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?
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free 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?
-
What You Learn Becoming Your Mother's Financial CaregiverWriter and certified financial planner Beth Pinsker talks to Kiplinger about caring for her mother and her new book.
-
I want to help pay for my grandkids' college. Should I make a lump-sum 529 plan contribution or spread funds out evenly through the years?We asked a college savings professional and a financial planning expert for their advice.
-
Seven Moves for High-Net-Worth People to Make Before End of 2025, From a Financial PlannerIt's time to focus on how they can potentially reduce their taxes, align their finances with family goals and build their financial confidence for the new year.
-
I'm a Financial Planner: These Are the Seven Tiers of Retirement Well-BeingLet's apply Maslow's hierarchy of needs to financial planning to create a guide for ranking financial priorities.
-
Why More Americans Are Redefining Retirement, Just Like I DidRetirement readiness requires more than just money. You have a lot of decisions to make about what kind of life you want to live and how to make it happen.
-
A Compelling Case for Why Property Investing Reigns Supreme, From a Real Estate Investing ProInvestment data show real estate's superior risk-adjusted returns and unprecedented tax advantages through strategies like 1031 exchanges and opportunity zones.
-
Are You Retired? Here's How to Drop the Guilt and Spend Your Nest EggTransitioning from a lifetime of diligent saving to enjoying your wealth in retirement tends to be riddled with guilt, but it doesn't have to be that way.
-
Government Shutdown Freezes National Flood Insurance Program: What Homeowners and Buyers Need to KnowFEMA's National Flood Insurance Program is unavailable for new customers, increased coverage or renewals during the government shutdown.
-
Separating the Pros From the Pretenders: This Is How to Tell if You Have a Great AdviserDo you leave meetings with your financial adviser feeling as though you've been bulldozed into decisions or you're unsure of what you're paying for?
-
Five Downsides of Dividend Investing for Retirees, From a Financial PlannerCan you rely on dividend-paying stocks for retirement income? You'd have to be extremely wealthy — and even then, the downsides could be considerable.
