How to ease the pain of mandatory IRA withdrawals for seniors

— -- Lawmakers gave retirees a present last week, but like many holiday gifts, it wasn't exactly what they wanted.

Congress approved a bill that would allow retirees to defer required withdrawals from their individual retirement accounts and 401(k) plans in 2009. However, it won't help seniors who want to avoid taking a mandatory withdrawal in 2008.

Ordinarily, seniors 70½ and older are required to withdraw a minimum amount from their tax-deferred retirement savings plans every year and pay taxes on the money. The amount is based on a life-expectancy factor calculated by the IRS and the value of seniors' retirement plans at the end of the previous year.

This year, though, retirees have seen the value of their savings shrivel. Many seniors who don't need money to pay expenses have been postponing withdrawals in hopes that Congress or the Treasury Department would change the rule.

There's still a chance that the Treasury will use its authority to provide some relief, possibly by allowing retirees to calculate their withdrawals based on the value of their accounts at the end of 2008, instead of 2007. A Treasury spokesman said Monday that the department is still looking at the issue. But with the end of the year fast approaching, retirees who haven't taken their distributions need to be prepared to take their mandatory withdrawals. The penalty for not taking one is 50% of the amount you were supposed to withdraw.

Fortunately, there are steps you can take to minimize the damage to your IRA:

•Take an in-kind distribution instead of cash. Are you convinced the stocks or mutual funds in your IRA will recover next year? By taking what's known as an "in-kind" distribution, you can hold on to those investments and fulfill your requirement to the IRS.

Here's how it works: Instead of taking your withdrawal in cash, ask your IRA provider to transfer the equivalent amount of stocks or mutual funds to a taxable account.

You'll still have to pay income taxes on the withdrawal, and because you're not taking it in cash, you'll have to come up with another source of funds to pay the IRS. But by transferring your stocks or funds to a taxable account, you'll avoid locking in your investment losses. And as long as you wait at least a year to sell your stocks and funds, any future gains will be taxed at your capital gains rate, which for most investors is 15%, says Ed Slott, an accountant and IRA expert in Rockville Centre, N.Y.

•If you have more than one IRA, take your distribution from the account that will suffer the least amount of damage.

The IRS allows you to calculate your withdrawal based on the total value of all your IRAs, says Bob Trinz, senior tax analyst for Thomson Reuters. Once you've done that, you can take your withdrawal from any individual IRA, or a combination of IRAs, he says.

For example, if you have one IRA that's invested in severely depressed mutual funds and another that's invested in money market funds, you could lessen the damage by taking your entire distribution from the money market IRA.

To do this, though, you need to notify your IRA providers, Trinz says. Otherwise, they may automatically withdraw a minimum distribution, based on the value of the individual IRA, and transfer the money into a non-IRA account.

•Convert your IRA to a Roth. If you can afford it, this strategy will permanently end your distribution anxieties, because Roth IRAs aren't subject to minimum-withdrawal rules.

When you convert an IRA to a Roth, you're required to pay taxes on all pretax contributions, plus any gains. But because the taxes will be based on the value of your IRA when you convert, this is an ideal time to convert, Slott says. You'll pay a much lower tax bill now than you would have paid a year ago — or might pay in the future if your investments recover. And as long as you follow the withdrawal rules, future gains are tax-free.

Converting before the end of the year offers several advantages, Slott says. You'll pay taxes based on 2008 tax rates, which are still historically low. If the Obama administration increases taxes next year to pay for the bailout, you'll pay more to convert, he says.

In addition, Slott says, you'll start the five-year clock on tax-free withdrawals. To avoid taxes and penalties, you must hold your Roth IRA for at least five years and be at least 59½ when you take withdrawals. Convert before Dec. 31, Slott says, and you'll get credit for all of 2008.

Sandra Block covers personal finance for USA TODAY. Her Your Money column appears Tuesdays. Click here for an index of Your Money columns. E-mail her at: sblock@usatoday.com.