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Understanding and Managing the Retirement Tax Bomb

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’ve set aside millions in tax-deferred 401(k) plans and traditional individual retirement accounts (IRAs)?

Even successful retirement savers can face significant 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.

What Is a Retirement Tax Bomb?

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.

Although every situation is unique, here are some common components of a retirement tax bomb:

• Taxable distributions that add up: Distributions, including required minimum distributions (RMDs) from your 401(k) and traditional IRA accounts, are fully taxable. If you have large or multiple accounts, your combined distributions may be sizable.
• RMDs that rise over time: RMDs increase year-over-year as your life expectancy decreases.
• Other taxable income: Additional sources of taxable income include non-retirement investment income, business earnings, and taxable Social Security benefits.
• Income-related Medicare surcharges: A high income may trigger higher Medicare premiums, adding to your monthly expenses.

How Are 401(k) Withdrawals Taxed?

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 during your working years. You’re subject to the same marginal tax rates and tax brackets, but a few new rules come into play.

Estimating RMDs

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. For example, at 73, the IRS estimates your remaining life expectancy at 26.5 years. To estimate your RMD, divide your retirement account balance by your life expectancy.

Failing to withdraw the required minimum could result in up to a 50% penalty from the IRS.

Taking Stock of Additional Income

Unless your retirement accounts are your only source of retirement income, your tax liability doesn’t stop there. Your taxable income may also include:

• Investment income—capital gains, dividends, and interest
• Earnings or self-employment income
• Business income
• Gains from the sale of property
• Up to 85% of your Social Security benefits, if your income exceeds $34,000 as a single filer or $44,000 as a married couple

Factoring in Medicare Costs

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.

How to Minimize Your Taxes in Retirement

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:

• Start Saving in a Roth: 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.
• Consider Converting to a Roth: 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.
• Save Money in a Health Savings Account: 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, these expenses can be substantial in retirement.
• Think About Your Beneficiaries: 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.

Meet With a Retirement Planner

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.

The Bottom Line

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.

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