Strategies to Avoid the Retirement Tax Bomb
Chances are, the bulk of your retirement savings are tucked away in tax-deferred accounts like IRAs, 401(k)s, or 403(b)s. But as retirement approaches, you may not realize that a portion of your account already belongs to Uncle Sam.
Last month, we discussed why you may want to consider implementing a tax planning strategy. This month I'll give you a few strategies that can help mitigate the impact of what may be the largest bill of your life.
Unlike traditional retirement accounts, which offer tax deductions on the contributions, but tax withdrawals as income, Roth accounts are funded with after-tax dollars. This difference allows the savings in a Roth account to grow and be withdrawn tax-free in retirement.
Shift Your Retirement Plan Contributions to Roth.
Consider shifting to Roth options within your retirement plan to leverage tax-free growth and withdrawals. This move not only diversifies your tax exposure, but also locks in current tax rates on contributions, protecting against future tax rate increases. If available through your employer, Roth contributions can significantly boost your retirement wealth. Though it means skipping the immediate tax deduction, the long-term benefits of tax-free earnings could outweigh the upfront tax break.
Pause Your Pre-Tax Contributions at the Match.
For those whose retirement plan doesn’t offer a Roth option and who have saved a lot in tax-deferred retirement accounts already, it may make sense to contribute only enough to capture 100% of your company’s match. Beyond that, it's crucial to continue saving in a taxable account to maintain your savings rate. This can be achieved by setting up an automated transfer to a taxable brokerage account. Depending on your situation, you may want to invest these funds in a diversified portfolio, or build up enough cash for a few years of your retirement expenses.
Contribute to a Roth IRA.
Depending on your income, you may be able to save in a Roth IRA. For 2024, eligibility begins to phase out beginning at $230,000 of modified adjusted gross income for married couples filing jointly. If you’re eligible, you can contribute up to $7,000 of earned income, and if you’re age 50 or older, you can add a $1,000 “catch-up” contribution. If your spouse doesn’t work, you can also contribute to a Roth IRA on their behalf, provided that you have sufficient earned income.
Leverage Health Savings Accounts (HSAs).
If you're enrolled in a high deductible health plan in 2024, you can contribute up to $8,300 for families ($4,150 single) to an HSA. Those who are 55+ can add an extra $1,000 “catch-up” contribution.
HSAs offer a triple tax advantage: account contributions are tax-deductible, growth is tax-free and withdrawals for qualified medical expenses are tax-free.
Unlike FSAs, HSAs have no 'use it or lose it' policy, allowing funds to rollover annually. Investing these funds for future medical expenses in retirement can be a savvy strategy to prepare for healthcare costs in a tax-efficient manner.
Consider Roth Conversions.
A Roth conversion is the process of transferring funds from a tax-deferred account, such as a traditional IRA, into a Roth account, which enjoys tax-free growth. The converted amount is subject to taxes as ordinary income at the time of the transfer, making this strategy particularly advantageous during years of lower income. It's worth considering for those who retire early and wish to manage their tax situation around Medicare premiums, Social Security taxation and Required Minimum Distributions (RMDs).
Effectively applying these strategies can significantly enhance your financial well-being in retirement, reducing your tax liability and keeping more of your hard-earned savings. As always it's wise to consult with a financial advisor to tailor these strategies to your specific situation.
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Young, Roger "Tax-Efficient Withdrawal Strategies." T. Rowe Price. Published May 2023. Accessed March 12th, 2024. https://www.troweprice.com/content/dam/iinvestor/planning-and-research/t-rowe-price-insights/retirement-and-planning/pdfs/tax-efficient-withdrawal-strategies.pdf.
McClellan, David. "Is Your Retirement Portfolio a Tax Bomb?" Kiplinger. Last Updated October 11, 2022. Accessed March 12th, 2024. https://www.kiplinger.com/retirement/retirement-planning/605109/is-your-retirement-portfolio-a-tax-bomb.
Rae, David. "5 Steps to Defuse the Retirement Savings Tax Time Bomb." Forbes. May 18, 2021. Accessed March 12th, 2024. https://www.forbes.com/sites/davidrae/2021/05/18/5-steps-to-defuse-the-retirement-savings-tax-time-bomb/?sh=73da8a45cfcf.
