If you’re not familiar with charitable IRA donations, for the past few years taxpayers age 70 ½ or older have been able to make direct transfers of up to $100,000 per year from their IRA to a charity.  By giving the money directly to charity (rather than receiving the distribution then later cutting a check to your favorite charity), taxpayers were able to exclude the IRA distribution from their income.

This was a great strategy for IRA owners who didn’t need the money from the required minimum distribution as they won’t have to pay a large tax bill for IRA withdrawals that they wouldn’t otherwise have taken (if not required to by the RMD rules).

The direct transfer strategy not only reduced their taxable income, but it also reduced their adjusted gross income, which resulted in many taxpayers having less of their Social Security income taxed; it also allowed taxpayers to qualify for credits and deductions that they would not have qualified for otherwise because their income was too high.

This IRA donation strategy was introduced in the Pension Protection Act of 2006 and was originally only intended to apply to the 2007 tax year.  It was later extended to include 2008 and 2009.  IRA owners who have taken advantage of this strategy were hoping that it would be extended for 2010, but for a while it didn’t look like it would happen.  Thankfully, Congress included a provision in the tax bill passed last week to extend the ability to donate IRAs directly to charity for not only 2010, but 2011 as well.

Since this bill was passed so late in the year, you may have already taken your 2010 RMD and written a check to your favorite charity.  You can still deduct your donation on Schedule A: Itemized Deductions (if you itemize your deductions).  However, please note that you can’t do both.  If you do a direct transfer to a charity from your IRA you will exclude the distribution from your income; if you write a check to a charity you will deduct it on Schedule A.

Thanks to Kay Bell at Bankrate.com for the update on RMD charitable donations in “How the New Tax Law Affects Your 2010 Taxes”.

Kristine McKinley is a fee-only financial planner located in Lee’s Summit, Missouri.  Kristine provides retirement planning, tax preparation and planning, investment reviews and comprehensive financial planning on a fee-only, as needed basis.  To schedule your complimentary introduction meeting, please contact Kristine at kristine@beacon-advisor.com.

“We had a responsibility to protect middle class families from a tax increase that would have hit their paychecks and harmed the recovery”

Nothing like waiting til the last minute…

Financial advisors have been preparing their clients for higher taxes as we waited for Congress to do something to stop the Bush era tax credits from expiring at the end of this year.

Given the slow recovery the economy is experiencing an increase in taxes that would have resulted had the Bush tax cuts not been extended would have been a tough blow, especially for the middle income class.

Congress finally passed a bill that would extend the Bush tax cuts, as well as introduce a few new ones.  The bill, called the Tax Relief Unemployment Insurance Reauthorization and Job Creation Act of 2010 is expected to be signed by President Obama later today.

Here are some of the highlights of the new tax bill:

• The current tax rates have been extended for two years.  They were scheduled to go up in 2011.  The 10% bracket was going to disappear, and most of the other tax brackets were going to go up, which would have been devastating to taxpayers in this economy.  Hopefully the economy will have grown and will be stable before tax rates do go up in 2013.
• The current capital gains and dividends rates have been extended through 2012.  This will give many people an opportunity to sell positions that have a gain before capital gain rates go up.
• The Alternative Minimum Tax (AMT) exemption will remain at the higher levels for two more years, giving relief to middle income taxpayers who would have to pay AMT without this band-aid.  I’m still looking for permanent AMT changes in the future.
• The new tax bill includes a payroll tax deduction for workers.  Workers will get a 2 percentage-point break on their payroll tax for one year. Instead of paying 6.2% on wages up to $106,800, they will only have to pay 4.2% in 2011.
• Unemployment benefits will be extended for another 13 months, giving people who have been unemployed for an extended time period more time to find another job (with unemployment rates still close to 10% this was to be expected).
• The estate tax has been reinstated for 2011, but the top tax rate will be 35% and the exemption amount will be $5 million per person and $10 million per couple.  Without this tax bill, the estate tax would have been reinstated at 55% with only a $1 million exemption.

