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IRAs and 401(k)s Are Nice Now, But Will RMDs Hamper Your Retirement?

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A man with a white beard and a ball cap looks dismayed. Getty Images

Most people are conditioned throughout their working lives to save as much as possible for retirement and to be prudent investors.

Unfortunately, most people mindlessly put money in tax-deferred retirement accounts, such as traditional IRAs or their employer-sponsored 401(k)s. That approach helps them save on taxes during their working life, and it’s an effective way to build savings. But it’s not in their best interests, as they reach their 50s and 60s, to keep contributing money willy-nilly  to their IRAs and 401(k)s.

Why? Because of the tax ramifications in retirement and required minimum distributions (RMDs). It’s critical that, well ahead of retirement, people take a look at strategies that will reduce their tax burden in retirement. Because it’s not about all the money you make in your working lifetime, but about how much you get to keep.

Defusing your RMDs with a Roth

RMDs can be a ticking time bomb for some people in retirement. They are required of the many retirees — even if they don’t need the money at the time — who have a traditional IRA or 401(k) and those with other qualified plans, such as a 457(b), 403(b) or Simplified Employee Pension (SEP) IRA. Some people, when looking ahead toward retirement, think they’ll be in a lower tax bracket, but RMDs, especially when added to Social Security payments and other income, may actually put them in a higher one.

The SECURE Act of 2019 raised the required age to start taking RMDs to 72 from 70½; people with any of the aforementioned accounts must begin withdrawing money from their retirement account by April 1 of the year after they turn 72. In subsequent years, they must withdraw the RMD by Dec. 31, based on the RMD calculation. Not taking one’s RMD results in a penalty of 50% of the RMD amount that year.

But making contributions to a Roth IRA or Roth 401(k) or doing systematic, year-by-year conversions to a Roth from your current tax-deferred retirement accounts are effective ways to generate tax-free income in retirement and lessen — perhaps significantly — your tax burden in those golden years. With a Roth, you pay taxes upfront each year when contributing to the account, but investment growth and account withdrawals in retirement are tax-free (as long as you are 59½ or older and have owned the Roth account for at least five years). That’s a major difference from traditional pre-tax savings accounts, such as your basic 401(k) or IRA, where you get a tax break each year for your contributions but pay taxes later when you start withdrawing funds in retirement.

Beyond the tax savings of a Roth on the back end, in retirement, there are other benefits. While Roth 401(k) accounts are subject to the same RMD rules that apply to traditional 401(k) accounts, you can roll over the Roth 401(k) into a Roth IRA, which is not subject to RMD rules. Roth savings also can help reduce annual premiums for Medicare Part B, which are based on taxable income. Roth withdrawals are considered tax-free income, so pulling money from them can prevent one’s annual income from going over Medicare thresholds.

With many people having much, if not all, of their retirement funds in traditional 401(k)s or IRAs, strategizing with a financial professional to do year-by-year Roth conversions could be a wise move. There is no limit to how much money you can convert or transition from a qualified account to a Roth. There are, however, annual limits for how much you can contribute to a Roth IRA — up to $6,000 in 2022 ($7,000 for those 50 or older) — as well as contribution limits based on household income and filing status. You can contribute a maximum of $20,500 to a Roth 401(k) in 2022, the same as a traditional 401(k) (and an extra $6,500 as a catch-up contribution if you are 50 or older).

Gaining popularity – at least among employers

Many employers have added a Roth 401(k) option; the share of 401(k) plans offering a Roth has jumped 75% from a decade ago, to 86% in 2020. But according to the Plan Sponsor Council of America, only about 26% of workers who save in their 401(k) plans used the Roth option in 2020.

It’s important that people take advantage of the Roth 401(k) fairly soon in addition to their traditional 401(k). Why? The Roth makes more sense for many people now because the next four years provide a rare window of opportunity to take advantage of the relatively low tax rates stemming from the Tax Cuts and Jobs Act of 2017, which expires at the end of 2025. Some shun the Roth because they think their tax bracket will be lower in retirement, but that’s not always the case, and tax rates likely will start going higher anyway once the TCJA expires. And who knows how high they will go further into the future, given the trillions of dollars the government spent to help people and businesses through the pandemic.

The bottom line is this: Too many people, and accountants, are focused on saving on taxes in a given year. Individuals and the professionals helping them with money matters need to focus more on advance tax planning that will help them greatly in the years ahead, especially in retirement.

Pay more of the taxes now while rates are lower than they are going to be in the future. Enjoy more of the fruits of your labor in retirement by taking advantage of the Roth.

Dan Dunkin contributed to this article.

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