We spend most of our lives saving for retirement by putting funds away in tax-advantaged ways.  But many of us forget about planning the withdrawals so that they are tax-advantaged as well.

Although there are exceptions, retirement funds generally cannot be withdrawn until we are age 59.5. If taken out sooner, there is a 10% penalty that applies in most cases. In addition, there may be a state penalty.

A large number of taxpayers do not take distributions until they are forced to do so at age 70.5, not realizing they might benefit tax-wise by taking money out sooner. For example, if you are in a low or zero tax-bracket this year, you can take a certain amount out with no or minimal tax cost. That is where planning your distributions can save a significant amount of tax dollars.

Even if you are under 59.5, if your income for the year is below the taxable income limit, you can withdraw an amount that brings you up just short of the taxable income threshold and only pay the penalty.

If you receive Social Security benefits keep in mind that Social Security income is tax-free for lower-income retirees but becomes taxable as income increases.  IRA distributions can sometimes be planned in order to minimize the taxability of the Social Security income.

Once you reach age 70.5, you must start taking the required minimum distribution (RMD) from your Traditional IRA and other qualified pension plans.  But you can still withdraw more than the required amount.  If your income is low, it may be appropriate to take more than the minimum to save taxes in the future.  Unfortunately, many people simply take the IRS-specified minimum amount without considering the tax-planning aspects of the distribution.

The penalty for not taking the RMD after reaching age 70.5 is an additional tax of 50% of the amount that should have been taken that year, based upon the IRS rules.  The good news is that the IRS will generally, upon request, waive the penalty, provided that you show a corrective distribution was made in the subsequent year.  So if you missed an RMD for the prior year, you should contact this office right away with regard to taking corrective action.

The RMD is determined by taking the IRA balance on December 31 of the prior year and dividing that total by your remaining life expectancy from the IRS table.  If you have more than one IRA, figure the RMD for each one and then combine them to get the total required distribution for the year. (An owner of a Roth IRA is not required to take distributions at any age.)

For purposes of determining the minimum distribution, all Traditional IRA accounts, including SEP-IRAs, owned by an individual are treated as one, but the actual minimum distribution can be taken from any combination of the accounts.  If the owner chooses not to take the minimum distribution from each account, it is not uncommon for IRA trustees to require written certification that the owner took the minimum distribution from other accounts.

If you have other qualified plans besides Traditional IRA accounts, the RMD for those must be figured separately for each type and withdrawn from those plans and cannot be combined with the distributions from IRAs or other qualified plans.

A taxpayer who fails to take a distribution in the year he or she reaches age 70.5 can avoid a penalty by taking that distribution no later than April 1st of the following year.  However, that means the IRA owner must take two distributions in the following year, one for the year in which age 70.5 is attained and one for the current year.

If an IRA owner dies after reaching age 70.5, but before April 1st of the next year, no minimum distribution is required because death occurred before the required beginning date.

As you can see, there is more to the required minimum distribution than meets the eye, and there are some significant planning opportunities.  Give this office a call if you have questions or would like to schedule a planning appointment.

It’s not too late to make an IRA and/or SEP contribution or undo a Roth IRA conversion for 2011.

Generally, after the close of the year you can no longer take steps to alter the outcome of your tax return. However, both IRA contributions and SEP contributions can be made for a year after it has closed, and if you converted a traditional IRA into a Roth IRA, you can undo that conversion after the close of the year. Here are the details:

Traditional IRA Contributions – IRA contributions (tax-deductible and non-deductible) for 2011 can be made up to and including the un-extended filing due date for your 2011 tax return, which is April 17, 2012. The maximum contribution allowed is $5,000 ($6,000 if age 50 or over) for each taxpayer. The annual maximum must be allocated between traditional and Roth IRA contributions.

If you are an active participant in an employer-sponsored plan, the IRA contributions are phased out for higher income taxpayers. The traditional IRA AGI phase-outs for 2011 are: between $90,000 and $110,000 for married individuals filing jointly and individuals qualifying as a surviving spouse, $56,000 and $66,000 for unmarried individuals, and $0 to $10,000 for married individuals filing separately.

Where one spouse participates in an employer plan but the other does not, the non-participating spouse’s phase-out is between $169,000 and $179,000 for 2011.

SEP Plan Contributions – SEP plans are tax-deductible retirement plans for self-employed individuals. Contributions can be made up to and including the extended due date, which for the 2011 tax return is October 15, 2012. The maximum annual contribution to a SEP plan is the lesser of “25% of compensation” (20% of net profit after deducting the SEP contribution for the self-employed proprietor’s contribution) or $49,000. SEP plans have no AGI phase-out limitations and no catch-up contributions for older individuals.

Roth IRA Conversions – If you made a conversion from a traditional to a Roth IRA, there is a good chance the entire conversion is taxable. Generally, people plan those conversions for years with low income or when the stock market is down and the IRA value at the time of the conversion is low. However, if subsequent to the conversion conditions change, and you wish you hadn’t made the conversion, or you simply decide you can’t afford to pay the tax on the conversion, you can undo the conversion up to and including the extended due date of the return (October 15, 2012 for 2011 returns). However, don’t wait until the last minute to make that decision because it will require some paperwork on the part of the trustee (bank, broker, etc.).

