Are you among the growing ranks of “401(k) millionaires”?
The number of customers with $1 million or more in a Fidelity 401(k) rose to almost half a million as of June 30, according to a recent Retirement Analysis report from Fidelity. That’s an all-time high — and a great incentive for those who are still saving diligently for their future retirement. It’s good to know it can be done, especially considering that Northwestern Mutual's 2024 Planning & Progress Study found Americans now believe they’ll need $1.46 million to retire comfortably.
But this 401(k) trend is also an important reminder that if you don’t have a plan to minimize taxes, it’s time to get to work. Because if you have (or hope to amass) $1 million in a 401(k), you’re likely headed for some hefty tax bills when you begin withdrawing funds in retirement.
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Wait, how did that happen?
Remember when you first signed up for a 401(k) at work, and somebody (maybe the nice person in HR, your dad or even a financial professional) told you that deferring those taxes for years was OK, because you’d almost certainly be in a lower tax bracket in retirement?
Well, that might be true for those who haven’t saved much and expect to live mostly on their Social Security benefits. But without some proactive tax planning, it likely won’t be the case for many of the 401(k) millionaires.
Those folks have done a wonderful job of saving and investing their money. But often they’ve forgotten that Uncle Sam has been waiting — perhaps for decades — to get his share of their contributions and earnings. Depending on the tax bracket these retirees land in each year, the IRS’ share could be quite a chunk. Those who live in states with income taxes should consider that cost as well. For many, taxes will be their largest expense in retirement. And they won’t see it coming.
That’s because so many people, even these smart, steadfast savers, still tend to focus on minimizing what they’ll have to pay each year when it’s time to prepare their taxes, instead of reducing their tax burden over the long haul.
A micro vs a macro view
This micro, small-lens view may seem like the best way to proceed when workers are young. They’re stashing away money for the future, after all, and saving on taxes in the process. So, how could it go wrong?
Let me count the blind spots.
1. Tax rates are likely to be higher in the future.
Withdrawals from retirement accounts are taxed as ordinary income, which means your tax bracket and tax rates in retirement will matter a great deal. We already know certain parts of the 2017 Tax Cuts and Jobs Act (TCJA), including provisions that reduced individual tax rates and doubled the standard deduction, are scheduled to expire on December 31, 2025.
But it’s unlikely that will be the end of it. At some point, most experts seem to agree, the government is going to have to find a way to deal with the growing U.S. budget deficit. Many expect there will be changes in how — and how much — retirement savings and other investments are taxed.
2. 401(k) withdrawals can impact how certain federal benefits are taxed.
Many people aren’t aware that if they receive significant income from a pension, job and/or tax-deferred retirement accounts, they’ll likely be taxed on a portion (up to 85%) of the Social Security benefits they’re paid that year.
Plus: The federal government also adds an extra charge, or “surtax,” known as the income-related monthly adjustment amount (IRMAA), to your monthly Medicare premium if your income is above a certain threshold.
3. 401(k) withdrawals aren’t optional.
When you turn 73 (or 75 if you were born in 1960 or later), you must take what is known as required minimum distributions (RMDs) each year based on your life expectancy as calculated by the IRS. It doesn’t matter if you don’t need the money or that you might want to save it for your kids. You must take the required amount or face IRS penalties.
4. Your tax filing status may change in retirement.
Many couples forget that when one spouse passes away, the surviving spouse becomes a single filer and often faces a much steeper tax bill. That’s because single filers get a smaller standard deduction on their income tax return than joint filers do. With the same or similar amount of taxable income, there’s a good chance the surviving spouse will land in a higher tax bracket and pay a higher tax rate.
5. Your heirs could get stuck paying higher taxes.
Though there are exceptions, most 401(k) beneficiaries are now required to draw down inherited IRAs and 401(k)s and pay the taxes on that money within 10 years of the original owner’s death. If you or your surviving spouse leave a hefty 401(k) account to your children as part of your estate, it could end up pushing them into a higher tax bracket during their peak earning years.
What can you do?
Pull back and look at the bigger picture. Think macro instead of micro. If you haven’t already, you may want to get some help to avoid what could be an expensive tax headache down the road for you and your loved ones.
According to this year’s Planning and Progress Study, only 3 in 10 Americans have a plan to minimize the taxes on their retirement savings. Though most people I talk to believe tax rates are going to go up, few are doing anything to prepare.
The esteemed Judge Learned Hand once said, “In America, there are two tax systems: one for the informed and one for the uninformed. Both are legal.” Be informed.
Talk to a professional about how to manage your investments in a tax-efficient manner — not just this year but every year. Ask about the benefits of moving some of your money to a Roth account, which could lower your tax burden in retirement and make things easier for your beneficiaries. Don’t hesitate to inquire about other tax-saving strategies that might work for you and your family.
Kim Franke-Folstad contributed to this report.
The appearances in Kiplinger were obtained through a PR 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.
Investment advisory services offered through Graylark Financial, LLC, a Registered Investment Adviser with the State of Colorado. Content on this site is for informational purposes only. Opinions expressed herein are subject to change without notice. Graylark Financial, LLC has exercised all reasonable professional care in preparing this information. Some information may have been obtained from third-party sources we believe to be reliable; however, Graylark Financial, LLC has not independently verified, or attested to, the accuracy or authenticity of the information. Nothing contained herein should be construed or relied upon as investment, legal, or tax advice. An investor should consult with their financial professional before making any investment decisions.
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