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How can I legally protect my retirement savings from the IRS?

Most people take out a dedicated retirement account like a Roth or 401(k), but The Motley Fool has some advice to make the most of your savings.

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Last week the IRS announced that it will raise the contribution limits for tax-deferred retirement plans by 9.8% next year, the largest ever increase in terms of both dollars and the percentage rise.

The increase is reflective of the high rate of inflation recorded in the United States throughout 2022 and allows individuals to add more money to their pension pot without being subject to normal taxation.

However the fact remains that a significant proportion of the money you save for retirement will still be taxed by the IRS. To keep that amount to a minimum, financial advice group The Motley Fool has outlined three top ways to protect your savings from being taxed…

Make sure your money is in the right account

As a general rule, retirement savings should be kept in a dedicated retirement account because they are able to offer tax advantages that other types of account do not.

Putting money in a 401(k) or traditional IRA would bag you a tax break this year, but remember you will be liable to pay certain taxes when it’s time to withdraw. Alternatively, a Roth account will not offer the same tax breaks when you add into your pension pot, but most allow you to withdraw without being taxed in your retirement.

Make sure to research the options and decide what is best for you, remembering that withdrawing from a retirement plan before the age of 59.5 will likely land you with a 10% early withdrawal penalty.

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Consider converting your savings to a Roth IRA

As mentioned, Roth accounts do not typically require the holder to pay tax on withdrawals in requirement. Furthermore, Roth IRAs are also free from the required minimum distributions (RMDs) that dictate that individuals must begin to make annual withdrawals by the time they turn 72.

If you were to convert savings from other retirement accounts into a Roth account then you would have to pay a Roth IRS conversion tax, but you can choose when to make the conversion. If you are expecting your annual income to increase in the coming years, you can pay tax at a lower rate by making the conversion while you remain in a lower tax bracket.

This can be a gradual process too, moving your savings in a series of conversions spread out over many years to avoid being hit with a huge one-off tax bill.

Borrowing money can be cheaper that cashing out early

For all the tax advantages, the negative point of a retirement account is that you are fixed in until retirement, or face a hefty early withdrawal fee. Some accounts allow exceptions for certain reasons, such as a large medical bill, but mostly you’re be struck with an additional charge that eats into your savings.

Wherever possible, avoid adding money into your retirement account unless you are confident that you are not going to need it until your 60th birthday. But if you’re left with no alternative, The Motley Fool recommends considering taking out a loan to minimise disruption to your pension. You will be charged interest on the loan, but it could work out a lot cheaper when the 10% early withdrawal fee and lost tax advantages are considered.