If you are drawing close to retirement, you should probably save more than you did before with your retirement accounts. You may have also paid off your debts like mortgage and credit card debts.
Typically, with these in place, you should be set for retirement. However, there’s one problem – “the ticking tax bomb.” The tax debt built up in 401(k) accounts, IRAs, and other retirement saving plans can hugely deplete the savings you would rely upon in retirement.
How Does This Tax Problem Affect You?
While watching your retirement savings grow as the stock market flourishes, it’s essential to bear in mind that a good chunk of it will go to Uncle Sam as taxes. This is important because most retirement plans are tax-deferred, not tax-free. But it’s when you withdraw in retirement that you get to know how much you’ll keep and how much will go to the government.
- Also Read: 3 Reasons Certain Federal Employees Can Retire Years Earlier Than Their Peers Without Penalties
- Also Read: CSRS Retirement in 2024: Are You Making the Most of What This Classic Plan Has to Offer?
- Also Read: Roth IRA Basics for Beginners: What’s There to Learn?
What Can You Do?
With this information, you can change the potential outcome by taking steps to pay your taxes today and ensure you can withdraw tax-free in retirement. To do this, you have to build your retirement savings with tax-free vehicles like Roth IRAs and even permanent Life Insurance.
Additionally, if your workplace plan offers a Roth 401(k), you can make contributions to it. The 2021 contribution limit for 401(k) is $19,500 and an additional catch-up contribution of $6,500 for savers aged 50 and above.
Also, see if there’s a possibility to convert some of your existing 401(k) to a Roth IRA or Roth 401(k). Once you do this, you’ll need to pay taxes on the amount you convert. So it’s essential only to convert an amount that you can pay taxes on since the conversion is irreversible.
Converting existing IRAs to Roth IRA accounts
You can convert your existing individual retirement account (IRA) to Roth IRAs to lower your tax debts in retirement. Most people prefer tax-deferred accounts because it allows them to skip taxes for now. But the fact is that you will have to pay the taxes at some point, and it may even be higher in the future. So paying it now ensures you don’t have to worry about it again.
If you have a large amount in your traditional IRA, you can start converting small amounts to Roth IRAs each year to manage the tax bill.
More importantly, stop making contributions to traditional IRAs and channel the money to Roth IRAs instead. The 2021 Roth IRA contribution limit is $6,000 and an additional $1,000 in catch-up contributions for individuals aged 50 and above. You can contribute to a spouse’s account if he/she is not working. If both of you are aged 50 or above, you can contribute up to $14,000 each year.
With this, the money can compound tax-free. The truth is that paying your taxes now is far more rational. Most people don’t take advantage of it and then end up paying more in retirement.
