Will Taxes Shred Your 401(k) or IRA During Your Retirement? It's Very Likely

As your retirement savings in a traditional 401(k) grow over decades of working, you may feel an increasing sense of financial security. And that is good.

You're doing what you've been told to do: Save as much as possible, ideally in your 401(k) so you can defer tax.

After all, shouldn't you save on taxes today while you're making a bunch of money, and pay it later in retirement while you're in a lower tax bracket? That's what you're told.

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And don't forget, you often also get free money in the form of your employer's matching contribution.

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Between consistent contributions and wise investing, the compounding growth of a 401(k) can produce a large nest egg for your retirement. It feels great to see that balance.

However, when it's time to start withdrawing money from your 401(k), the tax bills start and your sense of comfort dissipates.

Here's what you need to understand: When you're ready to retire, a 401(k) becomes the highest-taxed asset(s) you own, and the IRS can't wait to get its share. The same goes for other pre-tax accounts, such as a 403(b) or traditional IRA.

What many people don't realize is that when they take money out of their 401(k), they could be taxed multiple times for each distribution. Here are the main reasons why you shouldn't leave your nest egg there, or at least not the majority of it.

Income tax and RMDs

The money you withdraw from a traditional defined contribution plan, such as a 401(k), is taxed as ordinary income at the rate of your tax bracket in the year you take the distribution.

A traditional 401(k) is subject to required minimum distributions (RMDs), which begin at age 73 for most people. If you save a lot of money in your 401(k), your annual RMDs could significantly increase your income, push you into a higher tax bracket and punish you in taxes.

By the time you reach your 80s, RMDs can become so large that they are a real problem, causing a shocking amount of taxation and leading to higher premiums on your Medicare.

Don't assume, as many people do, that you'll be in a lower tax bracket in retirement than the one you were in during your top earnings years. That's a big lie people are told.

If you do a good job saving for your retirement, aren't you going to be able to retire at roughly the same standard of living you enjoyed when you were working?

A similar standard of living equals a similar income, which leads to similar tax rates. Also consider that tax rates are likely to increase by the time you retire.

Social Security

Your 401(k) distributions could also make more of your Social Security benefits taxable. A withdrawal from a pre-tax account raises your combined income, an equation the IRS uses to determine how much of your Social Security may be subject to tax.

Up to 85% of your Social Security benefits may be taxable if you're single and earn more than $34,000 or are married and earn more than $44,000.

Higher Medicare premiums

When 401(k) distributions are added to your taxable income, it increases your modified adjusted gross income (MAGI). If your MAGI exceeds certain income thresholds, you must pay an income-related monthly adjustment amount (IRMAA), which is an additional surcharge on your Medicare Part B and D premiums.

Impact on the surviving spouse

If you're married and taking distributions from your 401(k), the good news is you're getting hit with all these taxes while you're in the most favorable tax bracket of married filing jointly.

But what happens when one of you dies? Then the surviving spouse goes into the higher tax obligation, filing single. The net effect is that the surviving spouse often sees their taxes doubled or more. We like to call this the "spousal tax trap."

The Roth solution

Part of financial fulfillment in retirement often comes down to this decision: Do you want to pay tax on the seed or on the harvest? With a traditional 401(k), you're saving tax on the seed, but you're paying tax on the harvest. That is the exact opposite of what you should be doing.

The 401(k) is a great tax shelter when you are working, but it's the worst place to have your money in retirement.

What can you do about it? The most obvious answer is to speak with a tax planner well in advance of your projected retirement. They can help you put together some type of Roth conversion glide path while using your current tax bracket.

With a Roth conversion, you transfer retirement assets from a 401(k) or other pre-tax accounts into a Roth IRA. You must pay income tax on the money you convert in the year you convert, according to your tax bracket at the time, but the advantages when you retire are well worth it.

Withdrawals are tax-free as long as you are at least 59½ and have had the account for a minimum of five years. And unlike other types of retirement accounts, Roth IRAs are not subject to RMDs.

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Also, if you don't need part or all the money, you can let your Roth IRA keep growing and leave it to your heirs or your spouse. Roth IRAs aren't just tax-free for you; they are also tax-free to your beneficiaries.

There are no IRS limits on the amount of money you can convert from a traditional IRA or other pre-tax retirement account into a Roth IRA, but spreading the conversion over several years can help reduce your tax burden in those conversion years.

Roth misconceptions

Of course, it's far better to start contributing to a Roth IRA, or Roth 401(k), earlier in your work life. But what sometimes happens, if you're a high earner in your 40s and doing a good job saving, is that everyone tells you to make pre-tax contributions to your 401(k).

So here you are, maxing out your 401(k) contributions, putting $25,000 a year into your 401(k) and getting that tax deduction for that amount. It feels like the "smart" move, because that's what everyone tells you to do.

But socking money away in your 401(k) may not actually be the most efficient tax move. You may even want to consider doing the opposite by changing those contributions to Roth. You won't get the tax deduction up front, but you will certainly appreciate tax-free money as you approach retirement.

When it comes to Roth conversions, people often have two misconceptions that make them hesitant to do them.

One is that they mistakenly think they have to pay the tax on the conversion in one lump sum by writing a check to the IRS or withdrawing from their savings or investment account.

However, provided that you are over the age of 59½, you can simply do it by having the tax withheld by whatever financial firm holds your retirement account.

The second misconception: If you do a Roth conversion, you must wait five years before you touch that money. The truth is that you have to wait five years to touch the earnings on that money.

When you're over 59½, just withhold the tax and you can take distributions on the principal from day one.

Take action to avoid 401(k) tax bombs

Beware of building your traditional 401(k) during your working years while ignoring the tax repercussions you'll face in retirement.

Take action now by changing your 401(k) contributions to Roth and strongly consider converting any IRAs you have to a Roth.

Don't wait until you're near retirement. Give yourself a true sense of future financial security and remember: It's far better to pay tax on the seed rather than the harvest.

Dan Dunkin contributed to this article.

Centennial Advisors, LLC is an Investment Adviser registered with the U.S. Securities and Exchange Commission ("SEC"). Registration as an investment adviser does not imply a certain level of skill or training.

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.

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