The tax bill that you’re putting off on your traditional IRA or 401(k) may be higher than you think, especially since it’s looking likely that tax rates could be rising sooner rather than later.
Getty ImagesMany people saving for retirement have long followed the tax-deferral concept behind a traditional 401(k) or IRA. One benefit they see is lowering their tax bill during their working years by making before-tax contributions to their retirement savings plan(s). While the concept of tax savings now sounds appealing, many overlook the potential implications for the future. You see, while they’ve saved on their taxes presently, the burden of paying taxes on those funds has shifted to the future when withdrawing them in retirement at an unknown tax rate. As time goes on, this concept is beginning to look risky to those whose retirement savings have yet to be taxed, especially when rising tax rates seem inevitable. The big problem is the growing national debt. It has doubled in the past 10 years, from $14 trillion in 2011 to $28 trillion in 2021. A lot of people in the financial services industry and most of our clients feel that taxes likely will go up due to this crushing debt. And as a result, taxes could heavily impact 401(k) and IRA distributions in the future. With the rapid increase of our national debt comes the likelihood of taxes rising. With money inside of your pretax retirement accounts, one way or another, you will eventually have to pay taxes on these funds upon withdrawal. It’s up to you whether you want to pay the tax now, at the current known rate, or later at a future unknown rate. Given the current economic environment, for many, the preference is to pay tax now. Roth to the Rescue The solution comes in the long-term tax benefits of a Roth retirement account. The big difference between a traditional and a Roth retirement account is how they are taxed. With a traditional IRA/401(k) all contributions are made pretax and distributions are taxable. With a Roth IRA or Roth 401(k) you pay tax now on the initial contribution, but all qualified distributions — including any growth — are withdrawn tax-free in retirement. While in the past, the traditional retirement account was the only option for many employees, we are starting to see more employers offer this Roth option within their company retirement plans. You can open your own Roth IRA to take advantage of these tax benefits or even convert existing IRA funds to a Roth. Here are some points to consider about making a Roth conversion: Roth Conversions: It’s Not Too Late to Take Advantage Converting to a Roth from a traditional pretax account is one way out of the high-tax-in-retirement predicament, and a conversion can be done at any age. However, many people are unaware of this option or the fact that, unlike contributions, there is no limit as to how much money you can convert annually. While the amount that you convert counts toward your taxable income for that year, you will get the future benefit of tax-free distributions from your Roth account in retirement. This becomes beneficial to those who are already retired looking for additional income sources without bumping into a higher tax bracket. In addition to the tax benefits, Roth IRAs are not subject to required minimum distributions (RMDs) at age 72 like a traditional IRA or 401(k). This allows the money you’ve socked away to continue to grow tax-free until you choose to access it. Contribution limits Generally, you contribute to a Roth in one of two ways – through a Roth 401(k) or a Roth IRA. It’s important to know the contribution limits for both.
- For a Roth 401(k) in 2021, $19,500 is the maximum, and people who are 50 or older can make an additional $6,500 catch-up contribution. Those limits are the same at they are for traditional 401(k) accounts. Some people may benefit by investing in both a Roth 401(k) and a traditional 401(k), but if you do so, the total amount you can contribute to both plans can’t exceed the annual maximums for your age – either $19,500 or $26,000 for 2021.
- For a Roth IRA in 2021, the maximum contribution is $6,000, and for those aged 50 and over, it is $7,000.
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