Why traditional retirement accounts have become the worst asset for estate planning

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Those saving for retirement have long viewed traditional individual retirement accounts (IRAs) as the ultimate savings vehicle, offering pre-tax savings, tax-free growth, and a good deal for beneficiaries of inherited IRAs.

However, people should stop thinking that’s the case, according to Ed Slott, author of “The Retirement Savings Time Bomb Ticks Louder.”

Recent legislative changes have stripped IRAs of all their redeeming qualities, Slott said in a recent episode of Decoding Retirement (see video above or listen below). They are now “probably the worst possible asset to leave to beneficiaries for wealth transfer, estate planning, or even to get your own money out,” he stated.

Many American households have an IRA. As of 2023, 41.1 million US households owned about $15.5 trillion in individual retirement accounts, with traditional IRAs accounting for the largest share of this total, according to the Investment Company Institute.

Slott, who is widely regarded as America’s IRA expert, explained that IRAs were a good idea when they were first created. “You got a tax deduction, and beneficiaries could do what we used to call the stretch IRA, he said. “So it had some good qualities.”

But IRAs were always tough to work with because of the minefield of distribution rules, he continued. “It was like an obstacle course just to get your money out,” Slott said. “Your own money. It was ridiculous.”

According to Slott, IRA account owners put up with the minefield of rules because the benefits on the back end were a good deal. “But now those benefits are gone,” Slott said.

IRAs were especially attractive once because of the “stretch IRA” benefit that allowed the beneficiary of an inherited IRA to stretch required withdrawals over 30, 40, or even 50 years, potentially spreading out tax payments and allowing the account to grow tax-deferred for a longer period.

However, recent legislative changes, particularly the SECURE Act, have eliminated the stretch IRA withdrawal strategy and replaced it with a 10-year rule that now requires most beneficiaries to withdraw the full account balance within a decade, potentially causing significant tax implications.

That 10-year rule is a tax trap waiting to happen, according to Slott. If forced to take required minimum distributions (RMDs), many Americans may find themselves paying taxes on those withdrawals at higher rates than they anticipated.

One way to avoid this is to take distributions long before they are required to take advantage of the low tax rates, including the 22% and 24% tax rates, and the large tax brackets, Slott said.

For account owners who only take the minimum required distribution, Slott offered this: The tax bill doesn’t go away by taking the minimum; in fact, it might get even larger.

“Minimums shouldn’t drive the tax planning,” he said. “The tax planning should drive the distribution planning, not the minimum.”

The question account owners should ask is this: How much can you take out at low rates?

“Start now,” Slott added. “Start getting that money out.”

Slott also advised traditional IRA account owners to convert those accounts into Roth IRAs.

The account owner would pay taxes on the distribution from the traditional IRA, but once in the Roth IRA, the money would grow tax-free, distributions would be tax-free, and there would be no required minimum distributions.

“Take that money out into Roths using today’s low rates,” Slott said. “That’s how you beat this game. That’s how you make the tax rules compound in your favor rather than against you.”

Converting to a Roth IRA essentially places a bet on future tax rates, Slott explained. Most people think they’ll be in a lower bracket in retirement because they won’t have a W-2 income.

But that’s actually the No. 1 myth in retirement planning, Slott said, and if you ignore this issue, the IRA continues to grow like a weed, and the tax bill compounds against you.

“The benefit for the Roth is you know what today’s rates are,” he said. “You’re in control. … You avoid the uncertainty of what future higher taxes do.”

Senior couple paying bills at kitchen table. (Getty Images) · MoMo Productions via Getty Images

Slott also advised those saving for retirement to stop contributing to a traditional 401(k) and start contributing to a Roth 401(k).

While workers contributing to a Roth 401(k) won’t reduce their current taxable income, Slott explained that that benefit is only a temporary deduction anyway. Contributions to a traditional 401(k) can be more accurately described as “an exclusion” from income, in which your W-2 income is reduced by the amount you put into the 401(k).

In essence, it’s “a loan you’re taking from the government to be repaid at the worst possible time in retirement when you don’t even know how high the rates might go,” Slott said. “So that’s a trap.”

IRA expert: Why traditional retirement accounts have become the worst asset for estate planning

Another way to reduce the tax trap that comes with being a traditional IRA account owner is to consider a qualified charitable distribution.

Individuals aged 70 and a half or older can donate up to $105,000 directly from a traditional IRA to qualified charities. This strategy helps donors avoid increasing their taxable income, which can keep them out of higher tax brackets.

“If you’re charitably inclined, you can get money out at 0% if you give it to charity,” Slott said. “That’s a great provision. The only negative with that is that not enough people can take advantage of it. It’s only available to IRA owners who are 70 and a half years old or older.”

Slott also noted that the income tax exemption for life insurance is the single biggest benefit in the tax code and is not used nearly enough. And life insurance can help people achieve three financial goals: larger inheritances for their beneficiaries, more control, and less tax.

“You can get to the ‘promised land’ with life insurance,” Slott said.

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