Capital Gains

When it comes to taxes, reaching age 70-and-a-half is an important milestone. That is because you must begin taking minimum annual distributions from your traditional Individual Retirement Account. If you have already retired, you must begin taking annual distributions from your former employer's retirement plan as well. Failure to timely take these minimum distributions could result in a 50 percent penalty tax.

Required beginning date

When must these minimum distributions begin? If you reach age 70-and-a-half in 2008, you actually have until April 1, 2009, to take your first year's distribution, namely the one for 2008 (your age 70-and-a-half year). However, waiting until 2009 to take the first distribution may result in the bunching of too much income into 2009. That's because you will also have to take your second year's annual minimum distribution in 2009, since the extended deadline until April 1 is only available in the first distribution year. That could result in unfavorable tax consequences since the additional distribution may push you into a higher tax bracket in 2009. Additionally, you may be hit with a larger tax on Social Security benefits and saddled with larger cutbacks for deductions (such as for medical expenses) that have an adjusted-gross-income-based "floor."

The required minimum distribution, or RMD, for each year from IRAs or individual accounts under a qualified defined contribution plan is determined by dividing the account balance as of the end of the preceding year by the life expectancy factor from a uniform table. This table is used in all cases, except where the account's designated beneficiary is the account owner's spouse and is more than 10 years younger than the owner, in which case, a joint life and last survivor life expectancy table is used.

The method for computing the RMD amount has become a problem for many retirees. Because stock prices have fallen dramatically, their account balances as of the end of 2008 are much smaller than the account balances upon which their distributions are based. This can result in a double hit — older individuals being forced to distribute a disproportionately large portion of their remaining account balance and being forced to sell stock or mutual fund shares when their value is exceptionally depressed. Another group of retirees, those attaining age 70-and-a-half this year, face another dilemma: Should they take their first RMD this year or wait with the first payout until next year? It is important to consult with a qualified tax professional when planning for RMDs.

Dilemma for taxpayers turning 70-and-a-half in 2008

Taxpayers who attain age 70-and-a-half in 2008 may postpone their required beginning date to April 1, 2009, as explained above, and take their first-year's RMD next year. If they make this election, there's a chance the market will recover in early 2009 thereby reducing the need to sell stocks and mutual funds at an economic loss (or to minimize the loss). However, these taxpayers will also have to take the RMD for tax year 2009 by Dec. 31, 2009, thereby resulting in the bunching-of-income dilemma.

Take the following example. Susan attains age 70-and-a-half during 2008, and her aggregated RMD for all her IRAs based on a Dec. 31, 2007, valuation is $45,000. Assume her aggregated IRA-RMD for 2009 — based on account values as of Dec. 31, 2008 — is $30,000. If Susan waits until March of next year to take the $45,000 RMD for her first distribution year (2008), she must withdraw another $30,000 from her IRA by the end of 2009. Both amounts must be included on her 2009 return and could result in larger cutbacks for deductions with an adjusted gross income "floor," and likely propel her into a higher tax bracket.

On the other hand, there may be some instances where taking both distributions in the second year is advantageous because of factors such as a lower tax bracket in the second distribution year (e.g., a taxpayer is still working this year but will be retired next year).

Tax Relief on the Way?

There's yet another potential opportunity for those who wait to take their first-year RMD for tax year 2008 by April 1, 2009. President-elect Barack Obama has endorsed proposed tax relief for seniors forced to take RMDs in a soured market and his plan would provide for a two-year suspension of the RMD requirements. However, more specific details are unavailable and it is uncertain whether this proposal will become actual law. Another alternative being considered is a suspension of the 50 percent penalty (which amounts to the same thing as a suspension of the RMD requirements). If proposed tax relief is enacted and applies to 2009, retirees could take smaller distributions next year to avoid the "bunching of income" problem.

The decision of whether to accelerate minimum distribution payouts is not an easy one and is not for everyone. Your overall financial picture must be considered. Be sure to consult with a qualified tax professional for a review of your financial and tax situation to determine whether you would benefit from the acceleration or deferral of your RMD and set up the right IRA and retirement plan payout strategy for you and your family.

Vincent M. Hannigan is a senior manager in the tax accounting group of Duane Morris and has more than 20 years' experience in federal, state and local income taxation. He also has experience in litigation consulting services, including civil tax controversies, damage measurement and preparation of special purpose reports. Hannigan supervises the fiduciary practice area and nonprofit practice area of the firm's tax accounting department.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.