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Your Large Retirement Account – Too Much of a Good Thing?
As tax time approaches, we contact many clients to recommend they make an annual contribution to a tax-advantaged retirement account. Saving for retirement – or whatever the next phase of life is – is generally the most important long-term goal for every investor. It takes discipline and commitment to accumulate the savings necessary for a comfortable and enjoyable retirement.
Today, we are also tickled to help 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 workplace pensions. Many young workers have heeded the best advice and worked to contribute regularly to the maximum allowed, reducing their current taxable income and saving for the future. The magic of compounding and a couple of very long bull markets has helped many people accumulate large, growing retirement savings by the 50s. It’s easy to think, “I did everything right and I can watch this account continue to grow for years.” However, that might not be the best approach.
The challenge is that traditional 401K plans and traditional IRAs require withdrawals to begin at age 70 ½, and those withdrawals will be taxed as ordinary income — both the savings you’ve made as well as the capital growth. This works well if you find yourself in a low tax bracket in retirement. However, many successful savers today are forced to make mandatory large withdrawals in their 70s as they find themselves paying high income taxes in their later years.
In contrast, a Roth IRA accepts only after-tax contributions, but there is never a required withdrawal. In addition, after age 59 1/2 all withdrawals that meet certain conditions are completely tax-free – both your after-tax savings 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:
Make a Roth IRA contribution each year. If your annual income qualifies, you should make a contribution 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 in a traditional IRA and converting it to a Roth IRA.
Switch to Roth 401k contributions instead of traditional contributions from work. Your Roth 401K is funded with after-tax contributions. This means they will no longer reduce the income you report on your W2 each year, but these funds will now 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 money tax-free when needed, or leave the money untouched in the account, to grow for your heirs.
Convert traditional IRAs in low income years. If you’ve stopped working or have a year with unusual 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 tax on any amount in your traditional IRA that 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 consider taking small annual distributions starting early. Check with your accountant to find out how much you could withdraw (or convert) without being pushed into 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 you could “win the retirement game” but lose it all in taxes? When 401ks were first launched, everyone imagined a structure that would encourage savings and offer a source of income later in life when one’s taxes would be lower. Today, some of us hope that US tax rates will be lower this year. If you’ve done a great job saving for your company’s retirement plan or a traditional IRA, you may now realize you could be forced to withdraw hundreds of thousands each year one day- at the same or higher tax rate than you. can pay today. . Consider the steps you can take now to manage those taxes in the future.
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