The Retirement Tax Bomb
If you are a diligent saver socking away money into your retirement accounts, you may be setting yourself up for some unintended income tax consequences. The good news is with some careful planning, you may be able to defuse the effects of the “retirement tax bomb.”
What is the retirement tax bomb?
The term "retirement tax bomb" typically refers to the potential tax consequences retirees may face when forced to withdraw funds from their tax-advantaged retirement accounts. Contributions to these accounts offer significant tax benefits during the accumulation phase, as contributions are tax deductible and the earnings within the accounts grow tax-deferred. However, when the retiree is forced to withdraw funds from these accounts during retirement, the distributions are subject to income taxes.
The "retirement tax bomb" scenario often arises when retirees have significant pre-tax amounts in their 401(k)s and Traditional IRAs. Once the retiree reaches a certain age, they are required to take distributions (RMDs) from these accounts.
What Are Factors That Can Make The Retirement Tax Bomb Worse?
Factors that can contribute to the retirement tax bomb include:
Significant Account Balances: If retirees have diligently contributed to their retirement accounts and have substantial balances, their RMDs could be sizeable, potentially increasing their tax liability.
Loss of Deductions: In retirement, individuals may have fewer deductions to offset their income, leading to a more significant portion of their withdrawals being subject to taxation.
Potential Future Tax Rate Increases: Tax rates could change, leading to retirees paying higher taxes on their withdrawals than initially anticipated.
Investment Income: Diligent savers can have large retirement account balances and significant investment account balances. These balances can generate investment income such as dividends, interest, and capital gains.
Social Security: If you implement a successful social security maximization strategy, you will have more income in retirement.
Pension Income: Pensions can significantly increase a retiree's income.
Inheritance: An increase in investable assets will lead to higher investment income.
What Are Strategies That Help Mitigate The Retirement Tax Bomb?
To mitigate the potential impact of the retirement tax bomb, retirees may want to consider using some of the following strategies:
Roth Conversions: Converting a portion of Traditional IRA or 401(k) funds into Roth accounts could result in paying taxes upfront but can provide tax-free withdrawals in retirement.
Strategic Withdrawals: Planning the timing and amount of withdrawals to manage tax brackets and minimize the impact of RMDs. A great time to employ this strategy is during your Retirement Income Gap.
Diversified Tax Strategies: Having a mix of different types of retirement accounts, such as Traditional IRAs, Roth IRAs, and taxable accounts, can provide flexibility in managing income tax implications.
Tax Planning: Consulting with financial advisors or tax professionals to create a retirement income strategy that considers tax implications and potential changes in tax laws.
Estate Planning: Incorporating estate planning strategies that consider tax-efficient ways to pass on retirement assets to beneficiaries.
Tax Efficient Asset Allocation and Investment Strategy: Structuring your investments to optimize after-tax returns.
Start Early: Being strategic early in your career can be a lifesaver. Take advantage of low or no-earning years with Roth contributions or conversions. Don't wait to you are in retirement to start planning.
It's important to note that individual circumstances vary, and tax laws constantly change. Working with a financial professional knowledgeable about retirement planning and tax strategies can help you make informed decisions tailored to your specific situation and help you avoid the “retirement tax bomb.”
About the author:
JP Geisbauer is a Certified Public Accountant, a Certified Financial Planner ®, and the founder of Centerpoint Financial Management, LLC, a financial planning, investment management, and income tax planning firm located in Irvine, CA. JP Geisbauer is dedicated to helping California-based business owners and executives transition into retirement. He has been quoted in many news outlets including Forbes, Newsweek, US News & World Report, MarketWatch, YahooFinance, CNN and NerdWallet.
Need help with your transition into retirement? Schedule a complimentary 30-minute call with JP here.
Disclaimer:
This article is for general information and educational purposes only. Nothing contained in this article constitutes individual financial, investment, tax, or legal advice. Before taking any action on any topic discussed in this article, consult with your own financial planner, investment advisor, tax professional, and/or attorney for advice on your specific situation.