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Government Help That's No Help at All

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The federal government has handed out assistance to just about everyone lately, from taxpayer stimulus payments earlier this year to the huge bailout payments that financial companies have already tapped into. A long line of prospective applicants hope to get a share as well -- and so far, Congress and the Treasury haven't been inclined to say no.

One group of investors who are facing having to make large withdrawals from retirement accounts at exactly the wrong time, however, had thought they might be in for some relief. In the end, the government's attempt at support fell short of their hopes.

Retirement accounts and required minimum distributions
If you've ever invested in a traditional IRA, 401(k), or other retirement plan, you're familiar with the basics of these accounts.  In exchange for saving your money now, you get a current tax break on your contribution. Also, you enjoy the benefit of tax-deferred growth throughout your career on the investments within your account. After you retire, you can withdraw the money at any time with no penalty -- although you will pay taxes on the money you take out.

  • However, you don't get to keep deferring taxes forever. At some point, the IRS forces you to start taking money out of your retirement accounts, whether you need it or not. This happens either:
  • When you turn 70 1/2; or
  • If you inherit an IRA from someone else and elect to stretch out distributions over time.

If you don't, you face a huge 50% penalty on the amount you should have taken out. The appropriate amount, also known as the required minimum distribution or RMD, is calculated from the value of your retirement accounts at the beginning of the year. You're required to take a fraction of your assets out, based on your life expectancy -- the older you are, the bigger the chunk you have to withdraw.

Bear market = big problem
It's that calculation that has created a huge problem for investors this year. The RMD calculation used account values at the end of 2007. But because many investors typically wait until much later in the year to think about RMDs, the market's collapse pushed their account balances downward -- while the RMD amount stayed the same.

Many hoped that the government would suspend the rules to allow retirement account holders to skip their RMDs this year. But Congress instead suspended the rules for 2009, while leaving them in place for this year.

How's that gonna help now?
Unfortunately, the problem is much larger in 2008 than 2009. Fears from those who say that RMDs will force investors to sell stocks at their low are overblown, as they can usually take the money and buy the same stocks in a taxable account. But the new law still forces account holders to take a huge tax hit this year.

Consider, as an example, the potential tax hit in a portfolio of seven dividend-paying stocks you might find among a typical conservative investor's holdings:

Stock

Value of 3,000 shares at end of 2007

Current value of same 3,000 shares

Chevron (NYSE: CVX  )

$271,710

$207,600

General Electric (NYSE: GE  )

$107,550

$49,290

Kellogg (NYSE: K  )

$153,210

$124,290

Coca-Cola (NYSE: KO  )

$178,920

$131,910

3M (NYSE: MMM  )

$246,000

$166,320

PepsiCo (NYSE: PEP  )

$221,910

$162,510

United Technologies (NYSE: UTX  )

$224,850

$151,860

Total

$1,404,150

$993,780

For someone who turned 72 in 2008, the RMD would be $54,850. Next year, if account values on Dec. 31 are the same as they were yesterday, the RMD for that same person at age 73 would be $40,234 if it weren't suspended.

So while suspending the 2009 RMD will provide some help, the difference of $14,616 means that top-bracket taxpayers will pay over $5,000 more in tax in 2008 and 2009 than they would have if Congress had made the law effective for 2008.

One last chance?
Even though the congressional action didn't address 2008, some believe that the Treasury could unilaterally make changes to this year's RMD rules. But with time running out, it looks increasingly unlikely.

Regardless, for investors, the real damage has already been done. Although RMDs are an immediate concern, the more fundamental problems facing the economy, the financial markets, and programs like Social Security and Medicare are much more important to seniors in the long run. Without solutions to those bigger problems, relief for seniors will only have a minimal impact on their overall financial security.

For more on making the most of your retirement:

At our Rule Your Retirement newsletter, we have answers to all your tax and other retirement questions. We'll make sure you get everything done on time with helpful reminders and guidance on how to do things the right way.  See everything Rule Your Retirement has to offer with a free 30-day trial today.

Fool contributor Dan Caplinger already took his RMD from his inherited IRA this year. He owns shares of GE. PepsiCo is a Motley Fool Income Investor selection. 3M and Coca-Cola are Inside Value recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy will help you out.


Read/Post Comments (1) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 27, 2008, at 8:49 PM, IRS706 wrote:

    Your "typical conservative (sic) investor" knew in early 2008, they would have to take out exactly $54,850, but decided to wait. He could have converted $54,850 of his stocks into a money market and then had the cash available at year end, instead he chose to speculate that his stocks would go higher - tough, you pays your money and takes your chances.

    If the RMD is such a burden, convert to a Roth. I & the Mrs. did and then put later contributions into the Roth. We now have no such worry.

    Uncle Sam has provided a way to avoid the RMD (a Roth IRA) but you have to give up your tax benefit. The "typical conservative investor' made the choice to save taxes and invest that savings to increase their assets, but the trade off was future tax payments. Having taken the chance, they are now whining when it comes time to pay up.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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4/17/2014 4:00 PM
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