Distribution holiday has its complications

No required minimum distributions for 2009. That will certainly reduce the tax bite for millions of retirees and their beneficiaries — at least, for this year. The tax relief sounds easy, but as with any new tax law, along with the tax savings on avoiding RMDs come the usual complications and tax traps.

The Worker, Retiree, and Employer Recovery Act of 2008 was signed into law on Dec. 23, and among its many provisions is the suspension of RMDs for 2009.

Many retirees were hoping that RMDs would be suspended for 2008 since the decline in the stock market had reduced the value of their individual retirement accounts and their 401(k)s. But no such relief was enacted.

The rules for calculating RMDs state that the RMD for the year is based on the prior year-end market value. For 2008, that meant using the much higher balance from Dec. 31, 2007, resulting in an RMD that was a much larger part of the total account balance than it would normally be.

Congress avoided any 2008 problems by looking forward and making the suspension of RMDs effective only for 2009. There is no relief for 2008, even if the 2008 RMD is taken in 2009.

That would only be the case though for those who turned age 701/2 last year. In that case, the required beginning date for RMDs is April 1.

Even though that 2008 RMD can be taken in 2009, it isn’t suspended and must be taken because it is the RMD for 2008.

Clients will still use the Dec. 31, 2007, balance to compute their 2008 RMD, even if it is taken in 2009.

The suspension of RMDs is for one year only. In 2010, RMD requirements will resume.

But this suspension doesn’t apply to all retirement distributions. The suspension applies to distributions from IRAs and defined contribution plans such as 401(k)s, 403(b)s and 457s but not to defined benefit plans.

A DB plan is one where the contribution amount is the amount needed to produce an annual benefit of a stated amount. This term is used to describe traditional pension plans.

RMDs will have to continue to be paid from DB plans.

The suspension of RMDs applies to both account owners and account beneficiaries, including Roth IRA beneficiaries, who would otherwise be subject to post-death RMDs.

The new law says that distributions of amounts that would have been RMDs for 2009 won’t be treated as RMDs. However, the plan isn’t required to offer a direct rollover option, and the distribution won’t be subject to the 20% withholding on these would-be RMDs.

In addition, plan participants can roll over these distributions. Normally you can’t roll over a required distribution, but now, since it isn’t required for 2009, it can be rolled over.

This also means that what would have been an RMD can be converted to a Roth IRA if the plan participant or IRA owner qualifies under the $100,000 income eligibility limit. As with any rollover, the plan participant has 60 days to roll over the funds.

One exception though: a non-spouse beneficiary can never do a rollover.

IRA beneficiaries who are taking distributions from inherited IRAs or Roth IRAs over their lifetime (as a “stretch IRA”) can now stretch a little longer, keeping more of their inheritance growing tax-deferred in a traditional IRA or tax-free in an inherited Roth IRA. Although Roth IRA owners aren’t subject to RMDs during their lifetime, their beneficiaries are, but not for 2009.

When a non-individual is named the beneficiary of an IRA, and the individual dies before their required beginning date, then distributions must be made using the five-year rule. Under the five-year rule, the entire inherited ac-count balance must be emptied by the end of the fifth year following the year of death.

Beneficiaries who are taking distributions under the five-year rule will now get an extra year to empty the account. For purposes of the five-year rule, 2009 won’t count, so it is now really a six-year rule.

The suspension of 2009 RMDs mainly benefits those who don’t need the distributions to live on. They will have the ability to leave the funds intact and potentially see them recover, at least somewhat.

They will have more in their retirement accounts to leave to their beneficiaries.

Retirees who rely on their retirement plans to pay their living expenses will still need to draw money from those accounts in 2009, whether or not the account balance has declined.

Ed Slott, a certified public accountant in Rockville Centre, N.Y., created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.

For archived columns, go to investmentnews.com/iraalert.

Related Topics: Individual Retirement Accounts