Many Retirees Are Overlooking a Tax Move That Could Lead to Big Bills

After spending decades building up savings for retirement, it is natural to want to keep as much of that money as possible. But new research suggests many retirees may be unintentionally setting themselves up for an expensive tax surprise.

According to a Vanguard study, 78% of retirees with account balances above $100,000 do not take money out of their retirement savings between ages 60 and 72. Vanguard has also said many people tend to use retirement accounts only when a specific, unexpected need comes up.

Some retirees have no choice but to tap their savings soon after leaving work. But for those who do not need the money right away, the habit is often to wait until required minimum distributions, or RMDs, must begin.

Why timing matters

IRS rules require retirees to start taking RMDs from tax-deferred retirement accounts beginning at age 73. For people born in 1960 or later, that starting age rises to 75. After years of saving carefully, it can feel instinctive to leave those 401(k) or IRA funds untouched for as long as possible.

Retirement specialists say that strategy can create problems later, because larger withdrawals down the road may lead to much higher tax bills and reduce money that could be needed for health care, long-term care or other age-related expenses.

“There’s a benefit to smoothing out those withdrawals,” said Aaron Goodman, senior investment strategist at Vanguard. He said workplace retirement plans have made it easier for people to build a savings habit, but retirees receive far less guidance on when to spend those assets.

“Retirement income is a difficult problem,” Goodman said, adding that many people are left to figure out on their own how to balance today’s income needs with future flexibility.

Why earlier withdrawals can help

The tax break built into a traditional 401(k) or IRA assumes that retirement income will be lower than earnings during working years. That can place someone in a lower tax bracket and reduce the overall tax burden. Depending on income, Social Security benefits may also be partly or fully untaxed.

RMDs, however, are taxed as ordinary income. The amount you must withdraw each year depends on the size of your account and your life expectancy. People who saved heavily and built substantial balances should consider running the numbers with a financial professional or on their own, because the required withdrawals may push total income into a higher tax bracket than expected.

Wealthier retirees may also face higher Medicare costs through Income-Related Monthly Adjustment Amounts, or IRMAA. These surcharges can add roughly $200 to $700 per person each month.

Scott Cole, founder and president of Cole Financial Planning and Wealth Management, says retirees can reduce that risk by shifting money out of tax-deferred accounts earlier in retirement. “Accelerate that income or convert that money to a Roth, and do that systematically every year, so when you get to RMDs, it’s usually not forcing you into an IRMAA,” he said.

Goodman also recommends setting up a regular withdrawal plan and making sure the money is working toward long-term financial goals.

What to do with early-retirement 401(k) withdrawals

If you do not need retirement-account money for everyday living costs, financial planners suggest several possible uses for those withdrawals.

Delay Social Security

Using some of your savings to cover routine expenses can make sense if it allows you to postpone claiming Social Security until full retirement age, which is 67 for people born in 1960 or later. Waiting until age 70 can also increase benefits through delayed retirement credits, boosting payments by as much as 24%.

Make Roth conversions

Moving money from a traditional retirement account into a Roth account creates a tax bill now, but it can help keep future income lower when RMDs begin.

Roth conversions may also help you avoid IRMAA surcharges, though the IRS tax brackets and Medicare surcharge brackets are not the same. Medicare uses a two-year look-back when calculating whether extra premiums apply, which gives retirees another reason to consider starting conversions sooner.

That timing can matter even more for people planning an early retirement. Although Roth withdrawals can be tax free after conversion, anyone under 59½ generally must keep the money in the Roth for five years to avoid a 10% early-withdrawal penalty.

Cole says being proactive is wise even for people who are uncertain about Roth conversions. “At the very minimum, convert $100 just to get the clock started on it,” he said.

Open or add to a taxable brokerage account

If you are unsure what to do with withdrawn 401(k) money, one option is to reinvest it. Cole noted that taxes are still due on the withdrawal and on investment earnings, but gains from securities held longer than a year are taxed at more favorable long-term capital gains rates, which can be as low as 0% depending on income.

And if markets fall, losses in a taxable account may help offset taxes from capital gains elsewhere. “That gives you the ability to do some tax management where you can harvest gains or losses,” Cole said.