A warning to high earners and super savers: That massive 401(k) or traditional IRA that you worked so hard to build may become a big problem in retirement, resulting in huge tax bills and Medicare surcharges. Here’s what you need to know, and what you can do about it.
Conventional wisdom suggests you should save everything you can in tax-deferred retirement accounts to minimize taxes in the current year and benefit from tax-sheltered growth. For many, that may still be good advice. Certainly, you should be saving everything you can for retirement. However, for high earners who save a lot, saving in tax-deferred accounts may prove to be bad advice. Why?
Tax-deferred savings have an associated tax liability that you will have to pay someday. The IRS will only let you avoid taxes for so long. Withdrawals from tax-deferred accounts are taxed as ordinary income. You may take withdrawals without penalty from tax-deferred accounts starting at age 59½, but many investors wait to make withdrawals until they are required to take required minimum distributions at age 72.
Your tax liability continues to grow over time through contributions, employer matches and your investment return. Eventually, this growing tax liability can snowball, but most investors have no idea of the damage it can cause in retirement.
For example, imagine a couple aged 40 who have saved $250,000 combined in pre-tax 401(k) accounts. Presumably, this couple is tracking well for a secure retirement. If they keep maxing out pre-tax 401(k) contributions and each receive a $6,000 employer match, their 401(k) accounts will have grown to an impressive $3.6 million by retirement at age 65. They’re in great shape, right?
The problem is that their pre-tax savings represents a growing tax liability. The couple’s first RMDs (required minimum distributions) will exceed $200,000 at age 72 and are likely to grow as the couple ages, reaching $300,000 at age 80.
Recall that RMDs are taxed as ordinary income. Do you think they may have a tax problem in retirement?
The story doesn’t end there, it gets worse. High RMDs are likely to trigger Medicare means testing (avoidable taxes by a different name) during retirement in the form of higher premiums on Medicare Part B (doctor visits) and Part D (prescription drugs). The couple in our example above is projected to pay large extra charges in Medicare means testing surcharges through age 90.
At death, assets remaining in inherited tax-deferred accounts have never been taxed, so the tax liability passes to your heirs. The 2019 Secure Act eliminated stretch IRA’s, which allowed heirs to stretch out RMDs from inherited IRAs over their projected life expectancy. Under the new law, RMDs for inherited IRAs no longer exist, but the entire account must be depleted within 10 years, and every withdrawal is taxed as ordinary income at the heirs’ marginal tax rate. Our example couple is projected to leave millions of of tax-deferred assets (and the associated tax liability) to their heirs at age 90.
These are not tax issues unique to the super-rich. The couple in this example is upper-middle class, and are simply good savers doing exactly what conventional wisdom has suggested they do. But they clearly need a plan that balances the benefits today of saving in tax-deferred accounts against the tax liabilities this creates for them in retirement. Yet most financial advisers and CPAs focus almost exclusively on minimizing taxes in the current year, without regard to the long-term consequences in retirement.
The solution to these issues typically requires implementation of a multifaceted strategy over many years. Some of the strategies I suggest with my clients include the following:
- Contribute to a Roth IRA. You’ll lose the tax deduction in the current year, but your tax-free savings will snowball into the future in a good way. This is also the easiest strategy to implement. Many people aren’t aware they have a Roth option in their 401(k)/403(b) or mistakenly think they can’t contribute to one because of income limits, but that’s not true, so find out if your plan offers a Roth option.
- In addition, if you have a high-deductible medical plan, contribute the maximum amount ($7,300 in 2022 if married) to the associated health savings account. Pay your medical expenses out of pocket (not from the HSA account) and invest the account aggressively so it grows to cover medical expenses in retirement. An HSA is one of the few accounts where you get a tax deduction on contributions and money is tax-free when withdrawn (for medical expenses).
- Take Advantage of Asset Location and place different asset classes into different tax buckets (taxable, pre-tax, tax-free). As an example, Asset Location typically places investments with low expected returns, such as bonds, into tax-deferred accounts and investments with high expected returns, such as small value or emerging market stocks, into tax-free Roth accounts. The net effect is that your tax-deferred accounts will grow more slowly (and so will your future tax liability), while your tax-free accounts will grow the most.
- Consider Roth Conversion and transfer money from an existing tax-deferred account to a tax-free Roth account. The transfer amount usually is fully taxable as ordinary income. This is a good strategy to consider in low-income years, especially for people who retire early in their 50s and early 60s who may have several years to do conversions before Medicare means testing surcharge, social security and RMDs kick in. conversions early in the trick is to do Roth conversions in the early years of retirement.
Saving for retirement is a good thing, but how you choose to save your money can be just as important as how much you save. Sometimes conventional wisdom can lead you astray.