There’s no denying it. We are in the midst tax season once again. That time of year when we’re all reminded of how much of our hard-earned money is going to those who govern us. If you’re anything like me, it’s also the time when you start thinking about ways you can find to pay less.
Lowering your taxable income by contributing pre-tax dollars into your retirement account is a great way to do that. But for many, you may ultimately pay less to Washington by paying more to them now.
I’m referring to provisions in the U.S. tax code that allow you to either reduce your taxable income now by contributing to a Traditional IRA or 401(k) or avoid taxes later by using a ROTH account, which provides you tax-free withdrawals in retirement. Both options come with significant tax benefits, but the best choice depends on multiple factors. Of course, everyone’s situation is unique, and we recommend you sit down with a qualified professional that can weigh the pros and cons of each choice, but here are a few questions you should ask yourself.
What is your tax bracket now? If you are currently in a higher tax bracket you may receive more tax savings by contributing to traditional retirement accounts,
How long will you allow the money to grow? The longer the amount of time a ROTH account has to grow tax free the more tax efficient ROTH’s are for most people.
How interested are you in avoiding Required Minimum Distributions for yourself or potential beneficiaries in the future? ROTH accounts have no annual RMD’s because the taxes have already been paid on the money in those accounts. This makes them ideal vehicles for transferring tax free money to your loved ones upon your passing.
If you’re thinking ROTH accounts align best with your retirement goals but have already contributed significantly to traditional retirement accounts. The good news is that you can convert some, or all, of your Traditional IRA to a ROTH IRA—you’ll just need to pay income tax on the converted amount at your current tax rate. When done strategically, this can lead to significant tax savings over time. If you’re considering doing a ROTH conversion picking an optimal moment is essential
For example, if you experience a temporary dip in income (e.g., early retirement, job transition, or a sabbatical), converting during these years can keep you in a lower tax bracket during the conversion. Or, if your investments have significantly dropped in value due to a market downturn, converting at a lower valuation allows you to pay less tax on the conversion while benefiting from tax-free growth upon a market rebound. A third advantageous time to execute a conversion is when taxes are lower. If you believe tax rates will rise in the future, converting now locks in today’s lower rates.
When it comes to saving money on taxes through retirement savings, a little planning can go a long way. Whether you’re snagging a tax break now with a Traditional IRA, locking in tax-free growth with a Roth, or avoid future money owed to the IRS with a Roth conversion, the key is knowing how and when to play your cards.
Tax laws change, incomes fluctuate, and retirement goals evolve, so developing a strategy (and having a good financial advisor in your corner) can make all the difference. At the end of the day, it’s not just about saving for retirement it’s about keeping more of your hard-earned money in your pocket.
(Past performance is no guarantee of future results. The advice is general in nature and not intended for specific situations)