“The market decline we've witnessed creates opportunities for some taxpayers, as well as substantial pitfalls to avoid,” says Bob Trinz, Senior Tax Analyst from the Tax & Accounting business of Thomson Reuters. “Here are some strategies to consider.”

Converting traditional IRA to Roth IRA. “A market decline gives eligible taxpayers a chance to convert a traditional IRA invested in beaten-down stocks or mutual funds to a Roth IRA at a much lower tax cost than would have been possible when stock market values were high,” says Trinz.

Recharacterizing a conversion to Roth IRA. Warns Trinz, “Someone who earlier this year converted from a traditional IRA invested in stocks to a Roth IRA when the market was much higher will wind up with an artificially high tax bill if he leaves things as-is.”

Fortunately, the conversion can be treated as if it had never been made by recharacterizing it. This involves a timely transfer of 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. For example, an IRA owner who expects the market to remain low for awhile, 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,” says Trinz.

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 (cost for tax purposes) 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 RAs.

Losses on investments held by Roth IRAs. Similarly, 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.

Trinz cautions, “Taxpayers who are thinking of liquidating their Roth IRAs should keep in mind that they will be giving up the opportunity to eventually withdraw any future gains taxfree. Also, miscellaneous itemized deductions can’t be claimed for AMT purposes.”

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.

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.

Says Trinz, “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 or a certificate of deposit that is about to mature to avoid selling at a market low and losing future appreciation potential.”

But there is a caution to this, he says. “Many financial institutions automatically place each year's RMD in a separate non-IRA account. This procedure avoids the risk of penalties for insufficient distributions. A taxpayer who wants to take his RMD from another IRA should notify the trustees or custodians of the IRAs from which he does not want to withdraw, otherwise, an amount might be automatically withdrawn from those IRAs.”

The rule permitting amounts in traditional IRAs to be aggregated for RMD purposes applies only to IRAs that an individual holds as an owner. It doesn't apply to IRAs that an individual holds as a beneficiary. IRAs held by a person as a beneficiary of the same decedent may be aggregated, but can't be aggregated with amounts held in IRAs that the individual holds as the IRA owner or as the beneficiary of another decedent. And no traditional IRA can be aggregated with a qualified retirement plan account or a Roth IRA to determine payouts.

Says Trinz, “Congressional members have been agitating for a relaxation of the rule requiring seniors to take RMDs or face big penalties. As Representative Frelinghuysen (RNJ) said in a October 17 letter to Treasury Secretary Paulsen, in today's stock market environment, by enforcing the RMD rules the “government is essentially mandating significant financial losses on some of our older citizens. We should help seniors by suspending minimum IRA withdrawal rules to spare them from being forced to sell their stocks when the market is low.”