Why Traditional Retirement Accounts Have Become the Worst Asset in Estate Planning
Why Traditional Retirement Accounts Have Become the Worst Asset in Estate Planning
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Those saving for retirement have long viewed traditional Individual Retirement Accounts (IRAs) as the ultimate savings vehicle, offering pre-tax savings, tax-free growth, and benefits for inherited IRA beneficiaries.
However, Ed Slaughter, author of “The Noise of the Retirement Savings Time Bomb Gets Loud,” says people should stop thinking that way.
Slaughter said on a recent episode of Decoding Retirement that recent legislative changes have taken away all the redeeming qualities of the IRA (see the video above or listen below). Now, he said, is “probably the worst asset to leave for beneficiaries to do wealth transfers, estate planning, or even take their own money.”
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Many American families have IRAs. According to the Investment Company Institute, 41.1 million U.S. households will have approximately $15.5 trillion in individual retirement accounts as of 2023, with traditional IRAs accounting for the largest share.
Slott, widely regarded as America's IRA expert, explains that IRAs were a good idea when they were first created. “You can get tax deductions and the beneficiary can do what we used to call an extreme IRA,” he said. “So it has some good qualities.”
But he went on to say that IRAs are always difficult to work with because of the minefield of distribution rules. “It's like an obstacle course, just to get your money out,” Slaughter said. “Your own money. This is ridiculous.”
According to Slaughter, IRA account owners endure a minefield of rules because the benefits on the back end are a good deal. “But now those benefits are gone,” Slaughter said.
IRAs were once particularly attractive because of their “stretch IRA” benefits, which allowed inherited IRA beneficiaries to stretch out required withdrawals for 30, 40 or even 50 years, potentially spreading the tax and allowing the account to grow tax-deferred for a longer period of time.
However, recent legislative changes, notably the SECURE Act, which eliminated the extended IRA withdrawal strategy and replaced it with a 10-year rule that now requires most beneficiaries to withdraw the entire account balance within ten years, may result in Significant tax implications.
Read more: 3 Ways Retirees Can Save Taxes
Slaughter said the 10-year rule is a tax trap waiting to happen. If forced to take required minimum distributions (RMDs), many Americans may find themselves paying taxes on those withdrawals at a higher rate than they expected.
One way to avoid this is to take distributions before they are required to take advantage of low tax rates, including the 22% and 24% rates, as well as large tax brackets, Slaughter said.
For account owners who only take minimum required distributions, Slott offers this advice: The tax bill won't go away because you take minimum distributions; in fact, it may get larger.
“At a minimum, tax planning should not be promoted,” he said. “Tax planning should drive distribution planning, not minimums.”
The question account owners should ask is: How much money can you withdraw at a low interest rate?
“Do it now,” Slaughter added. “Start taking the money out.”
Slott also recommends that owners of traditional IRA accounts convert these accounts to Roth IRAs.
Account owners will pay taxes on distributions from a traditional IRA, but once in a Roth IRA, funds will grow tax-free, distributions will be tax-free, and there are no minimum distribution requirements.
“Put that money into a Roth using today's low interest rates,” Slaughter says. “That's how you win this game. That's how you make the tax rules work in your favor and not against you.”
Converting to a Roth IRA is essentially a bet on future tax rates, Slaughter explains. Most people think they will be at a lower level when they retire because they don't have W-2 income.
But Slaughter says this is actually the No. 1 myth in retirement planning, and if you ignore it, the IRA will continue to grow like a weed and your tax bill will work against you.
“The good thing for Ross is you know what the rates are today,” he said. “You're in control. … You can avoid the uncertainty of higher taxes in the future.”
Elderly couple paying bills at the kitchen table. (Getty Images) ·MoMo Productions (Getty Images)
Slott also recommends that those saving for retirement stop contributing to a traditional 401(k) and start contributing to a Roth 401(k).
While workers who contribute to a Roth 401(k) will not reduce their current taxable income, Slaughter explained that the benefit is only a temporary deduction regardless. Contributions to a traditional 401(k) can be more accurately described as an “exclusion” from income, meaning that your W-2 income reduces the amount you contribute to your 401(k).
Essentially, it's “a loan you get from the government that you pay back at the worst possible time in retirement, when you don't even know how high the interest rate might be,” Slaughter said. “So it's a trap.”
Read more: 401(k) vs. IRA: The Differences and How to Choose the One That's Right for You
Another way to reduce the tax pitfalls faced by traditional IRA account owners is to consider qualified charitable distributions.
Individuals age 70 and a half or older can donate up to $105,000 directly from a traditional IRA to a qualified charity. This strategy helps donors avoid increasing their taxable income, thereby keeping them out of higher tax brackets.
“If you're philanthropically inclined, if you donate your money to charity, you can withdraw the money at 0 percent interest,” Slaughter said. “It's a great provision. The only drawback is that not enough people take advantage of it. It only applies to IRA owners who are 70 and a half years old or older.”
Slaughter also noted that the income tax exemption for life insurance is one of the largest benefits in the tax code, but one that is underutilized. Life insurance can help people achieve three financial goals: a larger inheritance for beneficiaries, more control and less taxes.
“You can get to the 'promised land' with life insurance,” Slaughter said.
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