Most retirees who are over the age of 70.5 are probably aware that the required minimum distributions (RMDs) for 2009 have been waived by Congress because of the market's rather drastic downturn in 2008. The purpose of this waiver was to give retirees time to recover some or all of the losses in their IRAs without having to deplete their savings by taking RMDs and paying taxes on those distributions. This reprieve didn't really benefit those retirees who still needed to take distributions to fund their current living expenses, because they needed the cash to pay their bills.
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However, retirees who hadn't planned on taking a distribution in 2009 because they don't need their RMDs for living expenses may well be overlooking an opportunity this RMD reprieve offers. While paying less in taxes by avoiding an RMD may sound like a great idea on the surface, these retirees should consider converting part of their traditional IRA to a Roth IRA in 2009 - at least up to an amount where the distribution won't force them into a higher tax bracket. (Note: You must have $100,000 or less in modified adjusted gross income to do a conversion in 2009 - that's $100,000 or less not counting the amount converted.)
A Roth conversion, in this situation, could accomplish several things:
-It would lower your future RMDs. For example; if you are 72 and convert $40,000 in 2009, your next year's RMD could be reduced by about $1,600. That $1,600 reduction in future RMD income just might keep you in a lower tax bracket next year, especially if you're currently at or near the top of your present tax bracket.
-There is no RMD for a Roth. The money can remain in your Roth, growing tax-free for years, and then pass to your heirs, who can withdraw the money over their own life expectancies tax-free.
-However, if you should need the money, all contributions can be withdrawn tax-free at any time, and any gains can be withdrawn after the Roth has been in existence for at least five years. (In other words, the converted amount can be withdrawn without tax or penalty if you're over 59.5.)
-While you will have to pay income taxes on the conversion, the tax rate is based on your 2009 tax bracket. Future tax brackets could be higher for the same withdrawal amounts. Of course you'd also want to consider how any conversion would impact the taxation of your Social Security income as well as your Medicare Part B premiums, which are higher for upper-income seniors.
To see if this Roth conversion strategy makes sense for you, talk with your tax advisor or use tax preparation software, such as the free preliminary version of Tax Act for 2009, which is now available for download. The software can help you determine the ideal amount to convert to a Roth in 2009.
The software will ask for your income, number of dependents, deductions, etc. Once you've provided that information, you can plug in various conversion amounts to see which scenario would provide you with the maximum benefit. If you believe your previous year's tax bracket was as low as it will possibly be and that you may end up in a higher tax bracket in future years, you may discover that the ideal amount to convert to the Roth in 2009 is somewhere close to the amount you would have normally taken for your 2009 RMD.
Remember, with the current low interest rates, your interest and dividend income for 2009 will likely be lower than it was in 2008, and you may also have some tax-loss carry-over to apply to your 2009 tax return. So, you just might be surprised at the amount you can convert to a Roth this year and still be in a low tax bracket.
There was a recent discussion on the Bogleheads forum on this topic. LarryG, a 78-year-old retired physician who didn't need a distribution in 2009 to pay his living expenses wondered if he should take a distribution and put it in his taxable account. You can read that discussion and follow the thought process and helpful exchanges with other forum members that helped LarryG make an informed decision.
There is another benefit to converting money distributed from a traditional IRA into a Roth rather than putting it in your taxable account. If you put the distribution in your taxable account, you would pay income taxes on the distribution, just as you would with the Roth conversion. However, any subsequent taxable mutual fund distributions would be taxed annually, and the sale of shares in the taxable account could trigger capital gains taxes. All of these problems can be avoided by simply converting unneeded IRA distributions to your Roth account, where future gains and distributions would be tax-free. That's what LarryG finally decided to do after the lengthy give-and-take with other Bogleheads.org forum members.
If you're in a tax bracket where it makes sense to convert some of your traditional IRA to a Roth, you'll need to act quickly though, since the conversion must be done before the end of this year.