Retirement changed forever in 1978.
That’s the year the 401(k) was invented. Now, over 40 years since, most Americans have adopted the 401(k) as their go-to vehicle for retirement savings. The 401(k) accounts for the bulk of most retirees’ total savings set aside for their retirement.
There’s a problem, though. Let’s say you have $1,000,000 sitting in your 401(k). That’s a worthy amount, and it means you’ve worked hard and done well.
The problem is that $1,000,000 is not 100% yours. If we’re honest, the name on your account should say “Joint Account with the IRS.”
The IRS and You
If you have $1,000,000 saved in a 401(k), you really only have about $600k-700k for yourself. The rest will go straight to the government.
Let’s say you owned a house worth $1,000,000. One day you decide to sell it, so you use a traditional real estate broker, who gets a sales commission of six percent. When you sell the house for $1,000,000, you’ll only get $940,000.
Your 401(k) or IRA acts the same way. You must pay the broker off what you’ve earned, and in this case, the “broker” is the IRS.
Now imagine being in business with a partner. You and your partner share a 50/50 split. However, your share is set in stone, and you cannot increase or decrease your stake.
But imagine your partner is legally allowed to change his share to whatever he wants, whenever he wants, without your consent. Talk about a power differential!
Let’s say you and your partner choose to sell the business. At sale, your partner decides to increase his share by 10%, leaving you with just 40% -- much less money than you were expecting.
That doesn’t seem fair, but it’s exactly the reality of your retirement. With the stroke of a pen, the government can increase what you owe when you take your money out, causing you to have less savings for retirement than you originally planned.
No Time Like the Present
How can 401(k) owners legally keep as much as possible and pay as little as possible to the IRS? Whenever my clients ask me this, I tell them two words: “Act now.”
For most people reading this, taxes have gone up in your lifetime. But the recent Tax Cuts and Jobs Act of 2017 reduced taxes for the first time in many years.
Between now and 12/31/25, you can take out your 401(k) money and pay less taxes on it than you would have. That’s why the best time to take advantage of your own money is now.
I encourage all retirees to think hard about this, especially if you’re close to retirement or already there. And considering the country’s national debt level is now at $23 trillion, there’s a good chance taxes will go up again after 2025. Wouldn’t you rather pay 24% on your taxes now so you don’t have to potentially pay 28% or higher after 2025?
For some, the answer might be “no.” If that’s the case, there’s another option to consider.
If withdrawing from your 401(k) to take advantage of tax rates is not possible right now, or you have more than five years until retirement, converting to a tax-advantaged Roth account might be the second-best option for you.
Converting to a Roth now could lead to you paying lower taxes in the long run. It allows you to take advantage of the current taxes rates while still letting your money accumulate until you retire.
The only roadblock: Any money you move to a Roth will be taxed as ordinary income in the year you convert. If you’re worried about moving into a higher tax bracket, I suggest a systematic Roth conversion.
Systematic = Smart
A conversion doesn’t have to be an all-or-nothing transaction. You can choose to convert just a portion of your 401(k) into a Roth. Through a systematic or partial Roth conversion, you can avoid being pushed into a higher tax bracket year after year.
For instance, it’s possible to calculate the maximum amount of money you can convert into a Roth each year until 2026 without pushing you into a higher tax bracket. That way, you can still take advantage of the tax rates until 2026. Even if you don’t convert all the money out of your 401(k), at least you’ll be paying less taxes when you withdraw funds in the future.
There’s a massive opportunity right now for retirees to pay less taxes in the long run and save a large portion of their accumulated wealth. Whether through 401(k) withdrawals or conversions to Roth, it can be a complicated process to make sure you’re making the wisest decision.
That’s why, if you’re close to retirement or have years to go, I encourage you to talk with a professional financial advisor. An advisor can help you make the best decisions with your hard-earned money, especially if you’re near retirement or already there.
If you want to continue reading about Roth IRA conversions and if they are right for you, I suggest you also read our article "Is A Roth IRA Conversion Right For Me?" or watch our video "Roth IRA Conversions: The When, The Why, and How"