This ‘Time Bomb’ Could Ruin Your Retirement Savings
There’s a “ticking time bomb” approaching the retirement funds of many Americans—but there’s still plenty of time to defuse it before it devastate the entire country’s retirement savings.
That time bomb comes in the form of the huge tax bill many savers will face when they start withdrawing money from widely used tax-deferred retirement accounts like 401(k)s and traditional IRAs—and that bill is likely to only increase, according to IRA expert Ed Slott, who just released a book. The retirement savings time bomb is ticking bigger..
As it stands now, people who invest in a 401(k) or traditional IRA pay no tax on their contributions, with the understanding that the bill will come in retirement when they withdraw the money. But that means the amount shown on their account statements is much higher than what savers can actually spend on living expenses, Slott said. And many people don’t understand how much they could owe.
“None of these accounts are taxed, that’s the deal we made with the government. We get a tax deduction, but we pay it later,” said Slott, who has worked as a certified public accountant for 40 years. Luck. “An IRA is an IOU from the IRS.”
And thanks to a soaring stock market, a large inheritance and increasing emphasis on early investmentAmericans have a staggering amount of wealth tied up in these accounts. In the first quarter of 2024, Americans $7.8 trillion invested in 401(k)s and $14.3 trillion in IRAsAccording to the Investment Company Institute. That means retirement savers pay trillions in taxes.
While many people focus on how much they should save now, Slott said people need to start thinking about their tax bill in retirement.
“If you don’t fix it now, you’re going to pay a lot of money later,” Slott said. “You have to look at the big picture. Don’t look at ‘what I can save now,’ look at ‘what I can get and what my family can get in the long run.’”
Now is the time to convert a Roth
One way to defuse the situation? Convert a Roth IRA. Savers will have to pay taxes now, but it’s better than waiting, Slott says. Especially since tax rates are “discounted right now,” with the top federal tax rate as high as 37% (many people pay as low as 10 or 12%). It’s the best deal many people can get.
“We’re at the lowest point in history that many of us have probably ever seen,” Slott said. “You don’t realize how good life you have. These are good days.”
A Roth conversion involves transferring assets from a traditional IRA to a Roth IRA. Tax The tax is paid at the time of conversion (ordinary income tax on the fair market value of the converted assets, as part of the saver’s tax bill in April of the following year), and while no one likes paying taxes up front, Slott says, it has never made more sense to do so. In more than 40 years of experience, he has never had a client regret a Roth conversion, he says. And while the highest earners are limited in their contributions to a Roth, there is no income limit on Roth conversions.
“As long as you pay taxes, it grows tax-free for the rest of your life,” he said. “All that compound interest grows in your favor, you don’t have to share it with Uncle Sam anymore. That’s what you get when you pay it now at a bargain price.”
Potential changes to tax law make today’s tax rates look twice as good. While many people expect to have lower tax rates in retirement, that’s not always true—Slott calls the belief that you’ll have a lower tax rate “the number one myth about retirement”). And given that the individual tax cuts made under the Tax Cuts and Jobs Act of 2017 are set to expire after 2025, many people could see their tax burdens increase. (Depending on the outcome of this year’s presidential election, they may not be extended.)
Slott also pointed to the country’s current debt levels — currently more than $35 trillion — as another reason he believes tax rates will rise. He argued that the last thing many people want is for their retirement savings to be subject to uncertainty about future tax rates.
“Either Congress is going to continue to delay, or they’re going to have to raise taxes,” he said. “And the people who are most at risk of being taxed are the people who have the most money in these tax-deferred vehicles.”
Recent changes in tax law have also made traditional IRAs a less attractive retirement savings vehicle, Slott said. Savers will start taking required minimum distributions (RMDs) at age 73 and The so-called stretch IRA has been eliminated..
“When you do a Roth conversion, you control your taxes. You control how much you pay each year,” he said. “With an RMD, you don’t control anything. It’s a required distribution.”
Other planning options include charitable donations and life insurance. Any savings plan that is motivated to be implemented now is better than standing still and getting a surprise in retirement, he said.
“Now there is an opportunity to take that money out,” Slott said. “After next year, interest rates are supposed to go back up. So you still have [around] two years at extremely low tax rates.”
