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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 a bargain for beneficiaries of inherited IRAs.
But people should stop thinking that's the case, according to Ed Slott, author of “The Retirement Savings Time Bomb Is Ticking Louder.”
Recent legislative changes have stripped IRAs of all their redeeming qualities, Slott said on a recent episode of Decoding Retirement (see the video above or listen below). They are now “probably the worst possible asset to leave to beneficiaries for wealth transfer, estate planning or even raising their own money,” he said.
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Many American households have IRAs. As of 2023, 41.1 million American households held about $15.5 trillion in individual retirement accounts, with traditional IRAs holding the largest share of that total, according to the Investment Company Institute.
Widely considered America's expert on IRAs, Slott explained that IRAs were a good idea when they were first created. “You got a tax deduction and the beneficiaries could do what we called a stretch IRA,” he said. “So it had some good qualities.
But IRAs have always been difficult to work with because of the minefield of distribution rules, he continued. “It was like an obstacle course just to get your money out,” Slott said. “Your own money. It was ridiculous.”
According to Slott, IRA account holders put up with the minefield of rules because the benefits on the back end were good. “But now those benefits are gone,” Slott said.
IRAs were once particularly attractive because of the “stretch IRA” benefit, which allowed the recipient of an inherited IRA to extend required withdrawals over 30, 40, or even 50 years, potentially spreading out tax payments and allowing the account to grow tax-deferred over a longer period.
However, recent legislative changes, notably the SECURE Act, eliminated the 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, which can have significant tax consequences.
According to Slott, this 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 higher rates than they anticipated.
One way to avoid this is to make distributions long before they have to take advantage of low tax rates, including the 22% and 24% tax rates, and large tax brackets, Slott said.
For account holders who take only the minimum required distribution, Slott offered this: The tax bill won't go away by taking the minimum; in fact, it may be even greater.
“The minimum should not drive tax planning,” he said. “Tax planning should drive distribution planning, not the minimum.”
The question account holders should ask themselves is this: How much can you withdraw at low rates?
“Start now,” Slott added. “Start pulling that money out.
Slott also advised traditional IRA account holders to convert those accounts to Roth IRAs.
The account owner would pay taxes on distributions from a traditional IRA, but once in a Roth IRA, the money would grow tax-free, distributions would be tax-free, and there would be no required minimum distributions.
“Move that money into Roths using today's low rates,” Slott said. “That's how you beat this game. That's how the tax rules stack up in your favor, not against you.”
Converting to a Roth IRA is essentially betting on future tax rates, Slott explained. Most people think they will be in a lower bracket in retirement because they won't have W-2 income.
But that's actually myth no. 1 in retirement planning, Slott said, and if you ignore the issue, the IRA will continue to grow like a weed and the tax bill will stack up against you.
“The benefit to a Roth is that you know what the rates are today,” he said. “You're in control. … You avoid the uncertainty of what future higher taxes will do.”
Senior couple paying bills at kitchen table. (Getty Images) ·MoMo Productions via Getty Images
Slott also advised those saving for retirement to stop contributing to a traditional 401(k) and start contributing to a Roth 401(k).
While workers contributing to a Roth 401(k) won't reduce their current taxable income, Slott explained that the benefit is only a temporary deduction anyway. Contributions to a traditional 401(k) can more accurately be described as an income “exclusion” in which your W-2 income is reduced by the amount you contribute to the 401(k).
Essentially, it's “a loan you're taking out from the government to pay off at the worst possible time in retirement, when you don't even know how high rates can go,” Slott said. “So it's a trap.”
Another way to reduce the tax trap that comes with being a traditional IRA owner is to consider a qualified charitable distribution.
Individuals age 70 and a half or older can donate up to $105,000 directly from a traditional IRA to qualified charities. This strategy helps donors avoid increasing their taxable income, which can put them out of higher tax brackets.
“If you're charitable, you can get money at 0% if you give it to charity,” Slott said. “That's a great provision. The only negative is that not enough people can take advantage of it. It's only available to IRA owners who are 70 1/2 or older.”
Slott also noted that the income tax exemption for life insurance is the single biggest benefit in the tax code and is underutilized. And life insurance can help people achieve three financial goals: a larger inheritance for their beneficiaries, more control, and lower taxes.
“You can get to the 'promised land' with life insurance,” Slott said.
