If you are working towards retirement or even half board, you are probably (hopefully) saving more than you could have done in your retirement accounts in the past. Maybe you paid off the mortgage and paid your university fees and other large expenses for raising children. It all sounds like you’re on your way, except for one big problem I call the ‘ticking tax time bomb’.
I am referring to the tax debt that builds up in your individual retirement account, 401 (k) or other retirement savings plans. And as I wrote in my latest book, The New Retirement Savings Time Bomb, it can quickly deplete the savings you relied on for your retirement years. But there are some ways you can avoid this problem.
What is the potential problem for retirement savings taxes?
While you can see your savings growing through your continued contributions and the rising stock market, Uncle Sam will get a good share of it. This is because most, if not all, of these retirement savings tax deductions are not tax-free.
The funds in most IRAs are pre-tax funds, which means they have not been taxed yet. But they shall be, when you come in to spend them on retirement. This is when you quickly realize how much of your savings you are going to keep and how much is going to the government.
The amount going to the Internal Revenue Service will be based on future tax rates. And given our national debt and deficit levels, these tax rates can skyrocket, leaving you with less than you planned, just when you need the money the most.
What you can do now
So this is the serious warning. However, you can change this potential outcome by doing proper planning and applying the way you save for your retirement.
You can start by taking steps to pay off the tax debt at today’s low tax rates and start building your retirement savings in tax-free vehicles like Roth IRAs, or even permanent life insurance, which can include the cash value that can be built up and tax-free in retirement .
If you are still working, you can change the way you save in your retirement plans. If you have a 401 (k) at work, you can contribute to a Roth 401 (k) if the plan provides it. With Roth 401 (k), your retirement savings can grow 100% tax-free for the rest of your life and even pass tax-free to your beneficiaries.
Learn more: All about the Roth IRA
For 2021, you can contribute up to $ 26,000 (the standard contribution of $ 19,500 plus a catch-up contribution of $ 6,500 for people 50 years and older). With some work plans for Roth 401 (k) you may be able to put in even more.
Then see if you can convert some of your existing 401 (k) funds to your Roth 401 (k) or to a Roth IRA. Once you do, your tax is due on the amount you convert. The conversion is permanent, so make sure you only convert what you can pay tax on.
Also read: We have $ 1.6 million, but most are locked into our 401 (k) plans – how can we retire early without paying so much tax?
Do not let the previous tax calculator stop you from shifting your retirement funds from accounts that are taxed forever to accounts that are never taxed.
Conversion of existing IRAs to Roth IRAs
You can also convert your existing IRAs to Roth IRAs, and also reduce the tax debt on those funds. The point is, do not be short-sighted and avoid it because you do not want to pay the tax right now. The tax will have to be paid at some point, probably at much higher future tax rates and on a larger balance.
It’s best to get this process started now, perhaps even with a plan to convert your 401 (k) or IRA funds into Roth accounts over a few years, and convert small amounts each year to manage the tax bill.
If you have contributed to a traditional IRA, stop contributing and start contributing to a Roth IRA instead. Someone 50 years and older can deposit up to $ 7,000 a year ($ 6,000 plus a catch-up contribution of $ 1,000) and you can do it for a spouse, even if the spouse does not work.
If one of you earns enough from a job or as a self-employed person (and you do not exceed the income limit for Roth IRA contributions), each of you can contribute $ 7,000, and a total of $ 14,000 in Roth IRA contributions per year. Not only will it pick up fast, it will pick up everything in your favor because you are now building up retirement savings tax-free.
Related: Should you convert your IRA to a Roth if Biden’s infrastructure plan succeeds?
Once the funds are in a Roth IRA or other tax-free vehicle (such as life insurance), the funds are compiled tax-free for you.
The secret is to pay taxes now. It is so simple, but also so counter-intuitive that most people do not take advantage of this and end up paying heavy taxes with retirement which could all be avoided.
Save Slott is a Certified Public Accountant, Expert Distribution Specialist (IRA) and author of ‘The New Retirement Savings Tax Bomb’. He is president and founder of Ed Slott and Company, and provides advice and analysis on IRAs.
This article is reprinted with permission from NextAvenue.org, © 2021 Twin Cities Public Television, Inc. All rights reserved.
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