The IRA Requirement You Can Skip

With the arrival of November, investors over 70 ½ are usually prodded to make their required withdrawals from retirement accounts, else they face whopping penalties.

But not this year. Last December, Congress suspended (for 2009) the rule that people with IRAs, 401(k)s and similar tax-deferred accounts take “required minimum distributions” every year after turning 70 ½. Lawmakers wanted to give some relief to investors who otherwise could have faced a hefty tax bill on withdrawals, even though their accounts had shriveled in 2008.

In September, the IRS followed up by instituting a new rule making it easier for people who took distributions to put the money back into their tax-deferred accounts. Still, some investors might be better off taking distributions even if it isn't required.

Required minimum distributions, or RMDs, are intended to assure that Uncle Sam eventually gets the tax revenue he has missed during the years of tax-deferred investment growth. The minimum size of the annual distribution is determined by dividing the value of the account on the previous Dec. 31 by the investor’s life expectancy, published in government tables. A person expected to live another 20 years would have to withdraw 1/20th of the account, for example.

Income tax is paid on withdrawals. The Required Minimum Distribution Calculator can show how much you would have to take out if the rule had not been suspended this year, and it can estimate future withdrawals.

Investors who do not need to tap their accounts for expenses have long found the requirement onerous. Although they can reinvest the withdrawals, they must pay tax and lose the benefits of tax-deferred compounding on the withdrawn money.

In September, the IRS issued a notice extending the time limit for people who had made withdrawals in 2009 to put the money back into tax-deferred accounts, to avoid income tax. Investors now have until Nov. 30 to roll over the funds, or until 60 days after the withdrawal was made, whichever comes later. You can only restore one withdrawal, even if you made a number of them during the year. Other rules apply to people with inherited accounts. The IRS explains them on its site.

Many brokerages and mutual fund companies, such as T. Rowe Price (Stock Quote: TROW) and Charles Schwab (Stock Quote: SCHW) also offer good explanations on their sites.

Some investors may find it best to make withdrawals even though they do not have to. If you expect to be in a higher tax bracket in the future, it could pay to make a withdrawal and pay tax at today’s lower rate, for example.

Also think about whether it makes sense to shift money from a traditional IRA or 401(k) to a Roth IRA. Those funds would be subject to income tax, but investment gains in the Roth would be tax-free. The Roth IRA Conversion Calculator can help with the decision.

Avoiding the RMD for 2009 could reduce your income and push you to a lower tax bracket. If so, it might make sense to sell other investments that have grown in value. People in the 10% and 15% income tax brackets will not face any long-term capital gains tax on assets sold through the end of 2010, for example.

Weighing all these issues can be tricky. It might make sense to talk to your tax preparer now, rather than waiting until February or March.

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