As tax time approaches, we reach out to many clients recommending they make an annual contribution to a tax advantaged retirement account. Saving for retirement- or whatever that next phase of life may be- is generally the most important long-term goal for every investor. It takes discipline and commitment to accumulate the necessary savings for a comfortable and enjoyable retirement lifestyle.
Today, we are also tickled to be helping clients with a more surprising challenge- How do you manage taxes when you have done too good a job saving in tax-advantaged retirement accounts?
401Ks were launched in 1978 to supplement and eventually replace traditional pensions in the workplace. Many young workers heeded the best advice and worked to regularly contribute 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, growing retirement accounts by their 50s. It is easy to think, “I have done everything right and I can watch this account still 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 70 ½, and these withdrawals will be taxed as ordinary income – both the deposits you made as well as the growth of capital. This works out well if you find yourself in a low tax bracket in your 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 there never is a required withdrawal. Additionally, after age 59 1/2 all withdrawals that meet certain requirements are completely tax free- both your after-tax deposits as well as the growth.
What can you do to celebrate the great savings you have accumulated in that IRA or 401K, and still make some smart decisions to limit your tax liability in the future? Here are 4 steps to start now to help avoid high income taxes later in life:
- Make a Roth IRA contribution each year. If your annual income qualifies, you should be making a contribution to a Roth IRA. This year, the limit is $6,000 per person and $7,000 for those over age 50. If your earned income exceeds the limits, you may be able to make a “back door” 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 contributions at work. Your Roth 401K is funded with 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. Then you may choose to withdraw the funds entirely tax-free when necessary, or leave the funds untouched in the account, to grow for your heirs.
- Convert traditional IRAs in low income years. If you have stopped working or have a year with 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 in the traditional IRA that you convert to a Roth IRA.
- Take distributions or make 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 as to how much you might be able to withdraw (or convert) without pushing you into a new tax bracket. Sometimes, you might even be able to make a small withdrawal/conversion with little to no additional tax in 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 401ks were first launched, everyone imagined a structure that could encourage savings and offer an income source later in life when a person’s taxes would be lower. Today, few of us expect that U.S. tax rates will be lower years from now. If you have done a great job saving on your company retirement plan or a traditional IRA, you now may be realizing you could be forced to withdraw hundreds of thousands per 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.
Source by Liz Miller