It's all about taxes.
This is an especially important concept for retirement savers, since IRAs and 401(k)s are only tax-deferred, not tax-free.
“These funds have not yet been taxed, so we need a plan to minimize these taxes. [so you] “How can you keep more of your hard-earned retirement savings?,” Ed Slott, a New York-based CPA and IRA expert, tells Yahoo Finance. “It's all about what you can keep.”
This plan was the core of Slott's tax-saving strategy for retirement. “Always pay the lowest tax rate,” Slott told Yahoo Finance. “People often overlook this key point and end up paying much more in taxes when they'll need the money most in retirement.”
Slott is author of the new book, “The Retirement Savings Time Bomb: How to Avoid Unnecessary Tax Landmines, Eliminate the Latest Threat to Retirement Savings, and Achieve Financial Freedom.” Below is what he recently told Yahoo Finance about minimizing taxes in retirement, edited for length and clarity.
read more: 3 ways retirees can save on taxes
Wow. Ed, the title of your new book is terrifying. What is the Retirement Savings Bomb and Why is it Ticking Bigger?
The time bomb is the tax built into all tax-deferred traditional IRA and 401(k) accounts — and I'm not talking about Roth IRAs or 401(k)s.
I say it gets louder as time goes on, I've always felt it was, but the reason it's really loud now is because at some point, taxes are going to go up to pay off the massive debt this country faces. People complain about taxes, but from 1946 to 1963, the top federal tax rate was 91%. In 1964, it went down to 77%. I was only 10 years old then, but I heard the whole country did a dance of joy. Look where it is today, the top tax rate is 37%.
The individual tax rate cuts in the Tax Cuts and Jobs Act of 2017 (TCJA) are set to expire on December 31, 2025 unless Congress acts to extend them, meaning you have less than two years left to take advantage of your current tax rates before they go up again.
What is the basic principle of any good tax planning?
Always pay tax at the lowest rate. People don't do this because they don't want to pay tax before they have to. That's why Roth IRA conversions are a pain for them. In my opinion, you should use these two years to get money out of taxable accounts. Reduce your IRA balance while you can still withdraw at the lowest rate and move it into a tax-free Roth account.
What do you see as the biggest threat to your retirement dreams?
Future taxes. I'm worried that my tax rate will increase after I retire.
Can you explain the difference between saving protection and investing?
I think of retirement like a football game. A football game can easily be divided into a first half and a second half. The first half is the accumulation phase, which we're all familiar with. That's when you do all the work: building assets, saving, investing, and making sacrifices to get more.
The problem is, most people think that when halftime comes around, the game is over. They come in and say, “Ed, I'm retired. Look how much money I've saved for retirement.” They think the game is over. Meanwhile, the IRS comes in for the third and fourth quarters. The IRS isn't playing anybody, so they win. Investing and saving is the first half, but protecting that money is the second half.
For most people, their largest assets, other than their home, are probably their IRA and 401(k) accounts, which are taxed. So it's the second half of the game that's important. Many games are won or lost in the last five seconds before the clock runs out. It's the same here.
Later in the game, you can really screw yourself up by paying too much tax, excessive and unnecessary taxes, losing out on unnecessary penalties, or not knowing about simple rollover rules or early distribution rules.
The stock market is booming and retirement savers are rejoicing. Isn't this a good thing for retirement savers?
That's money that you'll eventually have to pay to the U.S. government. Remember, much of that IRA or 401(k) isn't yours. Just like a mortgage, you owe the government a debt that you have to pay back. Most people would be better off stopping contributions to a traditional 401(k) or IRA and switching to a Roth 401(k) or Roth IRA.
Clients always tell me, “When I retire, I will be in a lower tax rate because I will no longer have an income.” What they miss is that if they do nothing, their IRA will continue to grow. Then, when they reach the new mandatory minimum distribution age of 73, they will be forced to withdraw their IRA.
What is the biggest mistake people make with distribution planning?
The reason you don't withdraw more when interest rates are low is because it would be shortsighted. You have to take the long view and pay the taxes. If you can withdraw at low interest rates, that's the real secret. But people don't do that because no one wants to pay taxes before they absolutely have to. But if you don't, you're forced to pay it at age 73. When you're out of options, you want your own plan, not the government's plan.
To take advantage of these low interest rates, it's a good idea to take distributions before you need them — do a Roth conversion or invest in tax-free vehicles like life insurance — and from the moment you put your money in a tax-free vehicle, it will grow and compound.
What is the best option for most people after retirement?, Or will they move on to another job in terms of their employer-sponsored retirement accounts?
Typically, it's an IRA rollover, but there are other options too. You can keep it in your 401(k), roll it over to a new company's 401(k) plan if you get a new job, or take a lump sum distribution. An IRA rollover gives you the most control.
What's your best advice for someone who's going to take required minimum distributions this year?
Invest it. You don't have to spend it unless you need it for living expenses. You can even withdraw more than you need and spread the tax out over a longer period of time in lower tax rates.
Once you're in RMD territory, you have to take that RMD. You can't convert an RMD to a Roth IRA. So take your RMD, then take a little bit more if you can, and convert that part. The goal is to keep your taxable IRA balance as low as possible, because if you just keep putting it away, you're going to get taxed.
Can you talk about the idea of charitable giving and RMDs?
RMDs are the perfect assets to give to charity. Take advantage of qualified charitable distributions (QCDs). Donate your taxable account to charity. The charity doesn't pay taxes.
Maybe you have a favorite cause or charity or you want to give to your alma mater. You should make the donation using a taxable IRA. One of the best ways to do this is to transfer money directly from your IRA to the charity.
QCDs are available to IRA holders who are age 70 1/2 or older at the time of distribution, subject to IRS rules. You can donate up to a total of $105,000 from your taxable IRA directly to one or more charities. You can't make a QCD from an employer plan, such as a 401(k), which is a reason to roll it over into an IRA and not leave it in your employer's plan.
You'll withdraw it tax-free and give it to charity, which is something you should be doing anyway. It's a great way to withdraw money from your IRA to achieve charitable purposes. Plus, if you time it right, it can offset your RMDs.
One word of caution: only do so if you already give. I would never tell you to give to charity for the tax deduction.
Kelly Hannon is a senior columnist for Yahoo Finance. She is a career and retirement strategist and author of “Taking control over 50: How to succeed in the new world of work. And, “You're never too old to be rich.” Follow her on X Kelly Hannon.
Click here for the latest personal finance news to help you invest, pay off debt, buy a home, retire and more.
Read the latest finance and business news on Yahoo! finance
