Are You Sitting on a Tax Ticking Time Bomb for Retirement?

Make sure you're making smart choices about where you stash retirement money.

Many people are making retirement investments that could leave them with a huge tax bill in their later years. You may be surprised to discover that you're actually one of those individuals sitting on a tax ticking time bomb because you're probably contributing to a retirement account that is widely viewed as one of the best options out there.

So, will you be shocked at your tax bill as a senior? Here's how to find out.

This popular type of retirement account could lead to huge tax bills

If you are doing what most people do to save for retirement, this is likely going to have major tax consequences for you as a senior.

See, most people contribute to a traditional 401(k) at work, and potentially also to a traditional IRA as well. Both of these accounts seem really attractive because they allow you to make contributions with pre-tax dollars. If you invest in them, your contribution comes off your taxable income and you don't pay taxes on it. As a result, it's cheaper upfront to contribute to these accounts because you are getting a little government subsidy in the form of tax savings.

The problem, however, is that withdrawals are going to be taxed in retirement. Now, in theory this is fine because you will likely have a lower income in retirement and so you should be in a lower tax bracket. If that's the case and your future tax bills will be lower, then obviously you would want to claim your tax savings now while you have to pay more.

But, there's a few big problems with this theory. First, tax rates are still extremely low right now by historical standards. And there's every reason to believe they will go up. Support for a more expansive government has grown, especially among younger people, and higher taxes will be needed to support additional programs. Higher taxes will also be needed to support an aging population and to address the national debt at some point in time. 

If your taxes go up, you could end up giving a good chunk of your 401(k) or IRA distributions to the IRS. And, as if that wasn't bad enough, distributions from traditional retirement accounts are considered to be part of your income when determining if Social Security benefits are taxed. 

Your Social Security benefits will be tax free only if your countable income is below $25,000 for single filers and $32,000 for joint filers. Half your Social Security plus all taxable income and some non-taxable income are all part of your countable income. And the problem is, these thresholds aren't indexed to inflation so more people get hit with taxes every single year. If you are primarily investing in traditional accounts, you could be one of them. 

What should you do instead?

For many people, a Roth account is a better choice. You don't get to make deductible contributions now, but you can withdraw money tax free later. And Roth distributions are not part of your countable income, so using this type of account can enable you to avoid taxes on Social Security. 

Now, a Roth isn't necessarily right for every single person. But both Suze Orman and Dave Ramsey recommend Roths over traditional plans, and if you don't want to worry about your tax time bomb exploding in retirement, they are the best choice. 

If your employer offers a Roth 401(k), you can contribute to a Roth and still get your employer match. If not, you should max out your employer match and then think about putting some or all of the rest into a Roth account at a brokerage firm instead. You may be very happy you did when you can enjoy your retirement income instead of sending some of it to the IRS.