/13), Mass.; South Bend (9/20/12), Evansville (11/16/12), or Indianapolis (6/21/13), Ind.; Provo (9/27/12) or Salt Lake City (9/28/12), Utah; San Antonio (Oct. 1-2, 2012) or Austin (10/2/12), Texas; Minneapolis (10/9/12); Pittsburgh (10/18/12); Atlanta (10/19/12, 11/1/13); San Diego (10/20/12, 2/15/13) or San Francisco (April 23-24, 2013); Albany, N.Y. (10/23/12); Iselin, N.J. (10/24/12); St. Charles, Ill. (11/29/12); Orlando (Jan. 17–18, 2013) or Palm Beach Gardens (2/20/13), Fla.; Manchester, N.H. (3/7/13); Overland Park, Kan. (4/26/13); Asheville, N.C. (5/1/13); Columbus, Ohio (5/17/13); or Denver, (8/9/13). See all of Natalie's upcoming speaking events.

Resources: For everything you need to know about Roth conversions and "recharacterizations," see Chapter 5 of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011; http://www.ataxplan.com). For more on QCDs, see Natalie's Special Report: Charitable Giving with Retirement Benefits, downloadable at http://www.ataxplan.com.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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