Your Large Retirement Account – Too Much of a Good Thing?
As tax time 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 usually the most important long-term goal for any investor. It takes discipline and commitment to accumulate the necessary savings for a comfortable and enjoyable lifestyle after retirement.
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 bring in the maximum allowable income regularly, reducing current taxable income and saving for the future. The magic of compounding and a few very long bull markets have helped many people build up large, growing retirement accounts by their 50s. It’s easy to think, “I’ve done everything right and I can watch this account continue to grow for many years.” However, this may not be the best approach.
The challenge is that traditional 401K plans and traditional IRAs require withdrawals starting at age 70 ½, and those withdrawals will be taxed as ordinary income — both the deposits you make and the capital growth. This works well if you end up in a low tax bracket in retirement. Many successful savers today, however, are forced to make such large required withdrawals in their 70s that they find themselves paying high income taxes well into their later years.
In contrast, a Roth IRA only accepts after-tax contributions, but no withdrawals are ever required. Plus, after age 59 1/2, all withdrawals that meet certain requirements are completely tax-free – both your after-tax deposits and the 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 down the road? Here are 4 steps to start now to avoid high income taxes later in life:
- Make a Roth IRA contribution each year. If your annual income qualifies, you must contribute 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 backdoor contribution by making your deposit into a traditional IRA and then converting it to a Roth IRA.
- Switch to Roth 401k contributions instead of traditional work contributions. Your Roth 401K is funded with after-tax contributions. This means they will no longer reduce your reported income on your W2 each year, but now those 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 entirely tax-free when needed or leave the funds untouched in the account to grow for your heirs.
- Convert traditional IRAs to low-income years. If you’ve stopped working or are having an unusually low taxable income year, it may be the perfect time to convert some or all of your traditional IRA to a Roth IRA. You’ll pay ordinary income taxes on any amount in a traditional IRA you convert to a Roth IRA.
- Take distributions or do partial IRA conversions. Even if you’re in a high tax bracket, if you have a particularly large IRA today and you’re over 59 1/2, you might want to consider taking small distributions each year, starting early. Check with your accountant how much you can withdraw (or convert) without pushing you into a new tax bracket. Sometimes you may even be able to do 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 you could “win the retirement game” but lose it all to taxes? When 401k’s were first launched, everyone envisioned a structure that could encourage savings and offer a source of income later in life when one’s taxes would be lower. Today, few of us expect that US tax rates will be lower in years to come. If you’ve done a great job saving into your company retirement plan or a traditional IRA, you may now realize that you may be forced to withdraw hundreds of thousands a year one day—at the same or higher tax rates than you may be paying today. Consider these steps you can start now to manage those future taxes.
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