If you’re working with a view to retirement or even semi-retirement, you’re probably (hopefully) saving more than you could have done in the past on your retirement accounts. You may have paid the mortgage and paid for college and other heavy parenting expenses. Everything seems to be on its way, except for one big problem I call the “fiscal time bomb.”
I am referring to tax debt accruing to your individual retirement account, 401 (k) or other retirement savings plans. And, as I wrote in my most recent book, “The New Retirement Time Time Bomb,” you can quickly run out of the savings you relied on during your retirement years. But there are some ways to avoid this problem.
What is the potential problem of retirement savings taxes?
While you may see your savings balances grow from your ongoing contributions and the rising stock market, much of that growth will go to Uncle Sam. This is because most, if not all, of these retirement savings are tax-deferred and not tax-exempt.
The funds of most IRAs are pre-taxed funds, meaning they have not yet been taxed. But them will be, when you get to spend them on retirement. That’s when you quickly realize how much savings you need to keep and how much it will go to the government.
The amount to be allocated to the Internal Revenue Service will be based on what the future tax rates are. And given our national deficit and deficit levels, these types of taxes could skyrocket and leave you with less than you anticipated, just when you need the money the most.
What can you do now
So this is the terrible warning. But you can change that potential outcome with proper planning and making changes in how you save for retirement in the future.
You can start by taking steps to pay off this tax debt at current tax rates and start generating your retirement savings on tax-free vehicles, such as Roth IRAs or even permanent life insurance, which can include a value cash that is generated and can be withdrawn without taxes. in retirement.
Also, if you’re still working, you can change the way you save on your retirement plans. If you have a 401 (k) at work, you can make contributions to a Roth 401 (k) if the plan offers it. A Roth 401 (k) allows your retirement savings to grow 100% tax-free the rest of your life and even pass on to your beneficiaries tax-free as well.
Learn more: All about the Roth IRA
For 2021, you can contribute up to $ 26,000 (the standard contribution limit of $ 19,500 plus a $ 6,500 recovery contribution for people 50 and older). With some Roth 401 (k) workplace plans, you may be able to introduce even more.
Then check if you can convert some of your existing 401 (k) funds to your Roth 401 (k) or Roth IRA. Once you do, you will be liable for taxes on the amount you convert. The conversion is permanent, so be sure to convert only what you can afford to pay in taxes.
Also read: We have $ 1.6 million, but most of it is included in our 401 (k) plans: how can we retire early without paying so many taxes?
Don’t let the initial tax bill deter you from moving your retirement funds from accounts that always tax to accounts that never tax.
Convert existing IRAs to Roth IRAs
Similarly, you can convert your existing IRAs into Roth IRAs, also reducing the tax debt of these funds. The point is not to be short-sighted and avoid doing so because you don’t want to pay taxes now. This tax will have to be paid at some point, and probably with much higher future tax rates and a larger account balance.
It is best to start this process now, even with a plan to convert your 401 (k) or IRA funds into Roth accounts for several years, converting small amounts each year to manage the tax bill.
If you’ve been contributing to a traditional IRA, stop making those contributions and start contributing to a Roth IRA. Anyone 50 years of age or older can earn up to $ 7,000 a year ($ 6,000 plus a $ 1,000 recovery contribution) and you can do so for a spouse, even if that spouse is not working.
If one of you has enough income for a job or self-employment (and you do not exceed the income limits of the Roth IRA contribution), each of you can contribute $ 7,000, totaling $ 14,000 in Roth IRA contributions each year. Not only will this add up quickly, but it will add up all in your favor because you are now accumulating tax-free retirement savings.
Related: Should you turn your IRA into a Roth if the Biden infrastructure plan passes?
Once the funds are in a Roth IRA or other tax-free vehicle (such as life insurance), those funds will be tax-free for you.
The secret is to pay taxes now. It’s so simple, but also so counterintuitive that most people don’t take advantage of it and end up paying heavy retirement taxes that could have been avoided.
Ed Slott is a Certified Public Accountant, an expert on individual retirement account distribution (IRA) and author of “The New Retirement Savings Tax Bomb.” He is president and founder of Ed Slott and Company, providing advice and analysis on IRAs.
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