Stop contributing to your IRAs and 401(k)s? That has to be a typographical error. After all, traditional retirement planning has always preached maximizing contributions to tax-deferred individual retirement accounts and 401(k)s to build retirement savings.
Why should you stop building those accounts and deferring the tax bill?
It’s because adding to these balances only increases your future tax bill in retirement.
Deferring the tax is only a short-term savings. In the long run, if tax-deferred retirement accounts continue to grow, so will the eventual tax bill. And that bill likely will have to be paid at higher tax rates. It’s a good bet that tax rates will increase in the future, but even if they stay the same, larger IRA balances mean larger required minimum distributions, which can result in income being pushed into higher tax brackets.
GO ROTH INSTEAD
Replace tax-deferred IRAs and 401(k) contributions with Roth IRA and Roth 401(k) contributions. Congress has provided new incentives to do that.
SECURE 2.0 provided added Roth 401(k) advantages like allowing matching and other employer contributions to Roth 401(k)s and eliminating RMDs on Roth 401(k)s (effective in 2024). SEP and SIMPLE Roth IRAs are also permitted. (Even though Roth plan employer contributions and Roth SEP and SIMPLE contributions are effective now, most record keepers and custodians don’t have that infrastructure in place quite yet.)
But won’t the tax deductions for my IRA and 401(k) contributions be lost? Yes, but that’s good. Tax deductions aren’t worth as much when tax rates are low, as they are now. Smart tax planning means taking income when rates are low and taking tax deductions when rates are high. A tax deduction for an IRA or 401(k) is really just a loan you’re taking from the government that has to be repaid in the future, and likely at higher tax rates. The tax deduction has no real long-term value.
If a tax deduction is taken now for IRA or 401(k) contributions, the accounts will continue to grow tax-deferred, but a much larger tax hit may result years later in retirement, when funds are needed the most.
By passing on the tax deduction, the Roth funds will grow tax-free for life (and for 10 years thereafter for non-spouse beneficiaries). The Roth retirement accounts are a hedge against the uncertainty of what future higher tax rates can do to your standard of living in retirement.
Instead of focusing on short-term tax savings by taking deductions and avoiding taxes on Roth conversions, look at the potentially much larger savings long term when those funds will be withdrawn.
Long term means not only during the IRA owner’s lifetime but also for your beneficiaries who will inherit and will also be subject to tax on higher balances. Under the original SECURE Act, most beneficiaries can no longer stretch inherited IRAs over their lifetime. They will generally have to withdraw all the inherited IRA and plan funds by the end of the 10th year after death. (Non-spouse beneficiaries also must take annual RMDs in years one through nine of the 10-year period if the IRA owner died on or after their RMD required beginning date — generally, April 1 after the year they turn 73.)
That creates a much shorter window for all the funds to be withdrawn, likely resulting in a substantial tax bill at the end of the 10 years. Even if tax rates don’t increase, beneficiaries may be in their own highest-earnings years at that point.
If, instead, beneficiaries inherit Roth IRA funds, they still must empty those in 10 years, but there will be no income tax and no RMDs for years one through nine of the 10-year term, regardless of how old the Roth IRA owner was at death. All Roth IRA owners are deemed to have died before their required beginning date since Roth IRAs have no lifetime RMDs. This is another good reason to do Roth conversions now, especially if the plan is to leave these funds to family beneficiaries. Roth conversions allow you to control your tax rate.
THE BIG RETIREMENT MYTH
But won’t my income and tax rate be lower in retirement (since I’m no longer working)? That’s a common question, with what seems to be an obvious answer. Yes, it would seem that once you’re retired, income will be lower. So why pay taxes now, when you can keep deferring them and building your IRA until you’re retired and taxes will be lower?
For most people, lower taxes in retirement are a myth. For those who build the largest IRAs, taxes down the road will generally be higher as a result of deferring withdrawals until they’re required. This triggers larger IRA tax bills when minimum distributions become required.
GOING THROUGH WITHDRAWAL
In addition to stopping pretax contributions, existing tax-deferred retirement accounts need to be reduced through a planned withdrawal strategy. Don’t wait until RMDs begin. It may be too late by then.
Delaying RMDs has been a popular article topic and tax-deferral strategy for decades, particularly whenever Congress raises the RMD age. Now, after the SECURE 2.0 Act, it’s age 73. But that’s not a good long-term strategy. It’s time to reverse that trend and start looking at ways to get funds out of IRAs well before they are required. That can reduce future tax exposure.
TAX RATES — NOW VS. LATER
It’s all about the difference in tax rates between those in effect now versus those in the future, when withdrawals will be required.
The foundation of all good tax planning is paying taxes when rates are the lowest, and that may be right now. We are currently experiencing the lowest tax rates most people have ever seen, and that will continue at least through 2025. After that, tax rates are scheduled to increase.
Recent inflation has also added an incentive to get funds out of IRAs now by expanding the current tax brackets so that more funds can be withdrawn at lower rates.
Reducing IRA balances isn’t simply about making withdrawals, paying taxes, and reinvesting the funds in a taxable account. It’s about getting those funds out at the lowest possible tax rates and then repositioning those funds to keep growing tax-free. The most obvious way to accomplish this strategy is with Roth IRA conversions.
IRA balances can also be reduced with charitable planning (for those who are charitably inclined) by using qualified charitable distributions or leaving IRA funds to charities. IRAs are the best funds to give or leave to charity to avoid taxation. QCDs are direct transfers from IRAs to a charity, but they are available only to IRA owners or beneficiaries who are 70½ or older.
Another way to reduce IRA balances is to use them to fund permanent cash-value life insurance. As with Roth IRAs, you pay the tax on the IRA distribution, but the cash value grows tax-free, avoiding the risk of future higher taxes.
REVERSE COURSE NOW!
Retirement savers should take steps now to alleviate the eventual tax problem of growing pretax IRA and 401(k)s balances — and advisors should be sounding the alarm. Have clients start making Roth IRA and Roth 401(k) contributions instead.
And have them start a plan to systematically reduce those existing balances by taking taxable withdrawals now at low rates and moving those funds to tax-free vehicles so they can continue to grow, but grow tax-free for life. These actions will guarantee that retirement account owners don’t have to lose sleep over the real possibility of higher future tax rates putting a dent in their retirement income when they can least afford it.
[More: Roth IRAs, 401(k)s for all? Not so fast, advisors say]
For more information on Ed Slott and Ed Slott’s 2-Day IRA Workshop, please visit www.IRAhelp.com.