Photo courtesy of Pexels: Darina Belonogova

Written by Alexis Grason, CFP®, RICP®

You are a savvy saver. You started early and increased your savings with each raise. When you turned 50, you took advantage of the catch up provision. Now you’ve built up a large traditional 401(k) and Rollover IRA. Yet, you have a nagging fear that you’re facing a huge tax bill in retirement. And you may be right!

This is one of the most common planning challenges we see — and it’s exactly what our retirement planning process is designed to address.

Who knew there are perils to saving too much in pre-tax accounts?

Are you too good at building pre-tax savings?

It’s pretty typical for your pre-tax 401(k) or Rollover IRA to be your largest savings bucket. But is your 401(k) your only substantial savings bucket outside of your cash accounts? This could actually hurt you in the long run and make your retirement less tax efficient.

Entering retirement with the majority of your savings in tax-deferred accounts means approximately ⅓ belongs to the government – aka taxes – each time you take a distribution. Yikes!

How does this happen?

• Employers’ retirement plans are convenient. The majority of these were pre-tax in the past which means they grow tax-deferred.
• Retirement plans offered by employers often have higher savings limits.
• Saving into a tax-deferred account on a pre-tax basis can save you money on taxes because the money isn’t taxed when it is deposited and it grows tax-free.

If you started your career saving into a pre-tax 401(k) and making sure you saved the maximum, you’ve probably accumulated a significant pre-tax portfolio. On top of this your employer’s matching and profit sharing contributions were most likely all pre-tax. Do you have a pension? That income will be taxable in retirement. All of these buckets can add up to a major tax bill.

Who doesn’t want a large pre-tax savings account?

The danger of only using pre-tax savings accounts

Depending on your tax bracket, approximately ⅓ of your account balance belongs to the government upon withdrawal. You enjoyed the ability to not pay taxes when you were saving but when it comes time to use your money, your contributions and all growth on your investments will be taxed as ordinary income.

A large pre-tax retirement account will increase your Required Minimum Distribution (RMD) calculation. This can effectively force you to take money out of your tax-deferred IRAs and pay more taxes when in reality you might not even need the money or want to take it from that account!

The withdrawals from your tax-deferred IRAs increase your income, which can have the ripple effect of increasing other taxes. For example, more of your Social Security payments could be taxed and your Medicare premiums could be higher. Here’s a chart that shows how your Medicare premiums increase as your income grows:

If your beneficiaries are not an eligible designated beneficiary, they could be forced to take the full balance of your Inherited IRA out over 10 years. This could create a complicated tax situation and a higher tax burden for them. The legacy you imagined leaving your heirs could be eaten away by high taxes.

Sally and Sue 1.0

Sally and Sue built their wealth over time. They may have been paid less than their male counterparts and Sue had to take time off to help transition her mom to a continuing care retirement community. They both worked hard over the years and saved diligently, always maximizing their 401(k) contributions, including the catch up provisions they started making when they were 50.

They juggled all the priorities and did all the things.

Then they met with a financial advisor at 55 to start planning retirement. They were on track, right?

✔️They maximized their 401(k)s.

✔️They had a cash emergency fund equal to 6 months of their expenses.

✔️All cash was in a high yield savings account.

✔️They spent below their means.

✔️Their mortgage had 10 years remaining on it.

✔️Their cumulative 401(k) portfolio balance was $2.5mm.

Now for the stark reality of how much this may cost them in taxes.

If Sally and Sue 1.0 are currently in the 32% marginal tax bracket, then they have received noteworthy tax savings on those dollars going into the 401(k). The peril is – the distributions will also be taxed!

Maybe they will be in a lower tax bracket during retirement but maybe they won’t. If tax rates increase in the future, they could stay in the same tax bracket even if their total income goes down. If they want to maintain their same standard of living during retirement, their tax bracket could also stay the same.

They live in a state that taxes retirement account distributions, so they are going to pay state income taxes too. For simplicity, let’s say their state taxes 6%, this means their retirement distributions could be taxed at 38%.

Their $2.5M portfolio balance just became $1.55M.

Yes, I know it doesn’t all come out in a lump sum. This is intended to create a dramatic emphasis on the point – don’t become the victim of what seems like a great, simple plan on the surface.

Plan for the reality that distributions from a pre-tax account are going to eventually be taxed and consider your taxes in retirement as you accumulate your wealth.

Sally and Sue 2.0

Sally and Sue built their wealth over time. They both worked hard over the years and saved diligently. They juggled all the priorities and did all the things. (Differences bolded)

✔️They maximized their 401(k)s but as soon as Roth 401(k) became available in their employer plans, they split their contributions between pre-tax and Roth. Then they strategically went back to pretax when they moved from the 24% federal tax bracket to the 32% bracket.

✔️They had a cash emergency fund equal to 6 months of their expenses.

✔️All cash was in a high yield savings account.

✔️They spent below their means.

✔️Their mortgage had 10 years remaining on it.

✔️Their cumulative 401(k) portfolio balance was $2M in pre-tax and $500k in Roth.

✔️Bonus Points: They could explore making Backdoor Roth Contributions

✔️More Bonus points: Accumulating a taxable brokerage account outside of these retirement assets.

Coordinating all three buckets — pre-tax, Roth, and taxable — is the foundation of our wealth management approach at Spark.

The $190,000 difference between the 2 scenarios

The estimated tax hit (38% state and federal) on their $2 million of pre-tax IRAs reduces their pre-tax IRA balances to $1,240,000, with their $500,000 in Roth IRA assets their total assets available for spending is $1,740,000.  By entering retirement with just 20% of their total retirement savings in a Roth, they saved themselves $190,000 in taxes in retirement.

Money is available in 3 different tax buckets: pre-tax, tax-free, and potentially taxable (bonus points).

This gives Sally & Sue choices for distributions so they can factor in tax brackets and how income may be different from year to year.

Their Required Minimum Distributions (RMDs) will be lower because they are only calculated on pre-tax account balances.

Their Roth assets will continue to grow tax-free throughout retirement and then are available to hedge against longevity, long-term care costs, or to pass to their beneficiaries tax-free.

During retirement, Sally & Sue’s Roth assets are available to take distributions tax-free strategically to avoid crossing into a higher tax bracket in a year when their expenses are higher.

Bonus points: If they also saved into a taxable account, then their taxable account could support an early or phased retirement! There is no penalty for withdrawing funds from a taxable investment account prior to age 59.5 and they may get favorable long-term capital gains treatment on the investments sold. The long-term capital gains tax rate is lower than Sue and Sally’s projected max income tax bracket.

Even more bonus points: If they implemented a strategy called “asset location” for tax efficiency, including the benefits of holding tax-efficient investments in taxable accounts and tax-inefficient investments in tax-advantaged accounts like Roth IRAs and HSAs. This could increase their after-tax return on their investments!

Want to get ahead of this and make sure you don’t fall into this trap? Whether you are saving to build your wealth or getting ready to rely on your savings in retirement, reach out to Spark Financial Advisors today. We can help you create a tax-savvy retirement strategy.