These are just a few of the provisions included in the new tax bill.  The response to the new tax bill has been mixed.  Some economists say this bill will boost economic growth and create millions of jobs.  Others are calling this bill “weak stimulus”.  While I’m not sure how much this bill will boost the economy, I do believe that if the Bush tax cuts were allowed to expire the higher taxes that would have resulted would have been very difficult for taxpayers in this struggling economy.

For more information on the new tax bill and how it will affect you, please visit Tax Cut Deal: How it Affects You at CNNMoney.com.

Why so much focus on Roth IRAs this year?  The rules that determine who can convert a traditional IRA to a Roth IRA have been changed which will allow more people to convert to Roth IRAs.  Before 2010, only people with modified adjusted gross incomes of less than $100,000 could convert.  Starting in 2010, this income limitation has been lifted, meaning most people are eligible to convert their traditional IRAs to Roth IRAs.

In addition to the income limitation being lifted, the IRS is allowing taxpayers who do a Roth IRA conversion in 2010 to spread their taxes out over two years.  So instead of paying it all on your 2010 tax return, you can pay half in 2011 and half in 2012.

This may seem like a no-brainer for people who want to do a Roth IRA conversion in 2010, but don’t leap before you look.  Just because you can do a Roth IRA conversion in 2010 doesn’t mean you should do a Roth IRA conversion in 2010.

Before you make a decision on whether to convert or not, here are some basics about traditional and Roth IRAs you should be aware of:

Traditional IRAs

• Money put into traditional IRAs is tax deductible (income limits apply if you are covered by an employer sponsored retirement plan)
• Withdrawals from traditional IRAs are taxed at your ordinary income tax rate, so if you are in the 15% tax bracket you’ll pay 15% on the amount withdrawn, if you’re in the 28% tax bracket you’ll pay 28% on any distributions, etc.
• Distributions must be taken from traditional IRAs once you reach age 70 1/2.

Roth IRAs

• Contributions to a Roth IRA are not tax deductible.
• Your ability to contribute to an IRA may be limited if your income is high.
• Qualified withdrawals (must be at least age 59 1/2 and have had the Roth for at least five years) are not subject to income tax.
• Roth IRAs are not subject to the required minimum distribution rule that traditional IRAs are.

As you can see, there are benefits and drawbacks to both types of IRAs, so how do you know which one is right for you?  Here are some general guidelines to help you determine whether a traditional or Roth IRA makes the most sense for you:

• If you expect to be in a higher tax bracket when you will need the money, then a Roth IRA probably makes more sense.
• If you think you will be in a lower tax bracket when you retire, then a traditional IRA may make more sense as you’ll get a tax break up front when your tax rate is higher.

So Should You Do a Roth IRA Conversion in 2010?

Many people are not able to contribute to Roth IRA accounts because their income is too high.  Thanks to the income limit for Roth conversions being lifted in 2010, taxpayers who didn’t have access to Roth accounts before can invest in them now by converting their traditional IRAs.

Because of the tax advantages of Roth IRAs, when you convert a traditional IRA to a Roth IRA, you have to pay taxes on the entire amount converted.  This can be a substantial tax bill depending on how much you convert and what tax bracket you are in.

Despite the fact that you have to pay taxes on the amount you convert, it may still make sense for some people to do a Roth IRA conversion in 2010.  You should consider converting to a Roth IRA if:

• You expect to be in the same or higher tax bracket when you retire (or when you will need the funds),
• You have a long time horizon for the funds that will be converted, and
• You have funds outside of the IRA to pay the tax resulting from the conversion.

While Roth IRA conversions won’t be right for everyone, some people will benefit from the new 2010 conversion rules.  The people who will benefit the most include people who have been unable to contribute to Roth IRAs due to income limits and people who expect to be in a higher tax bracket when they retire (or who are convinced that tax rates will continue to go up regardless of which bracket you are in).

