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Those saving for retirement have long viewed traditional individual retirement accounts (IRAs) as the ultimate savings, offering pre-tax savings, tax-free growth and a good deal for beneficiaries of inherited IRAs.
However, people should stop thinking that’s the case, according to Ed Slott, author of The Retirement Savings Time Bomb Is Higher.
“Recent legislative changes have stripped IRAs of all their redemption properties,” Slott said on a recent episode of “Decoding Retirement.” They’re now “probably the worst possible asset to leave behind beneficiaries for wealth transfer, estate planning or even withdrawing your own money,” he said.
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Most American Households Have IRAs As of 2023, 41.1 million U.S. households had about $15.5 trillion in individual retirement accounts, with traditional IRAs accounting for a share of this total, according to the Investment Company Institute.
Slott, widely regarded as America’s IRA expert, explained that IRAs were a good idea when they were created :
But working with IRAs has always been difficult because of the minefield of distribution rules, he continued. It was funny.”
According to Slott, IRA account holders put up with a minefield of rules because the back benefits were a good deal. “But now those benefits are gone,” Slott said.
IRAs were once particularly attractive because of the “stretch IRA” benefit, which allowed the beneficiary of an inherited IRA to extend required withdrawals over 30, 40 or even 50 years, potentially spreading out tax payments and allowing the account to grow tax-deferred. for: a longer period.
However, recent legislative changes, particularly the SECURE Act, eliminated the IRA’s rollover withdrawal strategy and replaced it with the 10-year rule, which now requires most beneficiaries to withdraw the entire account balance within a decade, potentially causing significant tax consequences.
That 10-year rule is a tax trap waiting to happen, according to Slott. If forced to take required minimum distributions (RMDs), many Americans may find themselves paying taxes on those withdrawals at higher rates than they should. expected.
One way to avoid this is to take distributions long before they’re required to take advantage of lower tax rates, including the 22% and 24% tax rates and large tax brackets, Slott said.
For account holders who take only the minimum required distribution, Slott suggested the following: in fact, it can be even bigger.
“Minimums should not promote tax planning,” he said. “Tax planning should drive distribution planning, not the bottom line.”
The question users should ask is: How much can you get out at low prices?
“Start now,” Slott added. “Start pulling that money out.”
Slott also advised owners of traditional IRA accounts to convert those accounts to Roth IRAs.
The account holder will pay taxes on distributions from a traditional IRA, but once in a Roth IRA, the money will grow tax-free, distributions will be tax-free, and there will be no required minimum distributions.
“Get that money into Roths using today’s low rates. That’s how you win the game. That’s how you stack the tax rules in your favor rather than against you.”
Converting to a Roth IRA is essentially betting on future tax rates, Slott explained. Most people think they’ll be lower in retirement because they won’t have W-2 income.
But it’s actually the No. 1 myth in retirement planning, Slott says, and if you ignore it, your IRA continues to grow like a weed and your tax bills stack up against you.
“The benefit of a Roth is that you know what the rates are today,” he said.
An elderly couple pays the bills at the kitchen table (Getty Images). ·MoMo Productions via Getty Images
Slott also advised retirement savers to stop contributing to a traditional 401(k) and start contributing to a Roth 401(k).
Although employees who contribute to a Roth 401(k) will not reduce their current taxable income, Slott explained that the contribution is still only a temporary deduction.Contributions to a traditional 401(k) can more accurately be described as an “exclusion” from income, in which your W-2 income is reduced by the amount you contribute to the 401(k).
It’s essentially “a loan you’re taking out from the government to pay off at the worst possible time in retirement, when you don’t even know how high the interest rates might be,” Slott said. “So it’s a trap.”
Another way to reduce the tax pitfalls of owning a traditional IRA account is to consider qualified charitable distributions.
Individuals age 70 and older can donate up to $105,000 directly from a traditional IRA to qualified charities.This strategy helps donors avoid increasing their taxable income, which can keep them out of higher tax brackets.
“If you’re charitable, you can get 0% money if you give it to charity,” Slott said. “The only downside to it is that not enough people can take advantage of it only to IRA owners who are 70 1/2 years of age or older.”
Slott also noted that the income tax exemption for life insurance is the single biggest advantage in the tax code and is not used nearly enough. And life insurance can help people achieve three financial goals: greater inheritance for their beneficiaries, more control and less tax.
“You can get to the ‘promised land’ with life insurance,” Slott said.
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