Is Your Portfolio a Retirement Tax Bomb?

A word of caution to high earners and supersavers: Your gigantic 401(k) or conventional IRA, which you worked so hard to accumulate, might become a significant problem in retirement, resulting in enormous tax payments and Medicare surcharges. This is the pertinent information and what can be done about it.

Social Security and Your Expenses
Social Security and Your Expenses

According to conventional thinking, you should save as much as possible in tax-deferred retirement accounts to avoid current-year taxes and profit from tax-sheltered growth. That may still be sound counsel for many. Certainly, you should save as much as possible for retirement. For high-income savers, tax-deferred accounts may not be the best option. 

Required Minimum Distributions 

Tax-deferred savings have a tax burden that must be paid at some point, and the IRS will only permit tax evasion for a limited time. Withdrawals from accounts that delay taxes are taxed as regular income. Tax-deferred accounts provide penalty-free withdrawals beginning at age 59.5, but many investors delay withdrawals until they are obligated to take required minimum distributions (RMDs) at age 72.

Your tax burden increases over time due to your contributions, employer matching, and investment return. Eventually, this increased tax bill can snowball, but most retirees are unaware of the damage it might create.

Consider a 40-year-old couple who has accumulated $500,000 in pre-tax 401(k) accounts. This pair seemed to be on pace for a secure retirement. If they continue to contribute the maximum amount to their pre-tax 401(k) and each receives a $6,000 company match, their 401(k) accounts will have grown to an amazing $7,3 million by the time they retire at 65. 

They’re in terrific condition, correct?

The issue is that their pre-tax savings result in a rising tax obligation. The couple’s initial RMDs will exceed $435,000 at age 72 and are projected to reach $739,000 by age 80. Remember that RMDs are taxable like regular income. It is reasonable to believe they may encounter tax issues in retirement. 

The Medicare Means Test

The situation continues to deteriorate. High RMDs are likely to trigger Medicare means-testing surcharges (another term for needless taxes) in the form of increased premiums for Medicare Part B (doctor visits) and Part D (prescription medicines) upon retirement (prescription drugs). The couple, in our case, is expected to pay $1.5 million in Medicare surcharges based on their income to age 90.

Tax Burden for Heirs

The remaining assets in inherited tax-deferred accounts have never been taxed. Thus the tax burden goes to your heirs upon your passing. The 2019 SECURE Act removed the stretch IRA, which permitted heirs to extend RMDs from inherited IRAs over their estimated life expectancy. RMDs for inherited IRAs no longer exist under the new law, but the whole account must be exhausted within ten years, and each withdrawal is taxed as regular income at the heirs’ marginal tax rate. At age 90, our example couple is predicted to leave their descendants $16.1 million in tax-deferred assets (and the accompanying tax burden).

These are not tax difficulties that are exclusive to the ultra-wealthy. The couple in this scenario is upper-middle class and are just excellent savers who adhere to traditional thinking. But they need a strategy that balances the benefits of tax-deferred accounts today with the tax obligations this causes in retirement. Nonetheless, the vast majority of financial advisors and CPAs are only concerned with avoiding taxes in the current year without considering the long-term effects on retirement.

Developing Strategies to Neutralize a Tax Bomb

Typically, these problems need the deployment of a complex plan across several years. Here are some of the tactics that may help you neutralize some of the Tax Bomb

Transfer pre-tax savings to Roth accounts.

You will lose the tax deduction in the current year, but your future tax-free savings will grow exponentially. This method is also the simplest to apply. Many of my customers are unaware they have a Roth option in their 401(k)/403(b) or wrongly believe they cannot contribute to one due to income constraints. However, this is not the case; thus, you should determine if your plan includes a Roth option.

HSA

Moreover, if you have a high-deductible health plan, you should donate the maximum amount ($7,300 in 2022 if married) to the related health savings account (HSA). Pay for medical bills out-of-pocket (not from the HSA account) and actively invest in the account so it can grow to pay medical expenses in retirement. An HSA is one of the few accounts where contributions are tax-deductible, and withdrawals are tax-free (for medical expenses).

Capitalize on Asset Location

Using this method, investors allocate various asset types to distinct tax buckets (taxable, pre-tax, tax-free). By way of illustration, asset placement often places assets with low expected returns, such as bonds, in tax-deferred accounts and investments with high expected returns, such as small-cap or developing market stocks, in tax-free Roth accounts. Your tax-deferred accounts will grow slower (and so will your future tax burden), while your tax-free funds will increase the highest.

Few investors are familiar with asset placement, which can be difficult to apply, yet it can dramatically lower your retirement taxes and improve your wealth after taxes.

Think about Roth Conversions

A Roth conversion entails moving funds from a tax-deferred account to a tax-free Roth account. In most cases, the transfer amount is fully taxed as regular income. This is a sensible technique to explore during low-income years, particularly for early retirees in their 50s and 60s who may have several years to convert assets before Medicare surcharges, Social Security income, and RMDs begin. Many people convert to Roth annually before retirement.

Saving for retirement is a wonderful idea, but how you save your money might be just as essential as the amount you save. Occasionally, conventional wisdom can be misleading.

You May Also Like