Do you plan on retiring “poor”?
If your answer is yes, then keep doing what the masses do and continue to contribute to your Traditional 401(k)/IRA.
If the answer is no and you want to learn a more effective model with a lot more options, then read on.
Most people believe Traditional 401(k)s and IRAs are great because it allows them to contribute pre-tax money. We say, Big Deal!
Traditional 401(k)/IRA owners pay ordinary income tax on withdrawals. Most financial advisers say at retirement you will make less money, and thus be at a lower tax bracket – i.e. retire “poor”.
Why the hell would anyone intentionally plan to “retire poor?” Retiring with the same or even higher income sure sounds a lot better than retiring poor…Most financial planners assume a low-income tax rate to justify Traditional 401(k)s & IRAs. Click To Tweet
Using the Traditional plans, you don’t pay taxes on the smaller “Seed” contribution, but you do end up paying taxes on the larger “Harvest” (after your investment has grown).
Additionally, with our national debt out of control, do you believe our tax rates will be the same as they are today? Our government will have to raise taxes in the future to pay for all this crazy spending and debt. If they do, why not pay a lower tax rate today (the seed) and never pay taxes again on that money.
Another big problem with the Traditional plans happens when you turn 70 ½. The IRS requires you to make scheduled withdraws whether you need the money or not. Uncle Sam wants his money (taxes) now that your funds have grown (the harvest).
The Solution: Roth IRA / Roth 401K
The best retirement plan you can have is a ROTH 401(k) or ROTH IRA. Benefits of a Roth plan include:
1. Tax-free Withdraws. IRS allows withdrawals of contributions without paying income taxes or early withdrawal penalty. One catch, the money has to be in your plan for at least 5 years. Withdrawing interest before the age of 59 ½, incurs income taxes and a 10% penalty.
2. Tax-free Income. All your savings grows and can be withdrawn tax free after the age of 59 ½. The money you pull out of your Roth will not add to your taxable income each year.
3. No Required Minimum Distribution.
The government forces distributions (withdrawals) from your Traditional plans when you turn 70 ½. Even if you don’t need the money you must begin taking money out and pay that tax.
With a Roth, you can leave the money there as long as you like. In fact, you can even contribute to a Roth after the age 70 ½ (not allowed with Traditional plans).
4. No Taxes When Moved to your Heirs.
A Roth creates PERMANENT tax savings, including when you transfer them to your heirs. The IRS currently enables you bypass the death taxes and pass the money to your heirs – tax free.
“But I make too much money to contribute to a Roth”
This may be true for your contributions – but not for conversions.
The IRS removed their income limit on Roth conversions in 2010. Since then, many high-income earners are using what is called a “backdoor” Roth. You convert your Traditional plan into a Roth plan. There is a prescribed set of forms and procedures to this. Only use a professional Administrator or Custodian when converting plans.
Forbes Magazine has a fun article on Mega-Roths. The article shows how owners and investors of start-ups have profited through backdoor Roths to the tune of $Millions.
Be Careful Of The Taxman
You will have to pay taxes on the amount you convert to the Roth. But it’s worth it.
Remember seed and harvest?
The amount of money you convert to a Roth is extra income that year. So, you will have to pay more income taxes. If the size of your plan is significant and you can’t afford all the tax, consider a partial conversion. You can break the conversion up and spread the tax burden over many years.
There are other tax strategies to help offset the tax burden. Such as charitable contributions, credits and deductions. I worked with my tax adviser when converting my Traditional 401(k) to a Self-Directed ROTH IRA. The strategies we employed saved me a ton of money.
To help you with putting together your strategies, we put together a Cheat Sheet of Tax Strategies to help with Roth Conversions.
Age is another factor that is a consideration. For example, a conversion to a Roth at age 58 may not make sense. Why pall all the taxes in one year (due to the conversion) when you can spread them out as you begin withdrawing after age 59 ½ .
Love It, But It’s Not For Me…
If you don’t want to convert to a Roth, you can still take steps to prepare for future potential tax burdens.
Gifting. If you plan on gifting your retirement funds to charity, that charity will not have to pay taxes on the donation.
Estate Taxes. With an irrevocable trust, you may be able to pass your retirement funds to your heirs without paying estate taxes. More on this in future articles.
Annual Income Tax Planning. Work with your tax adviser when you plan on withdrawing funds (or are forced to by the IRS). You may be able to push some of your other income forward or backward to lower your tax bracket. Other tax strategies such as credits or deductions are always another option. Our article “Amazing Tax Credits and Deductions You Need To Know” provides a ton of information and lists of tax credits and deductions.
Being entrepreneurs, we have some flexibility regarding the structure and conversions of our retirement savings plans. Converting to a Roth has changed my mindset, my investment strategy and most importantly will provide me with tax-free income during my retirement.
You can work directly with your existing 401(k)/IRA Custodian to help you with the conversion. If you have any desire to self-direct your Roth, check out our previous blog article Why Do People Think A Self-Directed IRA Is a Good Thing? This article will inform you of the benefits of self-directing your plan.
In an effort to make it even easier for you, we have interviewed many Administrators and Custodians and have come up with 2 companies that we really like work with. They have the same philosophy of keeping things simple, yet effective. We will introduce these companies in our next article.
Sean and I both have Roths and we love them. For those who have already converted to a Roth, please share some of the tax strategies, and lessons learned during the process.