How To Defuse a Retirement Tax Bomb To Keep More of Your Money

Shot of a senior man looking stressed while doing the household finances on a laptop in his kitchen.
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High earners who spent their careers diligently saving should be on the path to living large in retirement. But the wrong kind of account can harbor an unpleasant surprise that often goes unnoticed until it’s too late.

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Most people should save as much as possible in tax-deferred retirement accounts like IRAs and 401(k)s, but no one can avoid the taxman forever. Eventually, the IRS will collect its share of all that money you socked away into your pre-tax retirement fund. Between your contributions, employer matches and investment gains, supersized tax-deferred retirement accounts can become a ticking retirement tax bomb just waiting to explode.

Here’s how to defuse it before it detonates.

Tick Tick Tick … the RMDs Are Set To Explode

Most people can start withdrawing money from tax-deferred accounts at 59 1/2 without paying an early withdrawal penalty. At age 72, though, required minimum distributions (RMDs) force everyone to start drawing down their accounts, whether they want to or not. 

The IRS gets its due by taxing those withdrawals as ordinary income. For the biggest nest eggs, RMDs can create massive tax liabilities that grow larger with age — every year, a new tax bomb explodes. 

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Kiplinger gives the following example: A couple saves $500,000 in combined pre-tax 401(k) accounts by age 40 — they’re on the fast track to retirement freedom. They continue to max out and receive a $6,000 employer match until they’ve saved $7.3 million by age 65. So they’re on easy street, right?

Not so fast.

Their RMDs will force them to withdraw more than $435,000 when they turn 72, and since RMDs snowball over time, it grows to $739,000 at age 80. Taxed as ordinary income in 2021, that year-80 RMD would have dropped a $300,000 tax bomb in their laps.

That’s not the only surprise that RMDs have in store. High RMDs trigger Medicare means-testing surcharges — this couple would pay $1.5 million in avoidable Medicare taxes by age 90. On top of that, RMDs follow you after death, so your tax liability passes on to heirs who inherit any tax-deferred savings.

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Roth Saves the Day — an After-Tax Transfer Can Defuse the Bomb 

Tax bombs explode when you stumble into retirement with mountains of pre-tax savings. In most cases, you can wiggle out of the predicament fairly easily by transferring your untaxed nest egg to an after-tax Roth vehicle. 

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Roth IRAs have income limits, but Roth 401(k)s and Roth 403bs do not, so those are better bets for high earners whose employers offer them.

According to Fidelity, there are plenty of benefits no matter which Roth vehicle you choose:

  • You’ll owe taxes on the amount you convert, but you’ll be able to make tax-free withdrawals throughout your retirement. 
  • Roth accounts do not have RMDs.
  • Withdrawals are tax-free for both the original owner and any heirs, which lets Roth accounts double as convenient estate-planning vehicles.

Fidelity thinks that now might be a great time to convert to Roth. First, stocks are way down, so you might be able to transfer more of your holdings with a lower tax obligation than you could have when the markets were hot. Also, today’s rising deficits make it likely that taxes will be higher in the future. 

What’s the Difference in Retirement and Beyond? 

By converting an overstuffed IRA or 401(k) to a Roth account and settling up with the IRS now, you shield all remaining holdings and all their gains for life. For context, look back at the couple from the Kiplinger example:

  • Now, only their employer match carries a tax liability.
  • Their pre-tax savings drop by about half from $7.3 million to $3.6 million.
  • Their first-year RMD at 72 drops by about half from $435,820 to $215,281.
  • Their lifetime RMDs through age 90 drop by about half from $15.6 million to $7.7 million.
  • Their tax-free savings grow from $3.6 million at 65 to $20.4 million at 90.
  • Both their Medicare surcharges and the tax obligation passed to their heirs drop by about half. 
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HSAs Can Defuse Tax Bombs, Too

Roth isn’t the only game in town — health savings accounts can serve a similar purpose.

No other account — not even a Roth vehicle — is as versatile as a health savings account. That’s because HSAs are the only accounts that offer tax deductions for contributions like 401(k)s and IRAs, as well as the tax-free withdrawals — for qualified medical expenses — of Roth accounts. Also, HSAs have no income limits.

If you have a high-deductible insurance plan and you’re not enrolled in Medicare, you can contribute to one and invest your savings. HSAs don’t have to sit in cash. 

The smart bet is to shift contributions to your HSA as soon as you max out your 401(k)’s employer match to reduce the amount of pre-tax money that follows you into retirement.  

Then, you can draw from your HSA to cover the $315,000 that Fidelity says the average couple spends on healthcare in retirement. If you need to tap into it for qualifying medical expenses before you retire, you can do so tax-free.

The rules are tricky. For example, you must first convert a 401(k) to an IRA because the IRS doesn’t allow 401(k)-to-HSA direct rollovers. So, work with a professional and get it right the first time — you can only convert an IRA to an HSA once in your lifetime.

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About the Author

Andrew Lisa has been writing professionally since 2001. An award-winning writer, Andrew was formerly one of the youngest nationally distributed columnists for the largest newspaper syndicate in the country, the Gannett News Service. He worked as the business section editor for amNewYork, the most widely distributed newspaper in Manhattan, and worked as a copy editor for TheStreet.com, a financial publication in the heart of Wall Street's investment community in New York City.
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