Many investors often neglect to consider future taxes when contributing to pre-tax 401(k) plans or traditional individual retirement accounts (IRAs). These accounts may lower your taxable income now but can lead to substantial tax liabilities upon withdrawal. Renowned accountant Tim Donovan warns that as your balance increases, “your IRA essentially becomes an IOU to the IRS.”
Understanding the Implications of Traditional IRAs
According to the Investment Company Institute, traditional IRAs constituted about 31.3% of U.S. households by mid-2023, making them a prevalent retirement option. However, nearly two-thirds of those families hold accounts resulting from retirement plan rollovers. As these traditional IRAs grow, it’s common for retirees to lack a comprehensive withdrawal strategy, which can complicate their financial planning.
Your Traditional IRA: A Debt to the IRS
Tim Donovan emphasizes that traditional IRAs are viewed as debts to the IRS, as taxes are due at the time of withdrawal. Required minimum distributions (RMDs) typically kick in at age 73 based on your previous year’s end balance, forcing you to take withdrawals and potentially increasing your tax bracket.
In contrast, Roth accounts, funded with after-tax dollars, allow for tax-free growth and withdrawals. Only 24.3% of households owned Roth IRAs as of mid-2023, indicating a significant opportunity for many.
Leveraging Current Tax Rates
The Tax Cuts and Jobs Act of 2017 lowered income tax brackets, and these rates could be extended beyond 2025. Donovan suggests that it might be more advantageous to pay taxes now at these lower rates rather than waiting for higher rates in the future. This can be achieved by contributing to Roth accounts or executing Roth conversions, which involve an upfront tax payment but can result in tax-free growth.
With Roth accounts, beneficiaries also benefit as they are not subjected to the same withdrawal rules upon inheritance, allowing heirs to optimize the timing and amount of distributions.
Considering a Roth-Only Strategy
While focusing solely on Roth accounts can be tempting due to their tax-free growth advantages, experts caution about potential downsides. A “Roth-only” approach can limit options for future strategies and may not preserve liquidity in lower-income years if needed.
Tax expert Jeff Levine suggests that individuals should be strategic about incurring taxes at the lowest rates available. By paying all taxes in advance, you may lose out on opportunities to utilize tax strategies such as making qualified charitable distributions (QCDs) from IRAs, which can mitigate taxable income and support charitable causes.
Exploring a comprehensive retirement plan that includes a mix of account types can provide greater flexibility and ultimately enhance financial security throughout retirement.
