As tax season approaches, we reach out to many clients recommending that they make an annual contribution to a tax-advantaged retirement account. Saving for retirement, or whatever the next phase of life is, is generally the most important long-term goal for any investor. It takes discipline and commitment to accumulate the savings necessary for a comfortable and enjoyable retirement lifestyle.
Today, we’re also happy to help clients with a more surprising challenge: how do you manage taxes when you’ve done too good a job saving in tax-advantaged retirement accounts?
The 401Ks were launched in 1978 to supplement and eventually replace traditional workplace pensions. Many young workers followed the best advice and worked to contribute regularly to the maximum allowed, reducing current taxable income and saving for the future. The magic of compounding and a couple of very long bull markets have helped many people accumulate large and growing retirement accounts in their 50s. It’s easy to think, “I’ve done everything right and I can see how this account continues to grow for many years.” However, that might not be the best approach.
The challenge is that traditional 401K plans and traditional IRAs require withdrawals starting at age 70½, and these withdrawals will be taxed as ordinary income, both the deposits you made and capital growth. This works well if you find yourself in a low tax bracket during your retirement. However, many successful savers today are forced to make required withdrawals so large in their 70s that they find themselves paying high income taxes well into old age.
In contrast, a Roth IRA only accepts after-tax contributions, but a withdrawal is never required. Also, after age 59½, all withdrawals that meet certain requirements are completely tax-free, both your after-tax deposits and growth.
What can you do to celebrate the big savings you’ve accumulated in that IRA or 401K, and still make some smart decisions to limit your tax liability going forward? Here are 4 steps to start now to help avoid high income taxes in the future:
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Make a Roth IRA contribution each year. If your annual income qualifies, you must make a contribution to a Roth IRA. This year, the limit is $ 6,000 per person and $ 7,000 for those over 50. If your earned income exceeds the limits, you may be able to make a “back door” contribution by making your deposit in a traditional IRA and then converting to a Roth IRA.
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Switch to Roth 401k contributions instead of traditional contributions at work. Your Roth 401K is funded by after-tax contributions. That means they will no longer reduce your reported income on your W2 each year, but now these funds will increase tax-deferred and when you leave your employer, you can roll it over directly to a Roth IRA. You can then choose to withdraw the funds completely tax-free when needed, or leave the funds intact in the account, to grow for your heirs.
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Convert traditional IRAs into low-income years. If you’ve stopped working or have a year of unusually low taxable income, it might be the perfect time to convert part or all of your traditional IRA to a Roth IRA. You will pay ordinary income taxes on any amount of the Traditional IRA that you convert to a Roth IRA.
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Accept distributions or do partial IRA conversions. Even if you are in a high tax bracket, if you have a particularly large IRA today and you are over 59 1/2, you might consider taking small distributions each year starting early. Check with your accountant about how much you could withdraw (or convert) without pushing you into a new tax bracket. Sometimes you may even be able to make a small withdrawal / conversion with little or no additional tax during the year. These small amounts can add up over time and help reduce future taxes.
Who would have thought that you could “win the retirement game” but lose it all in taxes? When the 401k were first released, everyone envisioned a structure that could encourage savings and provide a source of income later in life, when a person’s taxes would be lower. Today, few of us expect US tax rates to be lower within a few years. If you’ve done a great job saving in your business retirement plan or traditional IRA, you may now realize that you could be forced to withdraw hundreds of thousands per year one day, at the same or higher tax rates as the ones you pay today. . Consider these steps you can start now to manage those future taxes.