The Retirement Account Error That Can Leave You Owing More in Taxes

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

But retirees still need to think carefully about taxes. If those issues are overlooked, these accounts can become expensive and lead to unexpectedly large tax bills later in retirement. Here’s what to understand.

Why a pre-tax account can turn into a tax trap

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your taxable income today and allow investments to grow tax-deferred, but taxes still have to be paid when the money is withdrawn.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

RMDs are calculated as a percentage of your account balance, and for some savers they can be substantial. For example, a 4% withdrawal from a $5 million portfolio would produce a $200,000 RMD, which means $200,000 more in ordinary income subject to tax. That higher income can also raise Medicare premiums and increase the share of Social Security benefits that are 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 it helps to have multiple tax buckets

Relying entirely on a traditional 401(k) or traditional IRA can leave retirees exposed to large RMDs and steep tax bills. Spreading savings across accounts with different tax treatments can help reduce the burden and distribute it over a longer period.

Roth IRAs and Roth 401(k) plans are one option, since qualified withdrawals are not taxed. Another option is a taxable brokerage account. Contributions to that account are made with money that has already been taxed, and the account does not shelter capital gains or dividends from tax. Still, a taxable brokerage account can be accessed at any time without the 10% penalty that may apply to early withdrawals from other retirement accounts.

How savers can rebalance before retirement

If most of your retirement savings are in pre-tax accounts, it may be worth diversifying. Future contributions can be divided between traditional and Roth accounts, for example. Some savers may also be able to use a backdoor Roth IRA conversion to build a Roth balance even if their income is too high for direct Roth IRA contributions.

That strategy involves shifting some money from a traditional 401(k) or IRA into a Roth IRA. Doing so gradually over several years can spread out the tax cost. In some cases, it may make sense to convert more aggressively during years when income is lower, since the tax rate could be lower as well.

It is also important to review your plan each year, especially after a job change, a raise or any other major shift in your finances. Having more tax flexibility now can help you keep more of your savings when it is time to withdraw them in retirement.