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Those saving for retirement have long viewed traditional individual retirement accounts (IRAs) as the ultimate savings vehicle, offering pre-tax savings, tax-free growth and a bargain 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 Ticks Louder.”
Recent legislative changes have stripped IRAs of all their redeeming qualities, Slott said on a recent episode of Decoded Retirement (watch video above or listen below). They are now “probably the worst possible asset to leave to beneficiaries for wealth transfer, estate planning or even to withdraw your own money,” he said.
Many American households have an IRA. In 2023, 41.1 million U.S. households had about $15.5 trillion in individual retirement accounts, with traditional IRAs accounting for the largest share of that total, according to the Investment Company Institute.
Slott, who is widely considered America’s expert on IRAs, explained that IRAs were a good idea when they were created. “You had a tax deduction and the beneficiaries could do what we called the stretch IRA,” he said. “So he had good qualities.”
But IRAs have always been difficult to work with because of the minefield of distribution rules, he continued. “It was like an obstacle course just to get your money out,” Slott said. “Your own money.” It was ridiculous.
According to Slott, IRA account owners endured the minefield of the rules because the back-end benefits were considerable. “But now those benefits are gone,” Slott said.
IRAs were once particularly attractive because of the “stretch IRA” benefit that allowed the beneficiary of an inherited IRA to spread required withdrawals over 30, 40, or even 50 years, potentially spreading out tax payments and allowing the plans to grow tax deferred for 30 years. a longer period.
However, recent legislative changes, particularly the SECURE Act, eliminated the IRA’s expanded withdrawal strategy and replaced it with a 10-year rule that now requires most beneficiaries to withdraw the entire balance of their account within a decade, which could result in significant tax implications.
Learn more: 3 ways retirees can save on their taxes
This 10-year rule is a tax trap waiting to happen, according to Slott. If forced to take required minimum distributions (RMDs), many Americans could find themselves paying taxes on these withdrawals at higher rates than expected.
One way to avoid this is to make distributions well before they are needed to take advantage of low tax rates, including the 22% and 24% tax rates, and high tax brackets , Slott said.
For account holders who only take the required minimum distribution, Slott offered this: The tax bill doesn’t disappear by taking the minimum; in fact, it could even become even more important.
“Minimums should not be the driving force behind tax planning,” he said. “Tax planning should guide distribution planning, not the minimum.”
The question account holders should ask themselves is: how much can you withdraw at low rates?
“Start now,” Slott added. “Start withdrawing that money.”
Slott also advised owners of traditional IRA accounts to convert those accounts to a Roth IRA.
The account owner would pay taxes on the distribution from the traditional IRA, but once in the Roth IRA, the money would grow tax-free, distributions would be tax-free, and there would be no distributions. minimum requirements.
“Move that money into Roths using today’s low rates,” Slott said. “That’s how you win this game. This is how you make the tax rules stack up 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 will be in a lower bracket in retirement because they won’t have W-2 income.
But it’s actually the No. 1 myth when it comes to retirement planning, Slott said, and if you ignore this problem, the IRA continues to grow like a weed and the tax bill stacks up against you.
“The advantage for Roths is you know what the current rates are,” he said. “You are in control. … You avoid uncertainty about the consequences of future tax increases.
Senior couple paying bills at the kitchen table. (Getty Images) ·MoMo Productions via Getty Images
Slott also advised those saving for retirement to stop contributing to a traditional 401(k) and start contributing to a Roth 401(k).
Although workers contributing to a Roth 401(k) won’t reduce their current taxable income, Slott explained that the benefit is only a temporary deduction anyway. Contributions to a traditional 401(k) can be more accurately described as an income “exclusion,” in which your W-2 income is reduced by the amount you put into the 401(k).
Essentially, it’s “a loan you take out from the government to get paid back at the worst possible time in your retirement, when you don’t even know how high rates might go,” Slott said. “So it’s a trap.”
Learn more: 401(k) vs. IRA: The Differences and How to Choose Which One is Best for You
Another way to reduce the tax trap of owning a traditional IRA account is to consider a qualified charitable distribution.
Individuals age 70½ or 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 are charitable inclined, you can withdraw money at 0% if you give it to charity,” Slott said. “It’s a great provision. The only downside is that few people can take advantage of it. It’s only available to IRA owners who are 70 1/2 or older.”
Slott also noted that the income tax exemption for life insurance is the most important benefit in the tax code and is not used enough. And life insurance can help people achieve three financial goals: larger inheritances for their beneficiaries, more control, and lower taxes.
“You can get to the ‘promised land’ with life insurance,” Slott said.
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