Ways to Save Yourself and Your 401(k) From Rising Taxes

Taxes will go up if provisions in the Tax Cuts and Jobs Act are allowed to sunset, but there’s still time to lock in lower taxes on your 401(k) savings.

A pair of scissors sits open on top of a calculator that displays the word tax.
(Image credit: Getty Images)

There are plenty of good reasons to save for retirement using your employer’s 401(k) or a similar tax-deferred plan. And if you’ve attended one or more new-employee sessions during your working life, you’ve probably heard all these reasons, including:

  • A 401(k) makes saving easy and almost automatic. You can pretty much set it and forget it.
  • Investing in the market can sometimes be seen as a better way to grow your money in the long term rather than using a CD or savings account. (Yes, even now, as interest rates have risen.)
  • If your employer matches a percentage of your contributions, you’re basically getting free money every month.
  • There’s the allure of the upfront tax break: The money you save to your 401(k) comes out of your paycheck before taxes are calculated. You won’t pay taxes on your contributions or earnings until you start making withdrawals in retirement.
  • Putting off paying those taxes until after you retire may make sense because you may be in a lower income tax bracket when you retire.

All of the above are powerful incentives for 401(k) savers — especially the last two. After all, if you can pay Uncle Sam now or pay him later, why not pay later if you expect your tax rate will be lower than it was while you were working?

Unfortunately, for some, that advice can be flawed.

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What many 401(k) savers may not realize is that, depending on the standard of living you hope to maintain, your taxable income won’t necessarily be reduced in retirement.

If you plan to travel, buy a boat, update your cars, renovate your home or help your grandkids pay for college, you’ll need income to cover those expenses. And as we’ve all seen in recent years, inflation can make life more expensive than planned.

Even if your income requirements are the same or less in retirement, some important tax deductions, exemptions and credits may go away as you age. Your children will probably be out of the house when you retire, and you may have your mortgage paid off. You also could find yourself in the more expensive single-filer tax status if you become widowed or divorced.

In addition to these things, the government requires that you start taking required minimum distributions (RMDs) on all your tax-deferred accounts. Depending on when you were born, RMDs will start at either age 73 or age 75. You will have to take these RMDs whether you want to or not, and you will have to pay income taxes on those withdrawals.

There may also be a chance that tax rates could go up in the future when provisions in the Tax Cuts and Jobs Act sunset. And your 401(k) may be especially vulnerable, because tax laws could change at any time. Which is why every time I meet Baby Boomers who confidently tell me they have $1 million or more in their 401(k) accounts, I wince. The reason is because they often aren’t thinking about the fact that they owe taxes on all that money.

Any withdrawals you take from your 401(k) in retirement will be taxed as ordinary income. If your withdrawals take you over certain income limits, you could also end up paying taxes on a larger portion of your Social Security benefits. It’s also possible you could owe an extra surcharge on your Medicare premiums. And finally, as if that weren’t enough, you may even have to pay higher taxes on capital gains.

So, what can you do about all of this?

Tax diversification can be key in retirement

Whether you are a retiree or a pre-retiree, tax laws could change that could affect your 401(k). But no matter what age you are, if you’re willing to pay taxes on some of that money now at potentially lower rates, you may still be able to minimize the tax hit that otherwise could be headed your way.

One thing to consider is a Roth retirement account. You probably have this option inside your 401(k) plan. The difference with a Roth 401(k) is that you pay taxes on the money now at your current tax rate, but you receive all the benefits on the back end. For example:

  • You can invest the money the exact same way you do in your 401(k), but now all growth on your money in the Roth is tax-free.
  • Qualified distributions from a Roth are tax-free.
  • You won’t have to deal with RMDs.

You may have missed out on the opportunity to contribute directly to a Roth — maybe because the option wasn’t offered by your employer through a Roth 401(k), or you’re a high earner who wasn’t eligible to make Roth contributions through a Roth IRA, or you simply didn’t understand the tax implications as you stashed all your savings in your traditional 401(k). However, you can still move some of your money through a Roth conversion. Or you might choose to move funds to a specially designed life insurance plan that works a lot like a Roth.

To be clear: You’ll have to pay taxes on any amount you withdraw or convert from your 401(k) in the year that you withdraw it. So, you’ll want to be cautious about how much money you move and what it might do to your tax bracket. (Older savers could find a good opportunity for doing a conversion after they retire but before they file for their Social Security benefits.)

Not having a tax plan for your retirement could put your money at risk for higher taxes in the future and cause issues you may not be aware of. However, timing taxes and IRS rules can make converting money to a Roth complicated, so it’s important to talk to a financial adviser about whether a conversion makes sense for you. A retirement professional can review your overall plan and develop a tax strategy that makes sense for your individual situation.

Kim Franke-Folstad contributed to this article.

Investment advisory products and services made available through AE Wealth Management, LLC (AEWM), a Registered Investment Advisor.

This is intended for informational purposes only. It is not intended to be used as the sole basis for financial decisions nor should it be construed as advice designed to meet the particular needs of an individual’s situation. Please remember that converting an employer plan account to a Roth IRA is a taxable event. Increased taxable income from the Roth IRA conversion may have several consequences. Be sure to consult with a qualified tax advisor before making any decisions regarding your IRA. Neither the firm nor its representatives may give tax or legal advice. Individuals should consult with a qualified professional for guidance before making any purchasing decisions. 1955748- 9/23

The appearances in Kiplinger were obtained through a public relations program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way. 2022737-10/23

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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Cole Czajkoski, Investment Adviser Representative
Freedom Financial Group

Cole Czajkoski is a retirement planner and Investment Adviser Representative with Freedom Financial Group. He graduated from Auburn University with a bachelor’s degree in marketing and holds a Series 65 securities license as well as life and health insurance licenses. Cole helps build retirement plans for new client families, and he assists with many of the behind-the-scenes functions at the firm.