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September 30, 2007 -- What is the impact of the recent stock market declines on tax planning for IRA’s?

The stock market's current roller-coaster behavior does not have an immediate tax impact on taxpayers who hold stocks and/or mutual funds in their traditional IRAs or Roth IRAs . That's because losses as well as gains are not recognized within either type of IRA . However, there are some tax strategies for owners of traditional or Roth IRAs to consider as the stock market sorts itself out.

  • Converting traditional IRA to Roth IRA. The distribution from the traditional IRA is a regular payout for income tax purposes and included in taxable income for the year in which the funds are transferred or withdrawn.

A market decline gives taxpayers a chance to convert a traditional IRA to a Roth IRA at a much lower tax cost than would have been possible when stock market values were high. This is because the low price per share reduces the total amount of the taxable distribution.

  • Recharacterizing a conversion to Roth IRA. A taxpayer who converted from a traditional IRA to a Roth IRA earlier this year, when the market was heading up to its all-time high will wind up with an artificially high tax bill if the market doesn't recover quickly. Fortunately, the taxpayer can reverse the conversion by recharacterizing it. This involves transferring the converted amount (plus earnings, or minus losses) from the Roth IRA back to a traditional IRA via a trustee-to-trustee transfer.
  • Reconverting a traditional IRA to a Roth IRA. A person who converted an amount from a traditional IRA to a Roth IRA may not only transfer the amount back to a traditional IRA in a recharacterization, but may later reconvert that amount from the traditional IRA to a Roth IRA.

Determining when to recharacterize a Roth IRA as a traditional IRA and then reconvert depends on how the IRA owner views the stock market . An owner who expects the market to remain low for a while but doesn't expect it to get much lower should recharacterize the Roth IRA now, and then reconvert as soon as eligible if the market is still low.

  • Effect of a market decline on traditional IRA owners currently receiving RMDs. Taxpayers taking required minimum distributions (RMDs) can't reduce their RMDs for 2007 to account for a drop in their IRAs ' market value this year because each year's RMD is calculated as of the end of the previous year.

The amount of each RMD is calculated separately for each IRA . However, the RMD amounts for the separate IRAs may be totaled and the aggregated RMD amount may be paid out from any one or more of the IRA accounts.

This rule gives flexibility to owners of multiple IRAs . If an IRA is invested in stocks or mutual funds shares whose price currently is depressed, the minimum distribution can be made from another IRA invested in a money- market fund to avoid selling at a market low and losing future appreciation potential.

While these times of financial uncertainty can be unsettling, it’s important to remember that such uncertainty can be used to a taxpayer’s benefit, through wise advance planning.

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