Other plans – Other plans such as Simple Plans and Keogh plans also permit contributions in 2012 for 2011.

For additional information related to making retirement plan contributions after the close of the tax year.

I recently fielded the following question from one of our clients:

“I opened my Roth IRA on September 5th, 2005 .   Can I withdraw the contributions now or do I have to wait until September 6th 2010 so that they will not be taxable or subject to penalty?”

Qualified distributions from a Roth IRA are not included in the recipients gross income, nor are they subject to the 10% penalty for early withdrawal.    

The actual contributions themselves can be withdrawn any time with out tax or penalty.  There is a 5-year holding period from the time of the first contribution into a Roth IRA until the time in which you may be able to withdraw the earnings on those funds without being subject to income taxes and a 10%  penalty.    In addition to satisfying the 5-year rule, in order to avoid the penalty and the tax, you must also satisfy one of the following:  (1)  the distribution must also occur on or after the date that you become age 59 1/2, (2) at or after your death, (3) the distribution is due to a disability, or (4) in conjunction to a first-time homebuyers purchase (up to $10,000). 

Contrary to what one might think, the 5-year clock does not start based on the date that you actually made the contribution, but rather the tax year you made the contribution.  The tax code deems all contributions made during a year as made on January 1st of that year.  In the above example, the initial contribution is deemed to have been made on January 1st, 2005.  Therefore, the taxpayer must wait until January 1, 2010 in order to be able to remove any earnings on those contributions without being subject to the 10% early withdrawal penalty. 

The good news is that any withdrawals are first assumed to come from contributions and then earnings.  Therefore, no amount is included in gross income until all of the after-tax contributions have been withdrawn.   Generally, if an individual receives a distribution of earnings from a Roth IRA that is included in income, they will also be subject to the 10% additional tax for early distributions.

This is final part of a five part series of posts related to Roth IRA Conversions and the rule changes that go into effect on January 1, 2010. As mentioned in prior posts in this series regarding Roth IRA Conversions, I will explain the rules around Roth IRAs, as well as what the recent changes in the law means. I will also provide you with some reasons to convert, as well as some reasons not to convert. In addition, my final post will include some tax planning tips around the Roth IRA.

For other posts in this series, please visit:

Part I: What is a Roth IRA? What is changing about Roth IRA Rules?
Part II: Reasons to Convert to a Roth IRA.
Part III: Reasons NOT to Convert to a Roth IRA.
Part IV: Planning Ideas around Converting to a Roth IRA
Part V: Planning Ideas – What is the Pro-Rata Rule?

In this post, I will review a few more tax planning considerations related to Roth IRAs. It is important to keep in mind that everyone’s situation is different and that these ideas may or may not apply to you. You should sit down with your tax professional and do proactive tax planning prior to doing anything.

Can’t Afford to Convert?  If you are like many taxpayers, you look at the cost of conversion and it is overwhelming.  The good news is that you don’t have to do the entire conversion all at once.  You can convert a small portion of your IRA each year over a several year period – depending upon what you can afford to pay in additional taxes for the year of conversion.  In addition, this allows you to sit down with your tax planner and find out the magic amount that you can convert this year without being pushed into a higher tax bracket.  By planning this conversion out over several years, you may be able to lower the taxes that you pay on the conversion, as well as spread it out over many years.

The Pro-Rata Rule.  Wouldn’t it be great if you could choose to convert your nondeductible contributions and keep the contributions that you deducted as traditional IRAs – thus paying very little, if any tax?  Sorry, but that is where the Pro-Rata Rule comes into play.  When determining the amount of your conversion that was from deductible contributions and the amount that was from non-deductible contributions, the IRS looks at all of your IRAs.  You must add the value of all of them together, then divide by the nondeductible contributions, and this will give you the percentage of any conversion that you make that is tax- free.    This prevents you from converting only your nondeductible contributions.  The good news is that you may be able to use a loophole – the 401(k) loophole below.

401K Considerations.  Balances in 401(k) accounts are not included in the calculations for the Pro-Rata Rules.  In addition, some employer 401(k) plans allow you to rollover your traditional IRA into the plan.  By doing so, it can allow the taxpayer to exclude some or all of their deductible contributions from the calculation.  This will result in a higher percentage that can be converted to a Roth IRA tax free.  In the event that a taxpayer that plans to do a conversion has already rolled their 401(k) into a traditional IRA, they may wish to consider rolling it back to a 401(k) if their employer plan allows.

Due to this Pro-Rata Rule, it is not usually recommended that you convert your 401(k) to a traditional IRA until after you are through with any Roth IRA conversions that you plan to do.  The exception to that would be if you wanted to convert the 401(k) balance to a Roth IRA as well.  Even if you do, it is probably a good idea to sit down with your tax planner to make sure that you structure the timing of the conversions in a manner that will maximize your tax savings.

Minimum Distributions.   As mentioned several times during this series of post, if you are over the age of 70 1/2 and you are taking Required Minimum Distributions (RMDs) from your traditional IRA or workplace plan, you can not include the current years RMD in the conversion amount.  You must pay the necessary tax on that RMD, and then you can convert the remaining balance.  (Note:  There are no RMDs for 2009 because Congress passed legislation to waive them due to the down market – fearing that they would wipe out many peoples retirement accounts.  RMDs are scheduled to resume in 2010.)