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Approximately 71% of non-retired adults are at least moderately worried about being able to fund their retirement, according to a 2023 Gallup poll. But what if you’re not worried about having enough money saved? What if you’ve set aside millions in tax-deferred 401(k) plans and traditional individual retirement accounts (IRAs)?
Don’t stop worrying yet. Some successful retirement savers find themselves facing big tax bills after they retire. Distributions from tax-deferred IRAs and 401(k)s create taxable income. Investment gains and side income add to the mix, while high-income retirees may be hit with additional taxes on Social Security benefits and surcharges on Medicare premiums. When your tax bill is higher in retirement than it is during your working years, you may have a retirement tax bomb on your hands.
Retiring from your job doesn’t mean you get to retire from paying taxes. The taxes you’ve put off through pre-tax retirement contributions and tax-deferred earnings come due in retirement.
If you’ve saved pre-tax money in a tax-deferred 401(k) or traditional IRA, you’ll pay regular income taxes on the full amount of your withdrawals when you retire.
The conventional wisdom is that your tax bracket will drop (or at least stay the same) in retirement, so squaring up with Uncle Sam won’t be so bad. But some retirement super-savers have a different challenge: an avalanche of taxable income.
Although every situation is unique, here are some of the common components of a retirement tax bomb:
When you retire, all the money you withdraw from traditional 401(k) and IRA accounts is taxed as ordinary income—the same as your wages are during your working years. You’re subject to the same marginal tax rates and tax brackets, but a few new rules come into play.
To encourage retirement account holders to use (and finally pay taxes on) their retirement funds, the IRS requires account holders to begin taking minimum distributions starting April 1 of the year after they either retire or turn 72 (or 73 if you turn 72 after December 31, 2022).
The amount you pay as an RMD is based on average life expectancy: At 73, for example, the IRS estimates your remaining life expectancy at 26.5 years. To estimate your RMD, divide your retirement account balance by your life expectancy.
The IRS has worksheets that help you estimate your RMDs by age. Here’s an example of how it might work.
Say you earn $150,000 a year. You’ve saved aggressively for retirement and your investments have done well. You have $2.5 million in a 401(k) and another $1 million in a traditional IRA. If you retire as a single person at 72 with $3.5 million in retirement, you’ll have to take an RMD of $132,075 in your first year of retirement (at age 73). Assuming your money grows at 6% annually, by age 80 your RMD could be nearly $196,000, placing you in the 32% tax bracket—versus the 24% you paid as a working person. In this scenario, your RMD could peak around age 97, when you may be required to take nearly $375,000 from your account, provided you stick to minimum withdrawals and continue to earn 6% on your funds.
Failing to withdraw the required minimum could result in up to a 50% penalty from the IRS.
Unless your retirement accounts are your only source of retirement income, your tax liability doesn’t stop there. Your taxable income may also include:
High-income retirees may also be required to add an income-related monthly adjustment amount, or IRMAA, to their Medicare Part B and Medicare prescription drug premiums. If your most recent modified adjusted gross income (MAGI) shows you’ve made more than $194,000 as a married couple or $97,000 as an individual filer, you may be subject to higher premiums, based on a sliding scale.
For perspective, individuals with a MAGI of $500,000 or more, or married couples with $750,000 or more, would pay an additional $395.60 per month for Medicare Part B and an added $76.40 per month for prescription coverage.
For retirement super-savers, meeting with a retirement financial planner or tax advisor (or both) can be a good place to start. A qualified pro can help you navigate tax laws and investment strategies so you can maximize the money you get to enjoy in retirement—and minimize your tax bill, even if you can’t eliminate taxes entirely.
Here are a few tactics that may help you defuse a ticking tax bomb.
If you’re still mid-career, consider funneling some of your retirement savings into Roth accounts instead of tax-deferred traditional IRAs and 401(k)s. Though you won’t get the same tax savings now, your money will grow tax-free in your account and won’t be included in taxable income when you withdraw it. Roth IRAs do not have RMDs and, starting in 2024, neither will Roth 401(k)s.
You can roll funds from a traditional IRA or 401(k) into a Roth IRA or 401(k), but your rollover will be taxed as regular income in the year you make the transaction. Weigh the pros and cons of converting all or some of your traditional retirement assets to a Roth.
If you have a qualifying high-deductible health plan, consider maxing out your contributions to a health savings account (HSA).
Although HSA funds may only be used to pay for qualifying health care expenses (including medical copays and deductibles, dental expenses, and vision care), these expenses can be substantial in retirement. Fidelity’s 2023 Retiree Health Care Cost Estimate found that a 65-year-old retiring in 2023 can expect to spend an average of $157,500 in health care and medical expenses throughout retirement.
HSAs have unique tax benefits for retirement savers: You’ll get a tax deduction when you contribute to an HSA and won’t be taxed on your withdrawals—as long as they’re used to pay for qualifying health care expenses.
Even death may not defeat your tax liability when you leave behind funds in a traditional IRA or 401(k). Non-spousal beneficiaries (like your adult children) have 10 years to distribute inherited IRA or 401(k) funds. These distributions are taxable, unless the money is in a Roth. If your estate’s value exceeds $12.92 million in 2023, your heirs may also owe federal and state estate taxes.
Ask your financial advisor for strategies that may help ease the tax burden for your heirs. You may want to convert some funds to a Roth or consider life insurance that helps to cover the cost of taxes.
Your retirement tax bill has many moving parts: 401(k) distributions, Roth and traditional IRA withdrawals, investment income, Social Security, Medicare surcharges, and more. An investment advisor can help you find ways to manage your funds to minimize your tax bill.
Although having too much income in retirement beats the opposite problem—having too little—tax considerations in retirement are serious, especially when you have substantial tax-deferred savings set aside. Whether you’re currently retired or doing some advance planning, now is a great time to get a handle on your post-retirement taxes. Finding out what your tax liability is likely to be, exploring ways to minimize your tax bill, and mapping out ways to pay can help make a retirement tax bomb less explosive.
For personalized advice and assistance with your mortgage needs, contact O1ne Mortgage at 213-732-3074. Our team of experts is here to help you navigate your financial future with confidence.