This “ticking time bomb” could destroy your retirement savings

The time bomb is the big tax burden that many savers will face after they begin taking withdrawals from widely used tax-advantaged retirement accounts similar to 401(k)s and traditional IRAs – and that burden is probably going only to extend, says IRA expert Ed Slott, who recently wrote the book The retirement provision time bomb is ticking louder.

Currently, those that put money into a 401(k) plan or traditional IRA don’t pay taxes on contributions because they assume the bill will come due in retirement after they withdraw money. But which means the quantity shown on statements is way higher than what savers can actually spend on living expenses, Slott says. And many individuals do not understand how much they could actually owe.

“None of these accounts have been taxed, that’s the deal we made with the government. We get a tax deduction, but we will pay for it later,” says Slott, who worked as an auditor for 40 years. Assets“The IRA is a promissory note to the IRS.”

And because of a rising stock market, sizable inheritances, and an increasing emphasis on early investing, Americans have a staggering amount of wealth tied up in these accounts. In the primary quarter of 2024, Americans had $7.8 trillion invested in 401(k)s and $14.3 trillion in IRAsbased on the Investment Company Institute. This implies that pension savers could have to pay trillions in taxes.

While many individuals deal with how much they need to save now, Slott says more people have to start thinking about their tax burden in retirement.

“If you don’t get this sorted now, you’ll pay a lot for it later,” says Slott. “You have to look at the big picture. Don’t look at ‘what I can save now’, but at ‘what I and my family can get in the long term.'”

Now it is time for a Roth conversion

One approach to defuse the bomb? A conversion to a Roth IRA. Savers pays taxes now, but that is higher than waiting, Slott says. Especially because tax rates are “on sale right now,” and the very best federal tax rate maxes out at 37% (many individuals pay as little as 10 or 12%). For many, that is the most effective deal they’ll ever get.

“We have the lowest interest rates ever that many of us will probably ever see,” Slott says. “You don’t realize how good you’re doing now. These are the good old days.”

A Roth conversion involves transferring assets from a conventional IRA to a Roth IRA. Taxes are paid on the time of the conversion (atypical income taxes in the marketplace value of the converted assets, as a part of the saver’s tax bill the next April), and while nobody likes paying taxes up front, it’s never made more sense to achieve this, Slott says. In over 40 years, he’s never had a client regret a Roth conversion, he says. And while top earners are barred from contributing on to a Roth, there is not any income limit on Roth conversions.

“As long as you pay the taxes, your wealth will grow income tax-free for the rest of your life,” he says. “The compound interest will grow in your favor, you won’t have to share it with Uncle Sam anymore. That’s what you get for paying at bargain prices now.”

Potential changes in tax law make today’s tax rates look twice pretty much as good. While many individuals expect to fall right into a lower tax bracket in retirement, that is not all the time the case—Slott calls the assumption that you’re going to fall right into a lower bracket “retirement myth number one.” And with the person tax cuts created as a part of the Tax Cuts and Jobs Act of 2017 set to run out after 2025, many individuals’s tax burdens could increase. (Depending on the final result of this 12 months’s presidential election, they might not be prolonged.)

Slott also points to the present national debt – it stands at over $35 trillion – as another excuse why he expects tax rates to rise. He argues that the final thing many individuals want is to show their retirement savings to uncertainty about future tax burdens.

“Either Congress will continue to delay the problem or it will have to raise taxes,” he says. “And the people who are most at risk of having to pay those taxes are the ones who have the most money in these tax-free investments.”

Recent tax law changes also make traditional IRAs less attractive retirement savings vehicles, Slott says. Savers will begin taking required minimum distributions (RMDs) at age 73, and the the so-called Stretch-IRA was abolished.

“When you do Roth conversions, you control your tax rates. You can control what you pay each year,” he says. “With RMDs, you don’t control anything. It’s a forced distribution.”

Other planning options include charitable giving and buying life insurance. Whatever savers plan now, it’s higher than doing nothing and being surprised in retirement, he says.

“Now there is an opportunity to get that money out,” says Slott. “After next year, interest rates are expected to rise again. So you still have [around] two years at lowest tax rates.”