RMDs Suspended

The Worker, Retiree, and Employer Recovery Act of 2008 (WRERA) suspended required minimum distributions (RMDs) for 2009.  If you’re not familiar with RMDs, these are distributions that you are required to take from your traditional IRA and employer sponsored plans (401Ks) beginning at age 70 ½.

This is a one-time suspension of RMDs, effective for 2009 only.  This suspension was created in response to the sharp declines in the stock market, with the purpose of allowing individuals to keep the funds invested in their IRAs instead of being forced to take distributions when the market, and thus their account values, were significantly down.

Many people took their RMD in 2009 either because they weren’t aware of the change, or they had their RMD setup for automatic withdrawals and they failed to modify withdrawal instructions with their broker or financial institution.

Reversing Unwanted RMDs

Thankfully, the 60-day rollover rule allowed many people to reverse unwanted RMDs, if caught in time.  The 60-day rollover allows taxpayers to roll funds received (from RMDs or other IRA distributions) back into an IRA or other qualified plan within 60 days to avoid the tax bill from the original distribution.

Unfortunately, many people missed the opportunity to do a 60-day rollover either because they didn’t know they could, or they weren’t aware that they didn’t have to take their RMD until after the 60 days had passed.

Relief For Taxpayers Who Missed the 60-Day Rollover Period

As a result, the IRS issued Notice 2009-82 which provides relief to people who missed the 60-day rollover window, allowing them to roll unwanted RMDs back into their IRAs, but only through November 30, 2009.  This relief is retroactive (the notice wasn’t issued until September 24, 2009), so people who took RMDs as early as January can use this exception to return the funds back to their IRA account.

This relief may not help everyone who took unwanted RMDs however.  The following people will not benefit from this exception to the 60-day rollover rule:

• IRA owners who took more than one distribution from their IRA in 2009.  The 60-day rollover only allows you to roll one distribution back into your IRA per year, so people who took their RMD in monthly or quarterly installments will only be able to roll one of those distributions back into their IRA.
• IRA beneficiaries: the suspension of 2009 RMDs applies to both IRA owners and beneficiaries, but the 60-day rollover rule (and the exception created by Notice 2009-82) only applies to IRA owners.  So if you inherited an IRA (and you are not the spouse of the IRA owner), and you took an RMD distribution in 2009, you can not roll that distribution back into the IRA.

How to Rollover the Funds

So far we’ve talked about rolling any unwanted RMDs back into your IRA account, but that’s not your only option.  Regardless of where the RMD came from, you have three options for rolling them back over, including:

• Rolling the funds back into an IRA (does not have to be the same IRA you took the distribution out of)
• Converting the funds into a Roth IRA (income limits apply for 2009), or
• Rolling the funds into a qualified plan (not all qualified plans accept rollovers)

Who Should Rollover RMDs Back Into Their IRAs?

Rolling unwanted RMDs back into your IRA may not be the best option for everyone.  People who want tax deferral or who want to convert traditional IRAs to Roth IRAs in 2010 should consider rolling any unwanted RMDs back into their IRAs, along with those who want to use their IRAs for charitable contributions.

However, people who rely on their RMDs to meet living expenses, or those who believe that taxes are going up (and expect to be in a higher tax bracket later) should not roll their RMDs back into their IRA.  In addition, if you’ve already done a 60-day rollover this year, you can’t do another rollover.

Bottom line, consult with your tax advisor to determine if you would benefit from rolling any unwanted RMDs back into your IRA.  But hurry, the deadline for completing rollovers (unless you are within the 60-day period) ends on November 30^th.

The notice provides that the new February due date established under a recent law change to provide Form 1099-B information to customers also applies to other tax information customarily reported to customers with Form 1099-B statements, such as interest and dividends.  This means that customers can expect to receive Forms 1099-INT and 1099-DIV late as well.

