Three new IRA strategies

Investing in an Individual Retirement Account (IRA) usually involves a few key decisions, but for 2009 and 2010 there are some important new considerations.

Annual IRA checklist

First, let's look at some items to evaluate every year.

• To be eligible to contribute to an IRA, you or your spouse must have earned income.
• Verify whether you're eligible for either or both types of IRAs — traditional or Roth — based on your age, income level, tax filing status and whether you or your spouse has a workplace retirement plan.
• Decide whether you prefer a tax deduction now with a traditional IRA or tax-free income in retirement with a Roth IRA. Key considerations: Your tax bracket now and when you retire and how long you'll be able to let the money grow before you access it. As a general rule, the lower your current tax bracket and the longer your timeframe, the more favorable a Roth IRA contribution is versus a deductible contribution.
• Consider other questions, such as:
  • Is it important to have the flexibility of a Roth IRA — the ability to take out your contributions at any time with no tax or penalty and no required minimum distributions?
  • Do you want to be able to keep contributing in your 70s if you are still earning income? A Roth IRA allows you to contribute in the year you turn 70 ½ and later, while a traditional IRA does not.
  • Do you plan on leaving a legacy for your heirs? Roth IRAs offer tax free income for your beneficiaries if conditions are met.
  • Is it important to lower your taxable income this year — for the direct tax savings or to be eligible for other income-sensitive tax credits, for example?

New opportunities for 2009 and 2010

This year, there are a few additional opportunities to examine.

1. 2010 Roth IRA conversion

Beginning in 2010, everyone will be eligible to convert a traditional IRA to a Roth IRA. This is great news if you earn more than $100,000 and have not been eligible to do a Roth conversion until now.

Even if you don't qualify for regular contributions to this type of account, through a conversion you can still gain the many benefits of a Roth IRA. And it can help you diversify the tax treatment of your retirement assets. For example, owning a mix of tax-free, tax-deductible and taxable investments would give you flexibility in deciding which account to take withdrawals from at any point in your life.

What you need to know:

• When you convert pre-tax contributions and earnings to a Roth IRA, you'll owe tax. The conversion needs to make sense based on your tax brackets now and in retirement, your ability to pay the taxes on the conversion from non-IRA assets, and your time frame (longer is better).
• In 2010, for one year only, you'll be able to defer taxes that you owe from the conversion, split equally in 2011 and 2012. In most cases, deferring taxes for as long as possible makes good sense. However, if you think your tax rates are likely to rise by 2011, deferring your taxes might not be such a good idea. Talk to your financial advisor and tax professional to learn more.
• If you aren't eligible for a deductible or Roth IRA, you could consider a non-deductible traditional IRA contribution. Your earnings grow tax-deferred and you could convert to a Roth IRA in 2010 or later, regardless of your income. Conversions of after-tax dollars are non-taxable, but be careful if you have other pre-tax IRA assets because special tax rules apply.

2. Recharacterizations give you another option

What if you change your mind or your situation changes after you contribute to a Roth or traditional IRA or convert from a traditional IRA to a Roth IRA?

You can always do an IRA recharacterization up to October 15 of the year following the year of the contribution or conversion. It's like a retirement account re-do. You can switch the type of IRA contribution from a traditional to a Roth IRA or vice versa, or undo a Roth IRA conversion, changing it back to a traditional IRA. Recharacterization removes any tax consequences you would have had otherwise.

Why do a recharacterization?

Here are a few reasons:

• You have exceeded the income eligibility limits for a Roth IRA contribution and/or a tax-deductible traditional IRA.
• You have exceeded the income limits for a 2009 Roth IRA conversion (there are no income limits on conversions beginning in 2010).
• You'd like to lower your adjusted gross income in order to qualify for certain tax credits. You could opt for a tax-deductible IRA and forgo the longer-term advantages of a Roth IRA.
• You aren't able or willing to pay the tax that would otherwise be due on the conversion.
• You did a Roth IRA conversion and then the value of your account dropped. You might think twice if you have paid taxes on a higher portfolio value. Rather than be stuck with that higher tax bill, you can undo the conversion and owe no taxes now. Note: If you convert an IRA during 2010 and recharacterize to take advantage of a decline in account value by reconverting later, you won't be able to do so until 2011. In this case you'll lose the ability to spread the taxation from the conversion over two years.

How to do a recharacterization

• Ask your financial advisor, or the company holding your IRA, for the paperwork required to process a recharacterization.
• The transfer must include any net income or loss incurred from the original date of the contribution or conversion.
• If you did not file for an extension and you are recharacterizing after your filing deadline, you'll have to file an amended return. If you're thinking of recharacterizing, ask your tax preparer to request an extension. Filing an amended return is usually more expensive than filing for an extension.
• Use IRS Form 8606 to report the recharacterization on your taxes.

Deadlines

• You have until October 15 of the year after your contribution or conversion was made to request a recharacterization.
• If you are recharacterizing a conversion, you can reconvert to a Roth IRA after the later of 30 days or January 1 of the year following the conversion.

3. Prepare for RMDs to pick up again in 2010

Traditional IRAs are subject to required minimum distributions (RMDs) once you reach age 70½. You may also have an RMD if you inherited an IRA or a Roth IRA, regardless of your age. If you fail to withdraw the required minimum each year, on time and in full, you'll have to pay a hefty IRS penalty: 50% of the amount you should have taken, but have not yet removed. For example, if your RMD is $5,000 and you withdraw just $3,000, your penalty would be 50% of $2,000. RMDs do not apply to Roth IRAs for the original Roth IRA owner or for a spouse beneficiary who rolls it to their own Roth IRA. RMDs do apply for non-spouse beneficiaries of Roth IRAs.

For 2009 only, there's a one-year suspension of RMDs. This applies to defined contribution plans, such as 401(k)s and 403(b)s, as well as IRAs. Although you're not required to make a withdrawal in 2009, you certainly can. Normal RMD rules are expected to apply for 2010 and beyond.

These issues are complex, yet vitally important, and making a mistake could be costly. Take advantage of the full array of IRA opportunities. Set up a meeting with your financial advisor today.