If you work carefully on retirement or even semi-retirement, you probably (hopefully) save more than you could in your retirement accounts in the past. You may have paid your mortgage and paid for college and other heavy parenting expenses. All of this sounds like you’re on the road, except for one big problem I call the “toll bomb.”
I am referring to the tax debt accrued in your individual retirement account, 401 (k) or other pension savings plans. And, as I wrote in my newest book, The New Retirement Savings Time Bomb, it can quickly deplete even the savings you relied on for your retirement years. But there are a few ways you can avoid this problem.
What is the potential issue of retirement savings tax?
Although you may be watching your savings balance grow from your continued contributions and the growth of the stock market, much of that growth will go to Uncle Sam. This is because most, if not all, retirement savings are deferred, not tax-exempt.
The funds in most IRAs are pre-tax funds, which means that they have not yet been taxed. But they Vol be, when you get to spend them on retirement. Then you quickly realize how much of your savings you can keep and how much it will go to the government.
The amount earmarked for the Internal Revenue Service will be based on what the future tax rates are. And given our level of national debt and deficit, those tax rates could increase, leaving you with less than you planned, just when you’ll need the most money.
What can you do now?
So this is the serious warning. But you can change this potential outcome with proper planning and making changes in the way you save for retirement in the future.
You can start by taking steps to pay off that tax debt at today’s low tax rates and start building your retirement savings in tax-free vehicles like the Roth IRA or even permanent life insurance, which can include cash value that creates and can be withdrawn without retirement taxes.
In addition, if you keep working, you can change the way you save in your retirement plans. If you have a 401 (k) at work, you can make contributions to a Roth 401 (k) if the plan provides. A Roth 401 (k) allows retirement savings to grow 100% tax-free for the rest of their lives and even pass on to tax-free beneficiaries.
Find out more: All about the Roth IRA
For 2021, you can contribute up to $ 26,000 (standard limit of $ 19,500 plus a $ 6,500 recovery contribution for people over the age of 50). With some Roth 401 (k) plans at work, you may be able to put even more.
Then see if you can convert some of your existing 401 (k) funds to either Roth 401 (k) or a Roth IRA. Once you do this, you will owe taxes on the amount you convert. The conversion is permanent, so make sure you convert only what you can afford to pay in tax.
Read also: We have $ 1.6 million, but most of it is stuck in our 401 (k) plans – how can we retire early without paying so many taxes?
Don’t let the advance tax bill stop you from moving your retirement funds from accounts that are taxed forever to accounts that are never taxed.
Convert existing IRAs to Roth IRAs
Similarly, you can convert your existing IRAs into Roth IRAs, reducing the tax debt of these funds. The idea is not to be short-sighted and avoid doing this, because you don’t want to pay taxes now. This tax will have to be paid at some point and probably at much higher future tax rates and on a larger account balance.
It’s best to start this process now, maybe even with a plan to convert your 401 (k) or IRA funds into Roth accounts over several years, turning small amounts each year to manage your tax bill.
If you have contributed to a traditional IRA, stop making those contributions and instead start contributing to a Roth IRA. Anyone 50 years of age or older can bring up to $ 7,000 a year ($ 6,000 plus a $ 1,000 recovery contribution) and you can do this for a spouse, even if that spouse is not working.
If one of you has enough earnings from a job or self-employment (and you do not exceed the income limits from the Roth IRA contribution), each of you can contribute $ 7,000, totaling $ 14,000 in Roth IRA contributions each year . This will not only add up quickly, but will add everything in your favor, as you are now accumulating tax-free retirement savings.
Related: Should you turn your IRA into a Roth if Biden’s infrastructure plan passes?
Once the funds are in a Roth IRA or other tax-free vehicle (such as life insurance), these funds are made tax-free for you.
The secret is to pay taxes now. It is so simple, but also so counterintuitive, that most people do not take advantage of this and end up paying high retirement taxes that could have been avoided.
Ed Slott is a certified public accountant, an expert in the distribution of the individual retirement account (IRA) and author of the “New Bank for Retirement Savings Tax”. He is president and founder of Ed Slott and Company, providing advice and analysis on the IRA.
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