If you normally receive Forms 1099-INT, 1099-DIV and 1099-B for investment income and transactions, be aware that these forms will arrive later than usual this year.  Some clients have reported that they have received letters from financial institutions saying not to expect these forms until the end of February (although the official due date is February 17).

As a tax preparer, I’m not particularly happy about this change, but on the bright side, I’m hoping the extended deadline will cut down on the number of corrected 1099s issued this tax season.

Congress approved legislation this week that will provide some relief to Americans over 70 1/2 who have suffered significant losses in their IRA accounts.  The bill will temporarily suspend the excise tax that is levied when seniors fail to the the required minimum distribution (RMD) from their retirement accounts.

This penalty is waived for 2009, which means that seniors will not be required to take withdrawals from their tax deferred retirement accounts during 2009, which will hopefully give these accounts time to recover before the 2010 required distribution.  Unfortunately, this law does not apply to 2008 when it would have made the most difference to investors who have lost significant amounts in their accounts.

If you’re not familiar with the RMD, basically taxpayers who are age 70 1/2 must take annual required minimum distributions from their tax-deferred retirement accounts, including traditional IRAs, 401Ks and 403Bs.  The amount is based on your life expectancy and the prior December 31 balance of your account.  Failure to withdraw this amount and you will be levied a 50 percent penalty on the amount that you should have withdrawn… and this is in addition to your regular income tax!

Surprisingly, there is still talk that the RMD for 2008 will be suspended.  If relief is passed for 2008, taxpayers who have already taken their distributions will be allowed to re-contribute those funds so they don’t have to pay taxes on them.  We should know by mid next week if the 2008 RMD is also suspended.

Here is a refresher on the original law (edited for 2009):

During 2009, individuals can make energy-conscious purchases that will provide tax benefits when filling out their tax returns. Manufacturers offering energy efficient items such as insulation or storm windows can assure their customers that their energy efficient items will qualify for the tax credit if certain energy efficiency requirements are met.

This tax law change provides a tax credit to improve the energy efficiency of existing homes. The law provides a 10 percent credit for buying qualified energy efficiency improvements. To qualify, a component must meet or exceed the criteria established by the 2000 International Energy Conservation Code (including supplements) and must be installed in the taxpayer’s main home in the United States.

The following items are eligible:

* Insulation systems that reduce heat loss/gain
* Exterior windows (including skylights)
* Exterior doors
* Metal roofs (meeting applicable Energy Star requirements).

In addition, the law provides a credit for costs relating to residential energy property expenses. To qualify as residential energy property, the property must meet certification requirements prescribed by the Secretary of the Treasury and must be installed in the taxpayer’s main home in the United States.

The following items are eligible:

* $50 for each advanced main air circulating fan
* $150 for each qualified natural gas, propane, or oil furnace or hot water boiler
* $300 for each item of qualified energy efficient property.

The maximum credit for all taxable years is $500 — no more than $200 of the credit can be attributable to expenses for windows.

Additionally, the new law makes a credit available to those who add qualified solar panels, solar water heating equipment, or a fuel cell power plant to their homes in the United States. In general, a qualified fuel cell power plant converts a fuel into electricity using electrochemical means, has an electricity-only generation efficiency of more than 30 percent and generates at least 0.5 kilowatts of electricity.

Taxpayers are allowed one credit equal to 30 percent of the qualified investment in a solar panel up to a maximum credit of $2,000, and another equivalent credit for investing in a solar water heating system. No part of either system can be used to heat a pool or hot tub.

Additionally, taxpayers are also allowed a 30 percent tax credit for the purchase of qualified fuel cell power plants. The credit may not exceed $500 for each .5 kilowatt of capacity.

These items must be placed in service after Dec. 31, 2008, and before Jan. 1, 2010.

This is a double whammy to investors because shareholders who hold mutual funds in taxable accounts must pay taxes on those capital gain distributions even if those capital gains were reinvested in the fund.  This may seem unfair when 1) you didn’t receive the money, and 2) your fund suffered a large loss for the year.

