The tax deadline is just around the corner, and whether you've finished yours up or you haven't even started, you've probably gotten a fresh reminder of how much you dislike this annual chore. You have to struggle with confusing questions, crunching numbers, and a lot of tedium just to get back money that should've been yours to begin with -- and that's the best-case scenario.
It'd be nice to think you could put all this behind you when you retire. But that's not the case for most people. If you'd like to slash your retirement tax bills, you need to invest heavily in Roth accounts right now. Here's why.
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How Roth accounts can slash your tax bill
You fund Roth accounts, like Roth IRAs and Roth 401(k)s, with after-tax dollars. So if you earn $60,000 in 2023 and put $5,000 into a Roth IRA, the government will still tax you on all $60,000 when you file your 2023 taxes, even though part of that money went into your Roth account.
This is different from tax-deferred accounts, like traditional IRAs and 401(k)s. These accounts give you a tax break upfront. So if you earned $60,000 and put $5,000 in a traditional IRA, you'd only pay taxes on $55,000 when you filed your 2023 return.
But things are reversed when you withdraw money later on. You have to pay taxes on all contributions and earnings you withdraw from tax-deferred accounts since you got your tax break upfront. But Roth account withdrawals usually don't count against your tax bill at all. After you pay taxes on your contributions, the government leaves the money in these accounts alone.
But in order to avoid all taxes and penalties on Roth account withdrawals, you must wait until you're at least 59 1/2 and have had the account for at least five years. You may withdraw contributions sooner than this without penalty, but taking earnings out before you meet both these criteria could cost you.
Are Roth accounts a good fit for you?
If you like the idea of reducing your retirement taxes, Roth accounts could be a good fit for you. Roth 401(k)s are only available through employers, but if your company offers one, you could earn a match, just like you would with a traditional 401(k). However, employer-matched funds might be tax-deferred instead of Roth.
If you don't have access to a Roth 401(k), you can open a Roth IRA on your own. You may set aside up to $6,500 here in 2023 or $7,500 if you're 50 or older. This is lower than the $22,500 401(k) contribution limit ($30,000 for adults 50+), but it should still be enough for most people. Plus, IRAs give you more flexibility to invest your money how you want.
Make sure you're eligible to contribute to a Roth IRA before stashing money here. These accounts have income limits that prohibit high earners from contributing directly to a Roth IRA. It's still possible to get around this, though, by doing a backdoor Roth IRA. This is where you place your money in a traditional IRA and do a Roth IRA conversion in the same year.
It may not get rid of all your retirement taxes
In order to completely avoid taxes in retirement, you'd need to have all your savings in Roth accounts, and that's not realistic for most people. A lot of workers accumulate at least some tax-deferred retirement savings over the years, and the only way to change this to Roth savings is to do a Roth IRA conversion. This will raise your taxes in the year you do the conversion, so it may not appeal to everyone.
But even if you retire with a mix of tax-deferred and Roth savings, you'll still have lower tax bills than you would if you'd placed all your money in tax-deferred accounts. As long as you budget for retirement taxes, you shouldn't encounter too many problems in retirement. Think about how much you plan to spend annually in retirement and what portion of that income will be taxable. Use this information to guide how much you need to save for retirement.
