Retirement: A New Wrinkle for 2009

By Lynn O'Shaughnessy

Congress hoped to help the typical retiree by eliminating mandatory withdrawals from tax-deferred retirement accounts in 2009, but it missed the mark. Many retirees in trouble are going to have to raid their accounts to pay their bills this year regardless of the congressional action.

But the move represents a great opportunity for older affluent investors, says Rockville Centre (N.Y.) CPA Ed Slott. The temporary reprieve could help these retirees reduce taxes, leave more of an inheritance, and shelter money in a tax-free Roth IRA.

Retirees with a good stash of cash on hand, for example, could convert tax-deferred retirement assets into a Roth IRA with far less of a tax bite than they could in 2008. Here's why: For retirees with hefty assets saved up, the minimum distributions they're required to start taking after the age of 70-1/2 can be so large that they are forced into a higher tax bracket. Thanks to the 2009 hiatus, qualified retirees can complete a Roth conversion in a lower tax bracket.

Roth IRA Game

"You can now get into the Roth IRA game and fund a Roth conversion for the lowest price you will ever have," says James Lange, an estate attorney and CPA in Pittsburgh. "This really is a one-time opportunity."

To illustrate the benefits of converting to a Roth this year, Lange crunched the numbers for a retiree with $3 million in tax-deferred retirement assets. The 2009 reprieve means the retiree will avoid having to take a $153,846 distribution. That will save him $39,844 in taxes—and will dip his adjusted gross income below $100,000 for the year, placing him in the income range where Roth conversions are allowed. If he chooses to still take that $153,846 out of his tax-deferred account, pays the tax on it at his current, lower rate, and puts it into a Roth, he will gain $54,429 in purchasing power over the next 15 years.

Roth conversions represent an even bigger boon for those who inherit these accounts. In Lange's example, a 58-year-old son inherits the Roth and withdraws $15,000 a year. Without the conversion, the inheritance would vanish by the time the son reaches the age of 91. But the value of a Roth account at the same period, assuming an 6% annual return, would be about $360,000.

The son of one of Lange's clients was so eager to inherit a tax-free Roth from his mother, who is a retired professor, that he paid her Roth conversion tax.

Tax Freebie

The new act has also served up this tax freebie: Up until 2009 retirees who were forced to take yearly IRA distributions and pay taxes on the money weren't allowed to make a Roth conversion with that cash. (In the earlier example, the individual, since he wasn't required to take an annual distribution, fell into a lower tax bracket and thus was able to do a Roth conversion.)

Now, retirees can't be stopped from taking a withdrawal and doing a Roth conversion on that amount because of the one-year hiatus. So instead of withdrawing what would have been the required amount, paying taxes on it, and then putting the cash in a taxable account, a retiree can pull out the same amount of money he would have been required to take, pay the taxes, and then escort it right into a Roth. Ensconced in the tax-free Roth, the owner will never have to worry about a mandatory withdrawal, or taxes, for this cash again.

While the year-long embargo is a boon to most affluent beneficiaries of inherited IRAs, beneficiaries with less common "trusteed" or "conduit" IRAs could end up furious with this latest IRA wrinkle. That's because these trusts typically allow them to pocket only the inherited IRA's required yearly distributions. Without any required distributions in 2009, there can't be any payouts. "Certain trusts are written so that the only thing the beneficiary gets is the minimum distribution, and there is no discretion to give them any more than that," says Natalie Choate, an estate planning attorney and author in Boston. That could be a cruel twist in a tough year.

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