If you work with retirement or even half-board in mind, you are probably (hopefully) saving more in your retirement accounts than you have in the past. You may have paid off the mortgage and paid for college and other heavy child-raising expenses. That all sounds like you’re on the road, except for one big problem I call the “ ticking tax time bomb. ”
I am referring to the tax liability that accrues on 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 a few ways you can avoid this problem.
What is the potential tax problem for retirement savings?
While you may see your savings grow through your continued contributions and the rising stock market, much of that growth goes to Uncle Sam. That’s because most, if not all, of those retirement savings plans are tax-free, not tax-free.
The funds in most IRAs are pre-tax funds, which means they have not yet been taxed. But they shall when you reach in to spend them in retirement. Then you quickly realize how much of your savings you can keep and how much goes to the government.
The amount that goes to the Internal Revenue Service is based on future tax rates. And given our sovereign debt and deficits, those tax rates could skyrocket, leaving you with less than you planned, just when you need the money the most.
What You Can Do Now
So that’s the serious warning. But you can change this possible outcome with proper planning and by making changes to the way you save for retirement in the future.
You can start taking steps to pay off that tax debt at current low tax rates and start building your retirement savings in tax-free vehicles like Roth IRAs or even permanent life insurance that can include cash value that accrues and can become tax-free included. retired.
In addition, if you are still working, you can change the way you save in your pension plans. If you have a 401 (k) at work, you can contribute in a Roth 401 (k) if the plan provides. A Roth 401 (k) allows your retirement savings to grow 100% tax-free for the rest of your life and even pass it on to your beneficiaries tax-free.
Find out more: Everything about the Roth IRA
For 2021, you can contribute up to $ 26,000 (the default limit of $ 19,500 plus a catch-up contribution of $ 6,500 for people 50 and older). With some Roth 401 (k) workplace plans, you may be able to enter even more.
Next, see if you can convert some of your existing 401 (k) funds into your Roth 401 (k) or into a Roth IRA. Once you do this, you will owe tax on the amount you convert. The conversion is permanent, so make sure to convert only what you can afford to transfer tax.
Also read: We have $ 1.6 million, but most of it is stuck in our 401 (k) plans – how can we retire early without paying so much tax?
Don’t let the upfront tax bill keep you from moving your retirement funds from accounts that are taxed forever to accounts that are never taxed.
Convert existing IRAs to Roth IRAs
Likewise, you can convert your existing IRAs into Roth IRAs, which will also reduce the tax liability on those funds. The point is not to be shortsighted and avoid it because you don’t want to pay taxes right now. That tax will have to be paid at some point, and likely at much higher future tax rates and on a larger account balance.
It’s best to get this process started now, perhaps even with a plan to convert your 401 (k) or IRA funds to Roth accounts over several years, converting small amounts each year to help settle the tax bill. manage.
If you contributed to a traditional IRA, stop making those contributions and start contributing to a Roth IRA instead. Anyone 50 or older can bring in up to $ 7,000 per year ($ 6,000 plus a $ 1,000 catch-up contribution) and you can do this for a spouse even if that spouse isn’t working.
If either of you has enough income from a job or self-employment (and you don’t exceed the income limits of the Roth IRA), each of you can contribute $ 7,000, totaling $ 14,000 in Roth IRA contributions per year. This will not only add up quickly, but also to your advantage, because you are now building up tax-free pension savings.
Related: Should you convert your IRA into a Roth if Biden’s infrastructure plan succeeds?
Once the money is in a Roth IRA or other tax-free vehicles (such as life insurance), those funds will be compounded 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 taxes on retirement, all of which could have been avoided.
Ed Slott is a Certified Public Accountant, an expert on individual retirement accounts (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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