Good savers, beware. The money you're stuffing into your 401(k) and other retirement accounts has to be withdrawn someday. If you're not strategic about how you save, you could face unnecessarily high tax bills and inflated Medicare premiums in retirement — plus, you could be saddling your heirs with higher taxes.
The earlier you start defusing this potential tax bomb, the better. But even people in their 60s or early 70s may have opportunities to lessen the potential damage — as long as they act swiftly.
"You do not want to be in the position as some clients are that all of their funds are inside of a tax-deferred account," says Pam Ladd, senior manager of personal financial planning at the Association of International Certified Professional Accountants.
TAX BREAKS NOW COULD CAUSE TAX PAIN LATER
Most retirement accounts offer a tax break when you put money in. Eventually, though, Uncle Sam wants to get paid. Required minimum distributions, or RMDs, typically must start at a certain age — currently 73 and rising to 75 for people born in 1960 and later. Retirement fund withdrawals usually are subject to regular income tax rates.
That's still a good deal for most retirees because their tax bracket will be lower in retirement than when they were working. But people who don't need to spend down their savings early in retirement may find that required minimum distributions push them into higher tax brackets.
"People are working longer, saving longer and accruing more within their retirement account, and as a result, their RMDs in many cases can be more than they earned while they were still working," says Colleen Carcone, director of wealth planning strategies at financial services firm TIAA.
Delaying the start of required minimum distributions can make matters worse because you're required to take out larger percentages of your balances as you age, Carcone says. Meanwhile, your accounts have more time to grow.
SAVERS COULD PAY MORE FOR MEDICARE — AND COST THEIR KIDS
Higher incomes can mean higher Medicare premiums as well, thanks to the income-related monthly adjustment amount, or IRMAA , which is based on your income from two years ago.
Most people will pay $164.90 per month this year for Medicare Part B , which pays for doctor visits. But Medicare recipients whose 2021 modified adjusted gross income exceeded $97,000 (for single filers) or $194,000 (for married couples) pay $230.80 to $560.50 monthly, depending on their income. The IRMAA surcharge for Medicare Part D coverage, which pays for prescriptions, can add $12.20 to $76.40 per month, depending on income. A couple with a $250,000 income in 2021 could end up paying surcharges totaling $4,711.20 for their Medicare coverage in 2023.
The tax toll may not stop there. If you leave retirement money to your kids or anyone other than your spouse, they're typically required to empty the accounts by the end of the 10th year following the year of your death . Required minimum distributions from inherited retirement accounts could push your heirs into higher tax brackets or cause other financial complications.
HOW TO DEFUSE THE TAX BOMB
Predicting who will face a future tax bomb can be tough, particularly if you're decades away from retirement. But most people would be smart to have at least some money in accounts that aren't subject to taxes or required minimum distributions — such as Roth IRAs , Roth 401(k) plans and Roth 403(b) plans — to better control their tax bills in retirement, Ladd says.
With Roths, contributions aren't deductible, but withdrawals in retirement are tax-free. You aren't required to tap a Roth IRA during your lifetime, and legislation passed at the end of last year removes required minimum distributions from workplace Roths starting in 2024. Non-spouse heirs are required to drain the account within 10 years, just as with regular retirement plans , but the withdrawals aren't taxable.
The ability to contribute to a Roth IRA phases out at modified adjusted gross incomes from $138,000 to $153,000 for singles and from $218,000 to $228,000 for married couples. But many 401(k) plans and 403(b) plans now offer Roth options, and these workplace plans don't have income limits, Carcone notes. Another option is to convert existing pretax retirement money into a Roth account, which typically requires paying income taxes on the conversion.
Paying taxes now versus later can make sense when you're young and expect to be in a higher tax bracket in retirement, tax pros say. But some older people may find a conversion can help lessen the tax impact of future required minimum distributions, Carcone says. Late-in-life conversions should be handled carefully because like required minimum distributions, they can end up inflating your tax bracket and Medicare premiums, she says.
Given the financial stakes, Carcone recommends consulting a tax pro or financial planner who can provide individualized advice.
"It's never too early to start working with a financial adviser and start getting that roadmap planned out," Carcone says.