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Those saving for retirement have long considered traditional individual retirement accounts (IRAs) as the ultimate savings vehicle, offering pre-tax savings, tax-free growth, and a good deal for inherited IRA beneficiaries.
However, people should stop thinking that’s the case, according to Ed Slott, author of “The Retirement Savings Time Bomb Ticks Louder.”
Recent legislative changes have stripped IRAs of all their redeeming qualities, Slott said on a recent episode of Decoding Retirement (watch the video above or listen below). They are now “probably the worst possible asset to leave to beneficiaries for wealth transfer, estate planning or even to take out their own money,” he said.
Many American households have an IRA account. In 2023, 41.1 million American households held about $15.5 trillion in individual retirement accounts, with traditional IRAs accounting for the majority of this total, according to the Investment Company Institute.
Slott, widely considered America’s IRA expert, explained that IRAs were a good idea when they were first created. “You got a tax deduction and the beneficiaries could do what we used to call the stretch IRA,” he said. “So he had some good qualities.”
But IRAs were always difficult to work with because of the minefield of distribution rules, he continued. “It was like an obstacle course just to get the money,” Slott said. “Your own money. “It was ridiculous.”
According to Slott, IRA owners endured the minefield of rules because the ultimate benefits were so many. “But now those benefits are gone,” Slott said.
IRAs were once especially attractive because of the “stretch IRA” benefit that allowed the beneficiary of an inherited IRA to spread out required withdrawals over 30, 40, or even 50 years, potentially spreading out tax payments and allowing the account to grow. with taxes deferred over a longer period.
However, recent legislative changes, particularly the SECURE Act, have eliminated the IRA withdrawal strategy and replaced it with a 10-year rule that now requires most beneficiaries to withdraw the entire account balance within of a decade, which could cause significant tax implications.
Read more: Three ways retirees can save on taxes
That 10-year rule is a tax trap waiting to happen, according to Slott. If they are forced to take required minimum distributions (RMDs), many Americans may be forced to pay taxes on those withdrawals at higher rates than they anticipated.
One way to avoid this is to take distributions well before they are needed to take advantage of low tax rates, including the 22% and 24% tax rates, and large tax brackets, Slott said.
For account owners who only receive the required minimum distribution, Slott offered the following: The tax bill does not disappear when taking the minimum; in fact, it could grow even more.
“Minimums should not drive tax planning,” he said. “Tax planning should drive distribution planning, not the bottom line.”
The question account owners should ask themselves is this: How much can be withdrawn at low rates?
“Start now,” Slott added. “Start taking that money out.”
Slott also advised owners of traditional IRAs to convert those accounts to Roth IRAs.
The account owner would pay taxes on the traditional IRA distribution, but once in the Roth IRA, the money would grow tax-free, distributions would be tax-free, and no minimum distributions would be required.
“Take that money into Roths using today’s low rates,” Slott said. “That’s how you win this game. “This is how you make the tax rules complicated in your favor and not against you.”
Converting to a Roth IRA is essentially a bet on future tax rates, Slott explained. Most people think they will be lower in retirement because they won’t have W-2 income.
But that’s actually the number one myth in retirement planning, Slott said, and if this issue is ignored, the IRA continues to grow like a weed and the tax bill stacks against you.
“The benefit to Roth is that you know what the current rates are,” he said. “You are in control. … It avoids the uncertainty of what future higher taxes will mean.”
Senior couple paying bills at the kitchen table. (Getty Images) ·MoMo Productions via Getty Images
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 benefit is only a temporary deduction anyway. Contributions to a traditional 401(k) can be more accurately described as an income “exclusion,” in which your W-2 income is reduced by the amount you put into the 401(k).
In essence, it’s “a loan you’re taking out from the government to pay it off at the worst possible time in retirement, when you don’t even know how high rates could go,” Slott said. “So that’s a trap.”
Read more: 401(k) vs. ANGER: The Differences and How to Choose Which One is Right for You
Another way to reduce the tax trap that comes with owning a traditional IRA is to consider a qualified charitable distribution.
Individuals age 70½ and older can donate up to $105,000 directly from a traditional IRA to qualified charities. This strategy helps donors avoid increasing their taxable income, which can keep them out of higher tax brackets.
“If you’re charitable, you can get 0% money if you donate to charity,” Slott said. “It’s a great provision. The only negative is that not enough people can take advantage of it. It’s only available to IRA owners who are 70 1/2 or older.”
Slott also noted that the income tax exemption for life insurance is the biggest benefit of the tax code and is underutilized. And life insurance can help people achieve three financial goals: larger inheritances for their beneficiaries, more control, and less taxes.
“You can get to the ‘promised land’ with life insurance,” Slott said.
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