- Many investors don’t plan for future taxes when funneling money into pre-tax 401(k) plans and traditional individual retirement accounts.
- But as balances grow, “your IRA is an IOU to the IRS,” said certified public accountant Ed Slott.
- However, your pre-tax IRA could offer planning opportunities in retirement, experts say.
Many investors don’t plan for future taxes when funneling money into a pre-tax 401(k) plan or an individual retirement account.
While pre-tax 401(k) contributions lower your adjusted gross income for that tax year, you pay regular income taxes on future withdrawals. Many of these accounts are rolled over to traditional IRAs, which also trigger taxes upon distribution.
But traditional IRAs are “the worst possible asset” for retirement savers and future wealth transfers, IRA expert Ed Slott said during a session this week at the Horizons retirement planning conference in Coronado, California.
‘Your IRA is an IOU to the IRS’
Traditional IRAs are the oldest and most common type of IRA, owned by 31.3% of U.S. households as of mid-2023, according to research from the Investment Company Institute.
Nearly two-thirds of families with traditional IRAs have accounts with retirement plan rollovers, and 43% made contributions on top of rolled over funds, ICI found.
These accounts continue to grow, and many retirees don’t have a plan to withdraw the money, experts say.
“Your IRA is an IOU to the IRS,” said Slott, who is also a certified public accountant.
Starting at age 73, pre-tax retirement accounts are generally subject to required minimum distributions, or RMDs, based on your previous year-end balance and a life expectancy factor.
By comparison, Roth accounts, which are funded with after-tax dollars and grow tax-free, don’t have RMDs until after the accountholder’s death. But these accounts are less common. As of mid-2023, only 24.3% of households had Roth IRAs, according to ICI.
Leverage ‘bargain basement rates’
Under the Tax Cuts and Jobs Act enacted by President Donald Trump, income tax brackets have been lower since 2018. That provision could be extended past 2025 under the current Republican-controlled Congress.
Slott argues it’s better to pay income taxes now at “bargain basement rates” than withdrawing from a pre-tax IRA when rates could be higher, depending on future legislative changes.
You can do that by contributing to Roth accounts or making so-called Roth conversions, which incur an upfront bill, but grow tax free. With Roth accounts, “there’s no obligation to share with Uncle Sam,” he said.
Plus, Roth accounts avoid tax issues for non-spouse heirs who inherit your IRA since most beneficiaries must follow the “10-year rule,” and empty accounts within 10 years of the original owner’s death.
Roth-only strategy could mean ‘fewer options’
While building a bucket of tax-free retirement savings is appealing to many investors, there could be some trade-offs, experts say.
With only Roth accounts, “you’re taking away choice from individuals … because they have fewer options down the road,” certified public accountant Jeff Levine said at the Horizons conference session.
You should aim to incur taxes at the lowest rates possible, Levine told CNBC. By paying all your taxes in advance, there’s no “dry powder” to withdraw from pre-tax accounts in future lower-income years.
Plus, you could miss future tax planning opportunities, he said.
For example, if you’re philanthropic, you can make so-called qualified charitable distributions, or QCDs, at age 70½ or older, which transfer money directly from an IRA to an eligible non-profit, Levine said.
The move lowers your adjusted gross income since you can use the withdrawal to satisfy RMDs and helps reduce your pretax balance for smaller future required withdrawals.
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