Will you be in a lower tax bracket during retirement? Some retirees who expect that break when their working years are over often get an unwelcome surprise.
Retirement accounts, such as 401(k)s and IRAs, are often sold on the premise that you defer paying your income taxes while you’re working because you’ll be in a lower tax bracket when you take money out in retirement.
But as a financial adviser, I rarely see someone in a lower tax bracket in retirement. In fact, growth in tax-deferred accounts can significantly increase your tax liability after you’re done working.
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Those who have built a big nest egg with savings in a 401(k) or IRA will have large required minimum distributions (RMDs) and the resulting tax burden when they withdraw those funds.
RMDs start at age 73 (or 75 if you’re born in 1960 or later) and force retirees to withdraw funds and incur taxes. If RMDs alone don’t put them in a higher bracket, those distributions combined with Social Security and pensions possibly could.
People often don’t realize that most of the money they’ve saved to fund their retirement lifestyle is typically in tax-deferred accounts. When they start pulling out that money in retirement, or when forced to take it out in RMDs, it adds to their taxable income.
It also impacts how much of their Social Security benefit is taxable, potentially leads to higher Medicare premiums, and often pushes them into higher and higher tax brackets.
But distributions from Roth IRA accounts aren’t taxable, nor are they subject to RMDs. Those are important things to think about when you plan for retirement and consider tax implications.
Getting ahead of a potential tax problem
Tax-deferred contributions during your work life feel like a tax deduction, but they only put taxes off. This pay-it-later concept is perpetuated by conventional financial advice, which emphasizes maxing out 401(k)s or IRAs.
If someone made $100,000 last year and put $10,000 in their 401(k), they’re paying taxes on $90,000. But when they’re forced to start taking RMDs, it can be a compounding tax problem.
For example, if you have $100,000 now and it grows at 7%* a year for the next 10 years, it will have doubled in value to $200,000. That’s the amount you’ll have to pay income taxes on when you start withdrawing.
Take someone who is 60 and has $1 million in tax-deferred accounts. Let’s assume their money will grow at 5.5% per year and eventually add up to $2.1 million when they’re 75.*
Let’s also say they’ll have a 25% tax rate that won’t go up in the future and they start taking RMDs at age 75. We have to consider the RMD withdrawal rate factor, where we take the account value and divide it by the factor for the year. (The individual’s withdrawal rate factor is 24.6 this year.)
That gives them $86,000 they’re forced to take out as an RMD at age 75, which will put them in a higher tax bracket.
Taxes on RMDs add up fast
Now go further down the road. The person passes away at 90. In the above scenario, they will have paid $505,000 in taxes on the RMDs they were forced to take out over that 15-year period.
RMD withdrawal rates generally increase each year as you age because the life expectancy factor used in the calculation decreases, meaning a larger percentage of your retirement account balance needs to be withdrawn annually as you get older.
And often when people are forced to take out that money, they don’t necessarily need all of it to cover their expenses. They can take some of that money, put it in another account and reinvest it, but they must pay taxes on the growth of that money.
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What’s more, most people fail to realize that whoever inherits their IRA or 401(k) account will also inherit the tax bill. At age 90, the tax bill to their beneficiary is an additional $507,000.
By converting tax-deferred accounts to a Roth IRA, you enjoy tax-free growth, avoid taxes on withdrawals, avoid RMDs, and may be able to prevent your heirs from having to pay taxes on the Roth IRA funds you left them.
Planning Roth conversions and contributions
You pay taxes on Roth conversions each year you make them. While there are Roth IRA contribution and income limits, there is no limit for the amount you can convert to a Roth from a traditional IRA or 401(k).
Three things to keep in mind:
- It may benefit you to contribute to Roth accounts if your employer offers the option in a 401(k)
- You may want to start Roth conversions as early as possible, especially before retirement or before turning 63, to minimize Medicare premium surcharges
- To reduce the tax impact and optimize the conversions, make the conversions over several years so you can stay within favorable tax brackets
Making Roth conversions from your tax-deferred accounts can make sense unless you know for certain you will be in a lower tax rate in retirement. A Roth IRA can enable you to maximize your hard-earned savings and save thousands in taxes.
* All examples of returns are hypothetical and should not be used to guide financial decisions.
Dan Dunkin contributed to this article.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
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