As tax time approaches, we reach out to many clients and encourage them to make an annual contribution to a tax-advantaged retirement account. Saving for retirement, or whatever the next phase of life may be, is generally the most important long-term goal for all investors. 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?
401Ks were launched in 1978 to supplement and eventually replace traditional workplace pensions. Many young workers heeded 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 watch this account grow for many years to come.” 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 the growth of principal. This works well if you are in a low tax bracket in retirement. Many successful savers today, however, are forced to make such large required withdrawals at age 70 that they find themselves paying high income taxes well into old age.
By contrast, a Roth IRA only accepts after-tax contributions, but a withdrawal is never required. Plus, 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 future tax liability? Here are 4 steps to start now to help avoid high income taxes later in life:
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Make a contribution to the Roth IRA 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 people age 50 and older. If your earned income is over the limits, you may be able to make a “back door” contribution by making your deposit into 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 grow tax-deferred and when you leave your employer, you can roll them directly into a Roth IRA. You can then choose to withdraw the funds completely tax-free when needed, or leave the funds in the account intact, to grow for your heirs.
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Converts traditional IRAs in low-income years. If you’ve stopped working or have an unusually low taxable income year, 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 amounts in the Traditional IRA that you convert to a Roth IRA.
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Take distributions or make partial IRA conversions. Even if you’re in a high tax bracket, if you have a particularly large IRA today and you’re over age 59 1/2, you might consider taking small distributions each year starting early. Check with your accountant how much you could withdraw (or convert) without moving to a new tax bracket. Sometimes you may even be able to make a small withdrawal/conversion with little or no additional tax in 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 because of taxes? When 401ks were first launched, everyone envisioned a structure that could encourage savings and offer 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 in a few years. If you’ve done a great job saving in your company retirement plan or a traditional IRA, you may now realize that you could be forced to withdraw millions of thousands per year one day, at the same or higher rates. taxes than you may be paying today. . Consider these steps you can start now to manage those future taxes.
