Editor’s note: This is part two of a seven-part series on retirement tax bombs. It dives more deeply into how required minimum distributions (RMDs) from tax-deferred savings can become a snowballing tax liability in retirement. If you missed the introductory article, you may find it helpful to start here.
For the remaining articles in this series, I’ll use a case study of a couple aged 40 who has saved $500,000 combined in pre-tax retirement accounts. Presumably, this couple is tracking well for a secure retirement. After maxing out their retirement plan contributions, they may not have much cash flow left over and may feel like they’re barely making ends meet. I meet couples like this all time. They aren’t rich, they’re simply good savers doing exactly what conventional wisdom has taught them to do.
The couple keeps making the maximum contribution each year ($20,500 each through age 49, then $27,000 from age 50 to 64, which are the current maximums), and each get a $6,000 employer match. I assume contribution limits rise by 2% annually. The couple’s contributions are in growth allocations that earn an annual 7% return. By the time they retire on their 65th birthdays, their retirement accounts will have grown to an impressive $7.3 million! They’re in great shape, right?
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Snowballing RMD Income
For simplicity, let’s assume they don’t draw down their pre-tax savings early in retirement, so their tax-deferred savings grows to about $11.9 million by age 72, when they must take their first RMD, which is $435,820. The RMD is 100% taxable, at their ordinary income rate, and by itself may put them in a high tax bracket. As you can see in the chart below, the RMD grows to $533,818 at age 75, $739,569 at age 80, $1 million at age 85 and $1.3 million at age 90.
The RMD income dwarfs their annual Social Security income, which I assume at $36,000 each at age 67, with a 2.0% annual cost of living adjustment.
Most people assume their taxable income in retirement will be very low because they’re not working, and will be receiving only Social Security benefits and perhaps some interest and dividend income. But clearly, if you’ve saved a lot in tax-deferred accounts, your RMD income can be frighteningly large. Meet your retirement tax bomb.
Even though the couple would take $15.6 million in total RMDs from age 72 to 90, their tax liability keeps growing, although at a decreasing rate as the RMDs gets larger. It’s not until age 89 that the RMD exceeds the projected portfolio growth and the tax liability starts shrinking.
Future Tax Rates
As scary as this sounds, think about where future tax rates may be headed. Current tax rates are near historical lows and may be the lowest we'll see for the rest of our lives. Consider solvency issues with Social Security and Medicare, chronic infrastructure issues, exploding deficits, climate change and pandemics. Each of these issues in isolation will require a lot of money to solve. And that doesn't even account for potential policy changes that would tax the wealthy more.
Simply put, paying taxes at today’s low rates may be a bargain compared to deferring, and growing, your tax liabilities into the future.
My next article focuses on problem No. 2: Medicare means testing surcharges.
- Part 1: Is Your Retirement Portfolio a Tax Bomb?
- Part 2: When It Comes to Your RMDs, Be Very, Very Afraid!
- Part 3: RMDs Can Trigger Massive Medicare Means Testing Surcharges
- Part 4: Will Your Kids Inherit a Tax Bomb from You?
- Part 5: How to Defuse a Retirement Tax Bomb, Starting With 1 Simple Move
- Part 6: Using Asset Location to Defuse a Retirement Tax Bomb
- Part 7: Roth Conversions Play Key Role in Defusing a Retirement Tax Bomb
- Bonus article 1: 2 Ways Retirees Can Defuse a Tax Bomb (It’s Not Too Late!)
- Bonus article 2: Can My Pension Trigger a Retirement Tax Bomb?
-
Alaska Airlines to Buy Hawaiian: Get Bonus Miles NowHow to use the Alaska Airlines credit card and frequent flyer program to save on trips to Hawaii, Alaska and beyond.
-
11 Reasons to Consider a 1031 Exchange
Deferring capital gains taxes might be at the top of the list, but growing your portfolio and your wealth and helping with estate planning are also compelling reasons.
-
11 Reasons to Consider a 1031 Exchange
Deferring capital gains taxes might be at the top of the list, but growing your portfolio and your wealth and helping with estate planning are also compelling reasons.
-
Why It’s Time to Give Bonds Another Look
Yields are much more attractive now, but you should use discretion to find the bond allocation that’s best for you.
-
Estate Planning and the Legal Quirks of Retiree Cohabitation
Creating an estate plan for an unmarried couple is already challenging, but when the cohabitating couple are in their golden years, it’s especially tricky.
-
Seven Financial Planning Stops to Put on Your Map to Financial Security
Creating a comprehensive plan is just the start, though. Checking in regularly to make sure you’re still on track is imperative.
-
How to Measure the Health of Your Retirement Plan
These five key indicators can help you make decisions based on the overall performance of your retirement plan rather than individual variables.
-
Four Easy Ways to Get Yourself Fired
Being a standout on the job can sometimes be as simple as showing up to meetings on time, responding promptly to requests, doing your homework and not being a jerk.
-
How Might the Great Wealth Transfer Change Society?
As $84 trillion in assets move from Baby Boomers to younger generations, we could see a greater emphasis on financial technology and investing based on values.
-
Why More Retirees Might Come Out of Retirement
It’s often not solely because of financial reasons, but because of a lack of purpose in retirement. This financial expert can relate.
