The Retirement Account Choice That Could Lead to Bigger Tax Bills

Traditional 401(k)s and individual retirement accounts, or IRAs, let savers defer income taxes by contributing pre-tax money and growing their nest egg over time.

But retirees also need to think about the tax consequences of these accounts. If those issues are overlooked, the result can be unexpectedly large tax bills well into retirement.

How a pre-tax account can turn into a tax burden

A pre-tax account can reduce your taxable income now and allow investments to grow tax-deferred, but taxes still come due when you withdraw the money. Although withdrawals from 401(k)s and IRAs can be delayed until retirement, required minimum distributions, or RMDs, generally begin at age 73.

Because RMDs are calculated as a percentage of your portfolio, they can be substantial for some investors. For example, a 4% distribution from a $5 million portfolio would equal $200,000, which is another $200,000 of ordinary income subject to taxes. That higher income can also raise Medicare premiums and increase the share of Social Security benefits that is taxed. By contrast, Roth retirement accounts are not subject to RMDs, and withdrawals are tax-free because contributions are made with after-tax dollars.

Why mixing tax treatment can help

Putting all of your retirement savings into a traditional 401(k) or traditional IRA can leave you exposed to large RMDs and higher taxes later in life. Spreading money across accounts with different tax treatments can help reduce that burden and make it easier to manage over time.

Roth IRAs and Roth 401(k) plans are funded with after-tax contributions, so withdrawals are not taxed. Another option is a taxable brokerage account. While contributions to that type of account are not tax-advantaged and gains or dividends are still taxable, the money can be accessed at any time without the 10% early-withdrawal penalty that may apply to other retirement accounts.

Ways savers can rebalance before retirement

If most of your savings are in pre-tax retirement accounts, it may make sense to diversify. One approach is to split future contributions between traditional and Roth accounts. In some cases, savers may also use a backdoor Roth IRA conversion to fund a Roth account even if their income is too high for a direct Roth IRA contribution.

That strategy involves moving some money from a traditional 401(k) or IRA into a Roth IRA. Doing it gradually can spread the tax impact over several years. In lower-income years, it may also make sense to convert more aggressively, since the tax rate could be lower.

It is wise to revisit your plan every year, especially after a job change, a raise, or any other major shift in your financial picture. Having more tax options now can help you keep more of your savings when retirement withdrawals begin.