December 28, 2008 - With the recent decline of the stock market, my IRA has taken a big hit. How can I take advantage of the losses and make the most of my retirement savings?

The sharp stock market decline we've experienced has no immediate tax effect on pre-retirement-age taxpayers who invested their traditional IRAs or Roth IRAs in stocks and mutual funds. 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, whether they are still in their working years or are retired and taking required minimum distributions (RMDs) from their accounts.

Converting traditional IRA to Roth IRA. A traditional IRA can be converted to a Roth IRA if, for the conversion year, (1) the taxpayer's modified AGI (not counting the taxable amount of the conversion) does not exceed $100,000, and (2) he isn't a married individual filing a separate return. The distribution from the traditional IRA is a regular payout for income tax purposes, and the income resulting from the distribution is included on the return for the tax year in which funds are transferred or withdrawn. However, the 10% premature distribution penalty doesn't apply.

Losses on investments held by traditional IRAs. Losses on investments held by traditional IRAs aren't recognized when the IRA holdings are sold at a loss. If a taxpayer hasn't made any nondeductible IRA contributions, a loss won't be recognized even when all amounts are distributed from his IRAs. That's because he has a zero basis in the IRA. However, if he has made nondeductible traditional IRA contributions, and liquidates all of his traditional IRAs, a loss is recognized if the amounts distributed are less than his remaining unrecovered basis in his traditional IRAs.

Losses on investments held by Roth IRAs. Roth IRAs are subject to the same rules that apply to losses in traditional IRAs. As a result, losses on investments held within a Roth IRA aren't recognized when the losses are incurred. However, if the taxpayer liquidates all of his Roth IRAs, a loss is recognized if the amounts distributed are less than his unrecovered basis, namely his regular and conversion contributions, all of which are nondeductible contributions. The loss is an ordinary loss but it can only be claimed as a miscellaneous itemized deduction subject to the 2%-of-AGI floor.

There is an unexpected tax trap for Roth IRA owners . A 10% premature withdrawal penalty tax applies if a taxpayer makes a traditional-IRA-to-Roth-IRA conversion and then withdraws converted amounts within the five-tax-year-period beginning with the tax year in which the conversion took place. Because the penalty tax applies to a distribution to the extent that the converted amount was taxable when the conversion took place, a taxpayer could wind up paying a penalty tax even though none of the distribution is includable in income.

Effect of market decline on traditional IRA owners currently receiving RMDs. Taxpayers must start taking required minimum distributions (RMDs) from their traditional IRAs by Apr. 1 following the year in which they attain age 70 1/2. These taxpayers can't reduce their RMDs for 2008 to account for a drop in their IRAs' market value this year. That's because each year's RMD generally is determined by applying a life-expectancy table factor to the IRA account balance as of the end of the previous year. ALERT: At press time, Congress had passed H.R. 7327, the "Worker, Retiree and Employer Recovery Act", which suspends the requirement for plan account participants and IRA owners to take RMDs for calendar year 2009 only. This legislation was signed by the President on December 23, 2008, and will be addressed more fully in a future Tax Talk article.

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