Conventional wisdom suggests that to minimize current-year taxes and benefit from tax-protected growth, you should save whatever you can into tax-deferred retirement accounts. That may still be good advice for many. Of course, you should save whatever you can for retirement. However, for high earners who save heavily, saving in tax-advantaged accounts may prove to be bad advice. Why?
This article is part one of a seven part series. Today’s article gives an overview of the problems and possible solutions.
Snowballing Minimum Distributions Required
Tax-deferred saving comes with an associated tax liability that you will eventually have to pay. The IRS will only let you avoid taxes for so long. Withdrawals from tax-advantaged accounts are taxed as ordinary income. You can withdraw from tax-deferred accounts from age 59½ with no penalty, but many investors wait to withdraw until age 72, when they are required to take minimum required distributions (RMDs).
Subscribe to something Kiplinger’s personal finances
Be a smarter, better informed investor.
Save up to 74%
Your tax liability continues to grow over time through contributions, employer grants and your return on investment. Eventually, that growing tax burden may snowball, but most investors have no idea the damage they can do in retirement.
For example, imagine a couple aged 40 who together have saved $500,000 in pre-tax 401(k) accounts. Presumably, this couple is well on their way to a safe retirement. If they continue to max out pre-tax 401(k) contributions and each receive a $6,000 employer contribution, their 401(k) accounts will have grown to an impressive $7.3 million by the time they retire at age 65. You’re in great shape, aren’t you?
The problem is that their pre-tax savings represent a growing tax burden. The couple’s first RMDs will top $435,000 by age 72 and will likely increase as the couple ages, reaching $739,000 by age 80.
Remember that RMDs are taxed as ordinary income. Do you think you might have a tax problem in retirement?
Medicare means test
The story doesn’t end here, it gets worse. High RMDs are likely to trigger Medicare drug review surcharges (avoidable taxes by another name) in retirement in the form of higher Medicare Part B (doctor visits) and Part D (prescription drugs) premiums. The couple in our example above is expected to pay $1.5 million in Medicare Mean Test supplements by age 90.
Tax burden for heirs
At the time of death, assets remaining in tax-advantaged inheritance accounts have never been taxed, so the tax liability passes to your heirs. The SECURE Act of 2019 abolished the stretch IRA, which allowed heirs to extend RMDs from inherited IRAs beyond their expected life expectancy. Under the new law, there are no longer any RMDs for inherited IRAs, but the entire account must be used up within 10 years, and any withdrawal will be taxed as ordinary income at the heirs’ marginal tax rate. Our example couple is expected to leave $16.1 million in tax-deferred assets (and associated tax liability) by age 90.
These are not tax issues that only affect the super-rich. The couple in this example is upper-middle class and just good savers doing exactly what conventional wisdom suggests. But they clearly need a plan that balances the benefits of saving in tax-deferred accounts today against the tax debt it creates for them in retirement. Yet most financial advisors and CPAs focus almost exclusively on minimizing taxes this year, with little regard for the long-term implications of retirement.
Planning strategies to defuse a tax bomb
Solving these problems usually requires the implementation of a multi-pronged strategy over many years. Some of the strategies I use with my clients include the following:
Move savings from pre-tax to Roth accounts
You’ll lose the tax deduction this year, but your tax-free savings will be thrown into the future in a good way. This is also the easiest strategy to implement. Many of my clients are unaware that they have a Roth option in their 401(k)/403(b) or mistakenly believe they can’t contribute to one due to income limits, but that’s not true, so find out , whether your plan exists offers a Roth option.
If you have a high-deductible health insurance plan, also pay the maximum amount ($7,300 in 2022 if you’re married) into the associated Health Savings Account (HSA). Pay your medical expenses out of pocket (not from the HSA account) and aggressively invest the account to grow to cover medical expenses in retirement. An HSA is one of the few accounts where you get a tax deduction on contributions and withdraw the money tax-free (for medical expenses).
Use asset location
With this strategy, investors place different asset classes in different tax brackets (taxable, pre-tax, tax-free). For example, Asset Location places investments with low expected returns, such as bonds, in tax-deferred accounts and investments with high expected returns, such as bonds. B. Low value stocks or stocks from emerging markets, in tax-free Roth accounts. The net effect is that your tax-deferred accounts will grow more slowly (and therefore your future tax liability), while your tax-exempt accounts will grow the most.
Few investors have even heard of asset location and it can be difficult to implement, but it can significantly reduce your taxes in retirement and increase your after-tax wealth.
Consider Roth conversions
A Roth conversion transfers money from an existing tax-deferred account to a tax-exempt Roth account. The transfer amount is usually fully taxable as ordinary income. This is a good strategy to consider in low-income years, especially for people retiring in their early 50s and early 60s who may have several years to transition before Medicare means surcharges, Social Security income and RMDs are checked. Many of my customers carry out annual Roth conversions in early retirement.
Saving for retirement is a good thing, but how you save your money can be just as important as how much you save. Sometimes conventional wisdom can lead you astray.
In the coming weeks, I’ll be releasing six more articles on pension tax bombs that will delve deeper into each of these problems and solutions through a case study.
This article was written by and represents our contributing consultant, not the Kiplinger editorial board. You can view advisor filings with the SEC or with FINRA.