Photo credit: www.cnbc.com
‘Your IRA is an IOU to the IRS’
As of mid-2023, traditional Individual Retirement Accounts (IRAs) represent the predominant form of retirement savings in the United States, being held by 31.3% of American households, according to the Investment Company Institute (ICI). These accounts have become crucial for many families, particularly as they approach retirement.
Research shows that nearly two-thirds of families with traditional IRAs also have rolled over funds from retirement plans, and 43% have made additional contributions beyond these rollovers. Despite the growth of these accounts, there remains a concern among experts that many retirees lack a clear strategy for withdrawing funds.
Ed Slott, a well-known retirement planning expert and certified public accountant, highlights a fundamental truth about traditional IRAs: “Your IRA is an IOU to the IRS.” This statement underscores the tax implications that come with these accounts.
Starting at age 73, individuals with pre-tax retirement accounts must adhere to required minimum distributions (RMDs), which are calculated based on their previous year-end balance and a designated life expectancy factor. In contrast, Roth accounts, which are established with after-tax dollars and allow for tax-free growth, do not require RMDs until the account holder passes away. Nevertheless, only 24.3% of households had Roth IRAs by mid-2023, indicating their lower prevalence.
Leverage ‘bargain basement rates’
Since the introduction of the Tax Cuts and Jobs Act in 2018, income tax brackets have been lower, a situation that could extend beyond 2025 if the current Republican-controlled Congress proceeds with these provisions. Slott argues that it may be more beneficial to pay income taxes now while rates are favorable rather than facing potentially higher rates upon withdrawing from pre-tax IRAs later.
Individuals can consider contributing to Roth accounts or executing Roth conversions, which, although they require an upfront tax payment, yield tax-free growth over time. Slott emphasized that Roth accounts present an advantage: “there’s no obligation to share with Uncle Sam.”
Additionally, when it comes to taxation for non-spouse beneficiaries who inherit an IRA, Roth accounts provide a smoother transition since most heirs must follow the “10-year rule,” requiring them to deplete the account within a decade of the original owner’s death.
Roth-only strategy could mean ‘fewer options’
While the allure of creating a bucket of tax-free retirement savings is evident for many investors, experts caution against fully committing to a Roth-only strategy, noting potential drawbacks. Jeff Levine, a certified public accountant speaking at the Horizons conference, remarked that relying solely on Roth accounts could limit future choices for individuals, potentially constraining options as tax scenarios evolve.
He advised that one should aim to pay taxes at the lowest possible rates. By front-loading all tax payments, individuals might find themselves without “dry powder” for future withdrawals from pre-tax accounts during lower-income years. This could also potentially eliminate valuable tax planning opportunities.
For those who are inclined towards philanthropy, the ability to make qualified charitable distributions (QCDs) becomes relevant at age 70½. This allows individuals to transfer money directly from an IRA to qualified charities, benefiting both their adjusted gross income and their future required minimum distributions.
In summary, while the choice of retirement accounts significantly impacts tax strategies and financial planning, individuals must carefully balance the benefits of tax-free growth with the flexibility offered by traditional IRAs.
Source
www.cnbc.com