Traditional 401(k)s and individual retirement accounts (IRAs) allow you to avoid paying income taxes now by contributing pre-tax dollars to your accounts and building your nest egg.
However, there are tax considerations that retirees must make — and these accounts can be expensive if those considerations are ignored. You can end up with high tax liabilities deep into your retirement if you are not careful. Here’s what you need to know.
Why a pre-tax account can be a tax trap
A pre-tax account allows you to reduce your current taxable income and accumulate gains on your tax-deferred investments, but you must ultimately pay taxes when you withdraw from the account. Although you can delay withdrawals from 401(k)s and IRAs in retirement, required minimum distributions (RMDs) usually kick in when you turn 73.
RMDs are based on a percentage of your portfolio, and can be higher for some investors. For example, if you’re required to withdraw 4% from a $5 million portfolio, you end up with a $200,000 RMD — and that’s $200,000 more than ordinary income you need to pay taxes on. Higher taxable income can increase Medicare premiums and increase how much of your Social Security benefits are taxable. Roth retirement accounts are not subject to RMDs, and you don’t have to worry about taxes on withdrawals or as you contribute after-tax dollars to those accounts.
The value of having different tax buckets
Putting all of your retirement funds into a traditional 401(k) or traditional IRA leaves you vulnerable to high RMDs and expensive tax liabilities deep into retirement. However, if you spread your nest egg across tax-adjusted accounts, you can reduce the hit and spread it over many years.
You can also invest in Roth IRAs and Roth 401(k) plans that don’t require you to pay taxes on withdrawals. This is funded through after-tax donations. Another option is to invest in tax-deductible brokerage accounts. You pay taxes on these account contributions and the money in them is not protected from taxes on capital gains or dividends. However, a taxable brokerage account is accessible at any time without the 10% early withdrawal penalty you may face when withdrawing from other accounts.
How savers can correct the imbalance before retirement
If your savings are mostly invested in pre-tax retirement accounts, you may want to diversify. Future contributions can be split between traditional accounts and Roth retirement accounts, for example. You may be able to use a late Roth IRA conversion to fund a Roth account even if your income is too high to qualify for direct Roth IRA contributions.
This plan involves moving some of your traditional 401(k) and IRA money into a Roth IRA. Moving the money gradually each year can spread the tax hit over those years. However, you may want to aggressively move money from a traditional plan to a Roth IRA during low-income years, because you may end up with a lower tax rate.
You should review your strategy every year, especially after job changes, income increases and other major changes in your financial situation. Giving yourself more tax options now often makes it easier to keep a higher percentage of your nest egg if you need to withdraw in retirement.
