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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 sweet deal 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 Is Ringing Louder.”
Recent legislative changes have stripped IRAs of all their compensatory qualities, Slott said on a recent episode of Decoding Retirement (see the video above or listen below). He stated that they are now “probably the worst assets you can leave to your beneficiaries for a wealth transfer, estate planning, or even to get your own money out.”
Many American households have an IRA. As of 2023, 41.1 million U.S. households have 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 regarded as an expert on IRAs in America, explained that IRAs were a good idea when they were first created. “It had a tax deduction, and the beneficiaries could do what we used to call a rollover IRA,” he said. “So it had some good qualities.”
But IRA accounts have always been difficult to deal with because of the minefield of distribution rules, he continued. “It was an obstacle course just to get your money out,” Slott said. “Your own money. “It was ridiculous.”
According to Slott, IRA account holders endured a minefield of rules because the benefits on the back end were such a good deal. “But those benefits are gone now,” Slott said.
IRA accounts were once particularly attractive because of the “Stretch IRA” feature that allowed the beneficiary of an inherited IRA to extend required withdrawals over 30, 40, or even 50 years, potentially spreading out tax payments and allowing the account to grow tax-deferred for a period Longer.
However, recent legislative changes, particularly the SECURE Act, have eliminated the extended IRA withdrawal strategy and replaced it with a 10-year rule that now requires most beneficiaries to withdraw the entire account balance within a decade, potentially causing significant tax implications.
Read more: 3 Ways Retirees Can Save Taxes
This 10-year rule is a tax trap waiting to happen, according to Slott. If they are forced to accept required minimum distributions (RMDs), many Americans may find themselves paying taxes on those withdrawals at higher rates than they expected.
One way to avoid this is to take distributions long before they are needed to take advantage of lower tax rates, including the 22% and 24% tax rates, and larger tax brackets, Slott said.
For account holders who only take the required minimum distribution, Slott offered the following: The tax bill doesn’t disappear by taking the minimum; In fact, it may get bigger.
“Minimums should not be the driver of tax planning,” he said. “Tax planning should drive distribution planning, not the bottom line.”
The question account holders should ask is: How much can you get at low rates?
“Start now,” Slott added. “Start getting that money out.”
Slott also advised traditional IRA account holders to convert these accounts to Roth IRAs.
The account owner will pay taxes on the distribution from a traditional IRA, but once in a Roth IRA, the money will grow tax-free, distributions will be tax-free, and there will be no required minimum distributions.
“Get that money out into Roths using today’s low interest rates,” Slott said. “This is how you beat this game. This is how you make the tax rules work in your favor rather than against you.”
Converting to a Roth IRA essentially places a bet on future tax rates, Slott explained. Most people think they will be in a lower bracket in retirement because they will not have a W-2 income.
But that’s actually the No. 1 myth in retirement planning, Slott said, and if you ignore this problem, your IRA continues to grow like a weed, and your tax bill stacks up against you.
“The benefit of a Roth is you know what today’s rates are,” he said. “You’re in control. …You avoid uncertainty about what higher taxes will do in the future.
Slott also advised those saving for retirement to stop contributing to a traditional 401(k) and start contributing to a Roth 401(k).
While workers who contribute to a Roth 401(k) won’t reduce their current taxable income, Slott explained that this benefit is only a temporary deduction anyway. Contributions to a traditional 401(k) can be more accurately described as an income “exclusion,” where your W-2 income is reduced by the amount you put into the 401(k).
In essence, it’s “a loan you take out from the government to be repaid at the worst possible time in retirement when you don’t even know how high interest rates might rise,” Slott said. “So this is a trap.”
Read more: 401(k) vs. IRA: Differences and How to Choose the Right Option for You
Another way to minimize the tax trap that comes with being a traditional IRA owner is to consider a qualified charitable distribution.
Individuals age 70 1/2 or older can donate up to $105,000 directly from a traditional IRA to qualifying charities. This strategy helps donors avoid increasing their taxable income, which can keep them out of higher tax brackets.
“If you’re philanthropically inclined, you can get money at 0% interest if you donate it to charity,” Slott said. “This is a great provision. The only negative thing about it is that there aren’t enough people who can take advantage of it. It’s only available to IRA owners who are 70 and a half or older.”
Slott also pointed out that the income tax exemption for life insurance is the single largest benefit in the tax code and is not nearly used enough. Life insurance can help people achieve three financial goals: a larger inheritance for beneficiaries, more control, and lower taxes.
“You can get to the ‘Promised Land’ with life insurance,” Slott said.
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