Finance
Avoid the ‘ticking tax time bomb’ of 401(K) and IRAs by going all-in on Roths, says expert
Saving for retirement is crucial for long-term financial success and comfort, but one expert says you may be doing it all wrong.
The two most popular investment vehicles for retirement include 401(k) and IRA accounts, each of which has a traditional and a Roth version. Traditional accounts are funded with pre-tax dollars, which are taxed at the time of withdrawal, while Roths are funded with after-tax contributions, so the money grows tax-free and withdrawals are not taxed. Additionally, Roth accounts are exempt from required minimum distributions.
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Typically, investors who think they’ll be in a lower tax bracket in retirement, like higher earners, prefer traditional accounts, while people who aren’t earning peak income early in their careers may opt for a Roth.
Ed Slott disagrees, saying Roth accounts are open to anyone, at any time. The certified public accountant at his eponymous firm, which specializes in IRA investments and analysis, is the author of The Retirement Savings Time Bomb Ticks Louder: How to Avoid Unnecessary Tax Landmines, Defuse the Latest Threats to Your Retirement Savings, and Ignite Your Financial Resources. Freedom.” Slott says savers will likely end up paying more if they wait to pay taxes on their benefits.
The current tax rates, set in the Tax Cuts and Jobs Act, are also expected to disappear by the end of 2025, and it is not yet clear what the new rates or tax brackets will be.
Slott says he’s seen the consequences of waiting before. While working on one tax return for a client who preferred a traditional retirement account during his higher-income years, he discovered that his client’s income in retirement was higher than during his prime income years because his IRA was growing so much and his required minimum benefits were low. more than the income he had when he worked. His client was shocked, but not him.
Slott spoke with MarketWatch about how to know if a Roth account is right for you, what to do if you don’t have a Roth 401(k) option at work, and how to consider the pros and cons of a tax bill. can weigh today. .
MarketWatch: Why did you write this book?
Ed Slott: Most importantly, the tax time bomb is ticking. The tax people don’t realize is building up in IRAs and 401(k)s. That money has not yet been taxed. You get deductions if you contribute, and that’s the deal. You get the deductions in advance, and like any deal with the devil, there is a day of reckoning: then you have to get that money out. What I fear is future higher taxes. Given the national debt situation, if Congress ever decides to do something about those debts, it may never do so, but let’s say things get serious: There will be a critical point. The people most at risk of taxes being raised are the people with IRA money. It’s like a big, juicy steak for Congress.
MW: Do you think people think about this when they contribute?
Lock: Most people are short-sighted. Even now that the market is doing well – the last few days, who knows – but the long-term market is doing well, they’re looking at the account balance. A large part of that money is owed back to the government. They think it’s their money, and that’s dangerous. You have $1 million in an IRA or 401(k), you may think you’ll use that for retirement. You can’t get to that money unless you pay taxes first, and you don’t know what that is.
MW: So what’s the argument for using traditional accounts versus something like a Roth?
Lock: I’m on my own, but I’m saying there’s no reason to contribute to one [traditional] 401(k) or IRA because you’re just building up a future tax bill. Get the money out. Go to a Roth and build a tax-free account. A Roth is insurance against what taxes can do to your standard of living in retirement. You owe a debt on your retirement account – your IRA is an IOU to the IRS. It’s a bit like a mortgage on a retirement account, but with a mortgage everyone understands that. You know how much you owe, you look at the statement. With a retirement account you don’t know how much. Imagine you took out a mortgage, did your homework, and asked the bank questions like, “What is the interest rate?” And the banker said, “Don’t worry about that.” Instead, the banker said, “We’ll tell you how much you owe, based on how much we need it and when.” Who would sign up for that?
MW: What about the people closer to retirement who may not be able to transition as easily?
Lock: Use today’s tax brackets. These are historically low rates. I have an “always rule” because it’s always true: always pay taxes at the lowest rates. It’s very simple. No one likes paying taxes upfront, so they let it go.
MW: Traditional accounts tend to be more ideal for people in their higher income years. How do you find that balance when you’re earning more than you might later?
Lock: That’s the number 1 question when we do training programs. The whole thing is moving your money from perpetual tax accounts to never tax accounts. It’s all one big guess as to where you think tax rates will be. I think they will be higher, but if Congress does nothing about the problem and tax rates stay the same, if you do nothing the balance in your account will be higher from all your contributions and income and you will be in a higher tax bracket. . Then you are forced to withdraw money and you have no control over the taxes.
The key is to check the taxes you pay. You say I’m in a higher tax bracket now, but that’s a myth that you’ll be in a lower tax bracket after retirement. The reason I say it’s a myth for most people is because those with the largest balances and incomes think they will fall into a lower category because they won’t have W-2 income. That may be true, but if you don’t do anything, that IRA will grow and keep growing and growing and then you will be forced to take that money out (at age 73 if you have RMDs).
Once you retire, your deductibles will be lower; you generally do not have that many credits. You don’t have the benefits of dependent children, you’ve probably paid off your mortgage, you don’t have the deduction for your IRA or 401(k), and you’re probably taking the standard deduction like most people do.
The only way it won’t pay to switch to a Roth is if Congress cuts taxes somehow. If that doesn’t happen and tax rates don’t go up, what’s the worst-case scenario? You have been converted and have locked in a 0% rate going forward. People do not want to pay tax in advance, but tax on pension savings is not if, but when.
MW: You mentioned using Roth accounts instead of traditional, but what about in cases where employees don’t have a Roth 401(k) option at work?
Lock: Well, they can do their own Roth [IRA]but then they are subject to income limits. They can regularly do a 401(k) at work, which is their only option if they want to put a lot of money away. Income limits apply to Roth accounts and contributions, not conversions.
MW: Roth earning limits are one obstacle that comes to mind. What can or should people do during the time they can’t contribute directly to a Roth account?
Lock: If there are no income limits for conversions (we are only talking about contributions) they can convert to Roth. There is no limit to how much they can convert or how much they earn. If they want to contribute to a Roth even though their income is too high, they can do a backdoor Roth where you contribute to a non-deductible IRA and then convert it. You end up in the same place.
MW: Is there anything else you think retirement savers should know?
Lock: In any case, consider it, because you now have low rates. Rates are available for purchase. No one likes paying taxes up front, but the last thing you want in retirement is to have to worry about taxes.
(This interview has been edited for clarity and length.)