So why do mutual fund companies distribute capital gains to shareholders when the fund itself has incurred a loss for the year?  There are three reasons that funds are making payouts, even though they’re up to their ears in losses:

First, emerging markets and energy funds had big gains when the year began and realized some gains along the way. Then they suffered redemptions, which means that those gains have to be spread among fewer shareholders (i.e., the shareholders who did not bail have to pay the price for those who are trying to time the market).

Second, gains realized in November and December can’t be charged off against losses realized the next year.  Third, gains from currency contracts have to be distributed each year regardless of other losses in the portfolio. Thus, funds that hedged their foreign currency exposure are making payouts this year.

Companies that have stated they will have capital gain distributions include Fidelity (although according to Morningstar their gains look pretty small), Vanguard (the Vanguard Precious Metals and Mining fund tops the list with a capital gain distribution of 19.4% of the fund’s NAV), Oppenheimer, American Funds, and Tweedy Browne.

If you have a fund that is expected to distribute a large capital gain, and this fund is held in taxable accounts, you can sell before the distribution date to avoid sharing in the capital gain distribution.  You should check with your tax professional to see if this strategy makes sense for you.

To see if any of your funds will be distributing capital gains this December, go to the Web sites of your fund companies.

The Pension Protection Act of 2006 allows IRA owners age 70 1/2 or older to make direct transfers of up to $100,000 per year from their IRA to a charity. The provision became available for IRA distributions taken after Aug. 17, 2006 and originally only applied through the end of 2007.  Note: the Emergency Economic Stabilization Act of 2008 extends this law to include 2008 and 2009.

Distributions can be made from taxable funds in an IRA or Roth IRA, but not from employer plans or SEP and SIMPLE IRAs. The distribution will not be taxable to you, but you don’t get to deduct the charitable contribution on your tax return. This is more advantageous to taxpayers because even though you get a charitable deduction if you take the IRA withdrawal and report that amount in income, many taxpayers do not itemize, and therefore they don’t always get to take advantage of the deduction.

The direct transfer from the IRA to the charity can also satisfy a person’s required minimum distribution for the year. If you are charitably inclined, it may be best to contribute from the IRA, at least up to the RMD amount thereby avoiding that amount being included in income. This will lower your adjusted gross income (AGI) and might avoid or lessen the amount of Social Security benefits that are taxed.

The reduction in AGI can also increase tax deductions, exemptions or credits that are pegged to AGI either in terms of specified amounts or as a percentage of AGI. The distributions are deemed to come from income first if the IRA has non-deductible contributions. This contrasts with the normal pro-rata rule that applies to other IRA distributions where there are after-tax funds in the IRA.

If you want to take advantage of this provision for 2008, then you must make a direct IRA transfer to the charity before year end. The distribution must be made directly from the IRA custodian/trustee to the charity. It cannot be distributed to the IRA owner, who subsequently writes a check to the charity. If that is done, then the provision will not apply and the distribution will be taxable. However, you may be able to take a tax deduction for the contribution (under the regular rules that applied before this provision became effective).

Finally, to qualify for this provision, you must have documentation to substantiate the donation (something in writing from the charity showing the date and amount of the contribution, and certifying that nothing of value was obtained in exchange for the contribution). It is generally a good idea to send the charity a letter notifying them of the amount of the contribution and where the contribution is coming from as well as requesting verification of receipt of the gift.

Charities must fall under IRS code section 170(b) to be eligible. Donor advised funds, charitable remainder trusts and private foundations are ineligible. The IRS has not yet provided guidelines regarding coding for 1099 forms or 1040 reporting. Until guidelines are published, many firms are relying on advice from the Investment Company Institute. For instance, the IRA owner is responsible for maintaining documentation to verify with the IRS that requirements were met. The IRA owner is responsible for verifying the charity is a qualified charity for this purpose. The IRA owner is also responsible for verifying their compliance with the annual limit of $100,000.

