If you’re like most people in the United States, you’ve done most if not all of your retirement savings in a pre-tax retirement account like your 401(k) at work or a Traditional IRA account. The beauty of these accounts is that you pay less taxes today because the amount you save is typically not included in your income that year.

One of the downsides is every dollar you take out of these accounts in the future will be taxed as income. Let’s assume you’ve saved $500,000 for retirement in one of these accounts. If your combined tax rate between Federal and State taxes ends up being 30%, then your future tax bill is going to be $150,000. In reality, you don’t have $500,000 to fund your retirement – you have $350,000.

What Can I Do About This?

When we’re working with our clients to prepare for retirement, we want to make sure you have money in all 3 of the different tax buckets:

  1. Pre-tax money like your 401(k) or Traditional IRA
  2. Tax-free money like a Roth 401(k) or Roth IRA
  3. After-tax money like an individual or joint investment account

By having three different tax sources, that gives us multiple levers to pull as we work to keep your taxes as low as possible in retirement. For the rest of this conversation, I’m going to focus on #2 – the Roth option.

You can increase your Roth savings by making contributions annually to your retirement accounts or by converting some of the existing balance from your pre-tax retirement account. This is called a Roth IRA Conversion. You will be required to pay income taxes today on the amount you convert, but then it will grow tax-free and come out tax-free in retirement.

Income tax rates in 2020 are near historical lows (1) so the Roth IRA Conversion is a strategy we are using regularly with our clients today. If tax rates end up being higher in the future, then it would be better to pay the tax today at a lower rate and get it tax-free during retirement. So often when people are looking at ‘beating’ the IRS by paying less taxes, they focus solely on the current year. If you really want to beat the IRS, it’s a 20-30 year game by planning ahead. That’s what we’re here to do and proper tax planning can save you tens of thousands of dollars in taxes during your retirement.

Please contact us if you’d like to discuss whether this is a financial strategy that would benefit your retirement plan.

  1. How have the top and bottom income tax brackets changed over time?