Traditional Individual Retirement Accounts (IRAs) have long been a staple in American retirement planning. As of mid-2023, 31.3% of U.S. households owned a traditional IRA, making it the most common type of IRA. However, financial experts are raising concerns about the potential tax pitfalls associated with these accounts.
Pre-tax 401(k) contributions, a popular feature among traditional IRAs, offer an initial tax advantage by lowering the adjusted gross income for the tax year. This immediate benefit, however, is accompanied by a significant drawback: withdrawals made in retirement are subject to regular income taxes. The goal, according to financial advisors, is to incur taxes at the lowest rates possible.
Since the implementation of the Tax Cuts and Jobs Act in 2018, income tax brackets have been lower, providing some relief to account holders. This provision may extend beyond 2025, but the uncertainty has led some to question whether traditional IRAs are "the worst possible asset" for retirement savers and future wealth transfers.
"Your IRA is an IOU to the IRS." – Ed Slott
The traditional IRA's tax burden becomes particularly apparent during wealth transfers. Non-spouse heirs who inherit a traditional IRA face substantial tax obligations. In contrast, Roth IRAs present a more favorable option for estate planning. Funded with after-tax dollars, Roth accounts grow tax-free and bypass many tax issues for non-spouse heirs. Additionally, Roth IRAs do not require minimum distributions until after the account holder's death.
Despite these advantages, only 24.3% of households held Roth IRAs as of mid-2023. Roth accounts offer a strategic alternative by avoiding the tax complications that accompany traditional IRAs. While they lack the immediate tax deduction, their long-term benefits present a compelling case for retirement savers seeking to maximize their future wealth.
For those with traditional IRAs, there are strategies to mitigate tax burdens. At age 70½ or older, account holders can make qualified charitable distributions (QCDs). These transfers allow money to move directly from an IRA to an eligible non-profit organization, offering a way to reduce taxable income while supporting charitable causes.