How to avoid a retirement tax problem

Published on 22/05/2021

One of the key goals while investing is to save enough capital for one’s retirement. That is the primary reason for putting money in a retirement account or setting up a retirement fund. And if you are steadily gearing up for your second innings, you may likely have paid off your mortgages, and your children are in an independent good place as far as finances are concerned.

Everything seems to be alright with all boxes checked out, except that there is a trap called the tax debt. Most individuals saving up for their retirement fail to take into account the tax debt being accumulated in their retirement accounts like IRA accounts or 401(k) accounts. And as you near the threshold age when you may want to take this money out, you will end up paying hefty taxes that have built up over time. 

Here’s how you can counter this threat.

Potential Retirement Savings Tax Issue

Nothing feels nicer than seeing your money grow in retirement accounts like IRA and 401(k) while giving you a tax deduction benefit for the amount deposited. You put a sizable chunk of your income in the account each year and watch it grow manifolds. What you may miss out on is the fact that a big chunk of this growth will have to be paid in taxes. Remember, the money that you put in retirement accounts like IRA and 401(k) accounts grows in a tax-deferred manner; it is not tax free. You will ultimately have to pay taxes when you withdraw money from these retirement accounts.

This pre-tax wealth is not taxed when you put it into a certain retirement account, it will be taxed when you withdraw it. What’s more, the tax rate you will have to pay when you withdraw the amount in the future will depend on the tax rate in the country at that point. Taking into stock the inflation, deficit markers, and national debt, tax rates in the future are bound to be higher than what it is presently. This will increase the amount of taxes you owe to the Government, decreasing what you get when you withdraw your retirement fund. 

How to decrease retirement savings tax

Your best bet is to act now when there is ample time to save yourself from losing money. All you need is proper planning, a fool-proof tax strategy, and small changes in how you save for your retirement.

One of the key steps to take is to start paying the tax now. You may choose to put money in your retirement accounts after it has been taxed to avoid a high tax load in the future when you withdraw the funds. Ideally, when you put a chunk of savings from your income into a tax-deferred retirement account, you claim a tax benefit as a tempting perk when you do so. Looking at the situation conversely, you can pay the taxes on your income before you put it in an IRA account. This way, your money grows in a tax-free manner. You can also escape paying taxes at a higher rate in the future when you withdraw the funds. 

One may also mull having a Roth IRA retirement account where funds can be withdrawn tax-free. However, you will have to pay taxes on the income right now to avoid taxation later.

You may also look at life insurance plans to have a tax-free retirement savings plan. 

The window to make immediate changes is even bigger for individuals who are currently employed. If your employer has offered you a 401(k) account, you could make contributions to a Roth 401(k) account if the plan has such an option. This will let your savings grow in a retirement account tax-free. 

Individuals younger than 50 years can contribute $19,500 to Roth 401(k) plans while those older than 50 years can contribute $26,000 to the same for 2021. 

One may also look at the possibility of converting existing 401(k) accounts into Roth IRA accounts or Roth 401(k) accounts. Upon doing this, you will have to pay taxes on the existing funds in the account. Your budget can take a hit when you opt to do so. You will have to pay taxes on your income right now. This means that a bigger chunk from your paycheck will go to the Government as taxes, affecting your monthly budget. On the bright side, the money you put into the Roth account post-conversion will be tax-free. 

However, if you can afford to pay the tax rate at this moment to convert your account, it is highly recommended that you do so. It may be a small price to pay right now. However, in contrast to what you may have to pay in the future with a regular 401(k) account, the conversion amount is only minuscule.

Convert existing IRA accounts into Roth accounts

Just like 401(k) accounts, you also have the option to convert your existing IRA accounts into Roth IRA accounts. This conversion gives you the same benefit of low tax debt for the future. You just have to pay taxes at the time of deposit and not pay taxes at all when you withdraw this money in your retirement. By doing so, you are avoiding having to pay a tax on a higher scale at a much higher rate. 

You need not convert the entire fund in one go. You can convert the funds in your IRA account to Roth accounts over time by spreading your liabilities over the years. This way, you will not have to foot the entire tax bill in one day.

Look at Roth IRA as an option

Taxpayers must consider investing their savings in a Roth IRA account instead of a traditional IRA account. Individuals over 50 years of age have the opportunity of contributing up to $7,000 per year into Roth IRA accounts. You can contribute the same amount for your spouse as well, even if they aren’t working. This will help you build a corpus quickly and tax-free upon withdrawal at retirement. 

The simplest method to reduce your tax load during retirement is to pay now. With simple strategies, you can pay off your taxes now and reap the benefits later without burning a hole in your pocket. Get in touch with our tax planners at tax@mytaxfiler.com


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