The Investment Account Mistake That Can Increase Taxes in Retirement
Traditional 401(k)s and individual retirement accounts (IRAs) allow you to put off paying income taxes now by contributing pre-tax dollars to your accounts and building your nest egg.
However, there are tax considerations retirees need to make — and these accounts can be costly if those considerations are ignored. You can suddenly end up with high tax bills deep into your retirement if you aren’t careful. Here’s what to know.
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Why a pre-tax account can become a tax trap
A pre-tax account lets you lower your current taxable income and accumulate gains on your investments tax-deferred, but you must eventually pay taxes when you withdraw from that account. While you can delay withdrawals on 401(k)s and IRAs into your retirement, required minimum distributions (RMDs) typically start to apply when you turn age 73.
RMDs are based on a percentage of your portfolio, and they can be high for some investors. For instance, if you are required to withdraw 4% from a $5 million portfolio, you end up with $200,000 RMD — and that’s $200,000 more in ordinary income you’re required to pay taxes on. A higher taxable income can hike Medicare premiums and increase how much your Social Security benefits get taxed. Roth retirement accounts are not subject to RMDs, and you don’t have to worry about taxes on withdrawals either since you contribute post-tax dollars to those accounts.
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The value of having different tax buckets
Putting all of your retirement funds into a traditional 401(k) or a traditional IRA leaves you vulnerable to high RMDs and expensive tax bills deep into retirement. However, if you spread your nest egg across accounts with different tax structures, you can minimize the hit and spread it out over many years.
You can also invest in Roth IRAs and Roth 401(k) plans that don’t require you to pay taxes when you withdraw. These are funded with after-tax contributions. Another option is to invest via taxable brokerage accounts. You pay taxes on these account contributions and the money in them isn’t shielded from taxes on capital gains or dividends. However, a taxable brokerage account is accessible at any time without a 10% penalty fee for early withdrawals that you may face when withdrawing from other accounts.
How savers can fix the imbalance before retirement
If your savings are heavily invested via pre-tax retirement accounts, you may want to diversify. Future contributions can be split between traditional and Roth retirement accounts, for example. You may be able to use a backdoor 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 funds into a Roth IRA. Gradually moving the money each year can spread the tax hit over those years. However, you may want to more aggressively move money from a traditional plan to a Roth IRA during lower-income years, since you could end up with a lower tax rate.
You should check in with your strategy each year, especially after job changes, income increases and other major changes to your financial situation. Giving yourself more tax choices now often makes it easier to keep a higher percentage of your nest egg when you need to make withdrawals in retirement.