Most firms will report the distribution as a normal distribution, but will advise the IRA owner to make a note of “charitable distribution” on their records. The IRA owner must provide instructions to waive withholding since the distribution will not be taxable.

The IRA owner is responsible for any reporting the IRS requires regarding the nature of the distribution. For most securities-based accounts including mutual funds, the IRA owner must obtain a signature guarantee on the request form since the distribution is being sent to someone other than the shareowner at the address of record.

It’s a good idea to consult with your financial planner before making your donation.

December 2008 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided (and edited) by Kristine McKinley, CPA, CFP, a local member of FPA.

Kristine McKinley is a fee-only financial planner located in Lee’s Summit, Missouri.  Kristine provides retirement planning, tax preparation and planning, investment reviews and comprehensive financial planning on a fee-only, as needed basis.  To schedule your complimentary introduction meeting, please contact Kristine at kristine@beacon-advisor.com.

Do an AMT sweep: One of the reasons why it’s wise to consult a tax adviser before you start accelerating deductions is that certain people over $75,000 find themselves more susceptible to the alternative minimum tax if they proceed. The AMT is an alternative taxation process that’s figured separately from your regular tax liability and you have to pay whichever tax is higher. State and local income taxes and property taxes, for example, are not deductible when figuring the AMT. Under the regular rules, medical expenses that exceed 7.5 percent of adjusted gross income can be deducted under the regular rules, but under the AMT, that threshold is 10 percent. Also, under regular rules, interest on up to $100,000 of home-equity loan debt is deductible no matter how the money is used, but under the AMT, the deduction holds only if the money was used to buy or improve a primary or second home. It pays to check your AMT risk before you execute any end-of-the-year tax-savings strategy.

Check investment gains and losses: After the market drops we’ve seen this year, it’s likely you have some capital losses in your taxable investment accounts.  It might make sense to sell and offset them against any capital gains you’ve realized this year. Such losses can offset 100 percent of capital gains plus up to another $3,000 in ordinary income. Any losses in excess of that number can be carried forward to the next tax year.  Note: According to Morningstar.com a lot of mutual funds are expected to distribute capital gains to shareholders, despite funds being down 30-40%.  Check your mutual funds to see if you are expected to receive a capital gain distribution; if so, it might make sense to do some tax loss selling before the December distribution to avoid another taxable event.

Prepay property taxes: If your income is higher in 2008 than in previous years (or higher than your expected 2009 income), it might pay to accelerate deductions.  If so, make sure you pay your property taxes before the end of the year.  If you typically pay property taxes early in the next year, consider pre-paying those expenses so you can deduct them on your 2008 tax return.

Prepay state taxes: Again, if it makes sense based on your tax situation, consider making your fourth-quarter estimated state tax payment in December instead of in January so you can take the deduction on your 2008 return.

Defer income if possible: Self-employed people and some business owners might elect to invoice customers in January so they don’t have to include that income on their 2008 return. Keep in mind that it only makes sense to defer income if you think you will be in the same or lower tax bracket next year.

Plan a stock donation to charity: If you have stock with a large unrealized capital gain that you’ve held longer than a year (Okay, I realize most stocks didn’t have a gain this year, but if you have stocks you’ve held for a long time, it’s possible you still have a gain), you can give that stock to a qualified charity and claim a deduction for the current fair market value of the security. If you have a stock with an unrealized capital loss, do the opposite – sell the stock, claim the capital loss, then donate the resulting cash proceeds to charity. This is actually better than just donating cash, because you get the same deduction and never have to pay the capital gains taxes from the appreciated security.

Make sure donations are documented: As of January 1, 2007, you now must have a either a receipt or a canceled check to back up any contribution, regardless of the amount. If you don’t have such a written record, the IRS will reject the write-off if the lack of proper record keeping is discovered in an audit.