Pay taxes now, save later
A crude illustration of tax-deferred accounts.
Buckets
When I discuss with clients paying taxes and saving for retirement, I find it helpful to picture a horizontal line with a bucket both above and below the line. Also above the line is a water faucet.
Income from your employer (or from self-employment) starts above the line. When you receive your paycheck, the money crosses the line and goes into your checking account below the line; as it crosses the line, you must pay taxes on the money. I call this bucket “tax-free” as you have already paid taxes on it. Also included in this tax-free bucket is a Roth account, which I will discuss in detail later.
When you contribute to a 401(k) or an IRA, you do not pay taxes on the money now. You are keeping some of the money above the line and putting it into the “tax-deferred” bucket.
If you have been working and contributing to a 401(k) or IRA for a couple decades, you likely have a lot of money sitting in that tax-deferred bucket, and when you retire you will pull from this bucket to replace your income.
How your retirement money is taxed
When you withdraw funds from your IRA or 401(k) (or any other tax-deferred account), you must pay taxes on the withdrawal.
The United States has a progressive tax system, which means as your income increases, you are required to pay a higher percentage of tax on the next dollar (known as your “marginal tax rate”).
Conversely, the lower your income, the more of your own money you get to keep.
Many people, when they retire, attempt to defer taxes as long as possible, living off of their savings accounts and social security checks, and only taking distributions when they have to, but letting the IRS control your spending plan could be a horrible idea!
If I’m a frugal person, do I need to withdraw from my tax-deferred accounts?
If you were born between 1951 and 1959, your RMDs begin at age 73.
If you were born in or after 1960, your RMDs begin at age 75.
You can’t defer your income forever, and eventually, the IRS will collect what they are owed. Beginning at age 73 or 75, your tax-deferred accounts are subject to a Required Minimum Distribution (RMD), in which the IRS requires you to withdraw a certain percentage of your tax-deferred accounts each year.
Once you begin RMDs, you must take them, every year, whether or not you actually need the income to live on. Because of our progressive tax system, this increase in income may be exposing you to a higher tax bracket. Even more, since you will be collecting your social security benefits by this time, you may be exposing yourself to the social security tax torpedo, in which your increased income causes more of your benefits to be taxed.
Expecting the unexpected
Even if you’re not exactly sure what retirement looks like, there is a good chance you will want tax-free money available for you to use in the future, whether for fun, such as an RV to visit every national park, or for not-fun things such as paying for healthcare or providing financial support to a family member who needs it.
A Roth account (Roth IRA or Roth 401k) allows you to pay taxes now, during your low-tax years, and withdraw the funds (including any growth), tax-free, later. This is ideal for you if you are fully retired or are working part-time, and you want to make the most of your lower tax brackets before you begin Social Security and RMDs.
As a nice little cherry on top, Roth account also allows you to give money to your heirs free from income tax.
In executing Roth conversions, you are also protecting yourself from future tax increases, including in 2026 when the “Trump tax cuts” (TCJA) are set to expire.
How does it work?
The first step is determining whether a Roth conversion is appropriate for your situation, which I’ll discuss in the next section. Please remember that a Roth conversion A) increases your taxable income and B) cannot be reversed.
Assuming a Roth conversion makes sense, you can execute a Roth conversion through your “custodian”, which is the financial institution that holds your IRA or 401(k). Some custodians let you do this online, while others may require a signed paper form. If you are unsure, the custodian’s customer support can help.
At tax time next spring, you will receive from your custodian a 1099-R reporting the distribution. You or your tax preparer will enter this distribution on your 1040 and use it to calculate your taxes.
Is this a good idea for me?
“A Roth conversion increases your taxable income and cannot be reversed”
Talk to your financial advisor or tax professional. They will assess your current tax situation including investments and income needs to determine if a Roth conversion is right for you.
In general, a Roth conversion can be good for you if:
You believe your tax bracket will be higher in retirement than it is today (remember the Social Security tax torpedo).
You have variable income (perhaps as a business-owner or commission-based income), and your income is lower than usual this year.
You can pay the additional income taxes out-of-pocket.
A significant portion of your assets is in tax-deferred accounts.
In general, a Roth conversion may not be good for you if:
You give generously to your church or another charity. Charitable distributions can be sent from an IRA without paying taxes using a Qualified Charitable Distribution.
You are currently in your peak income-earning years. It is probably best to wait until you are fully or partly retired.
Need help?
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