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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 good deal for inherited IRA beneficiaries.
However, people should stop thinking that's the case, according to Ed Slott, author of “The Retirement Savings Time Bomb Ticks Louder.”
Recent legislative changes have stripped IRAs of all their redeeming qualities, Slott said in 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 to get your own money out,” he said.
Many American households have an IRA. As of 2023, 41.1 million US households owned about $15.5 trillion in individual retirement accounts, with traditional IRAs accounting for the largest share of this total, according to the Investment Company Institute.
Slott, widely regarded as America's IRA expert, explained that IRAs were a good idea when they were first created. “You got a tax deduction, and beneficiaries could do what we use to call the extended IRA, he said. “So it had some good qualities.”
But the IRAs were always difficult to work with because of the 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 owners fell within the scope of the rules because the benefits on the back end were a good deal. “But now those benefits are gone,” Slott said.
IRAs were once particularly attractive because of the “stretch IRA” benefit that allowed the beneficiary of an inherited IRA to stretch out the required withdrawal over 30, 40, or even 50 years, potentially spreading tax payments and allowing for the account to grow tax deferred for a longer period.
However, recent legislative changes, notably the SECURE Act, have eliminated the stretch IRA withdrawal strategy and replaced a 10-year rule that now requires most beneficiaries to withdraw the full account balance within a decade, potentially causing significant tax implications.
That 10-year rule is a tax trap waiting to happen, according to Slott. 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 take distributions well before they are required to take advantage of the low tax rates, including the 22% and 24% tax rates, and the large tax brackets, Slott said.
For account owners who only take the minimum required distribution, Slott offered this: The tax bill doesn't go away by taking the minimum; in fact, it could go even more.
“A minimum should not drive the tax planning,” he said. “The tax planning should drive the distribution planning, not the minimum.”
The question account owners should be asking is this: How much can you take out at low rates?
“Start now,” Slott added. “Start getting that money out.”
Sott also advised owners of traditional IRA accounts to convert those accounts to Roth IRAs.
The account owner would pay taxes on the distribution from the traditional IRA, but once in the Roth IRA, the money would grow tax-free, distributions would be tax-free, and there would be no required minimum distributions. .
“Take that money out to Roths using today's low rates,” says Slott. “That's how you beat this game. That's how you make the compounding tax rules in your favor rather than against you.”
Converting to a Roth IRA is essentially placing a bet on future tax rates, Slott explained. Most people think they will be in a lower range after retirement because they won't have W-2 income.
But that's really the No. 1 myth in retirement planning, Slott says, and if you ignore this issue, the IRA continues to grow like a weed, and the tax bill stacks up against you.
“The advantage to the Roth is that you know what the rates are today,” he says. “You're in control. … You avoid the uncertainty of what future higher taxes do.”
Older couple paying bills at the kitchen table. (Getty Images) ·MoMo Productions via Getty Images
Sott also advised those saving for retirement to stop contributing to a traditional 401(k) and start contributing to a Roth 401(k).
While employees who contribute to a Roth 401(k) won't reduce their current taxable income, Slott explained that that benefit is only a temporary deduction anyway. Contributions to a traditional 401(k) can more accurately be described as an “exclusion” from income, where your W-2 income is reduced by the amount you put into the 401(k).
It's basically “a loan you take out from the government to repay at the worst possible time in retirement when you don't even know how high the rates might go, ” said Slott. “So that's a trap.”
Another way to reduce the tax trap that comes with being a traditional IRA account owner is to consider a qualified charitable distribution.
Individuals age 70 and a half or older can give up to $105,000 directly from a traditional IRA to qualified charities. This strategy helps donors avoid increasing their taxable income, which can keep them out of higher tax brackets.
“If you're charitably inclined, you can get money out at 0% if you give it to charity,” says Slott. “That's a great provision. The only negative with that is that not enough people can take advantage of it. It's only available to IRA owners who are 70 and a half or older.”
Slott also noted that the income tax exemption for life insurance is the single largest benefit in the tax code and is not used nearly enough. And life insurance can help people achieve three financial goals: larger inheritances for their beneficiaries, more control, and less tax.
“You can get to the 'promised land' with life insurance,” says Slott.
