Good savers, beware! The money you put into your 401(k) and other retirement accounts has to be withdrawn one day. If you’re not strategic about your savings, you could face unnecessarily high taxes and inflated Medicare premiums in retirement, plus you could saddle your heirs with higher taxes.
The sooner you start defusing this potential tax bomb, the better. But even people in their 60s or early 70s may have options to reduce potential damage as long as they act quickly.
“You don’t want to be in a position where some clients think all their funds are in a tax-deferred account,” says Pam Ladd, senior manager of personal financial planning at the Association of Certified Professional Accountants International.
See also: 5 things you need to know about taxes if you’re over 65
Tax benefits now can cause tax pain later
Most retirement accounts offer a tax break when you put money away. Ultimately, though, Uncle Sam wants to get paid. Required minimum distributions, or RMDs, generally must begin at a certain age, currently age 73 and rising to age 75 for people born in 1960 and later. Withdrawals from pension funds are usually subject to regular rates of income tax.
It’s still a good deal for most retirees because their tax bracket will be lower in retirement than when they were working. But people who don’t need to spend their savings to retire early may find that required minimum distributions push them into higher tax brackets.
“People are working longer, saving longer and saving more in their retirement accounts, and as a result, their RMDs in many cases can be more than they earned while they were still working,” says Colin Carko, a financial director of the organization’s wealth planning strategy. TIAA Services Company.
Delaying the start of required minimum distributions can make matters worse, as you’re required to withdraw larger percentages of your balances as you age, Carcone says. At the same time, your accounts have more time to grow.
See also: I am 55 years old and need cash. Can I access my IRA without penalty?
Savers can pay more for Medicare and cost their children
Higher incomes can also mean higher Medicare premiums due to the Income-Related Monthly Adjustment Amount, or IRMAA, which is based on your income two years ago.
Most people will pay $164.90 a month this year for Medicare Part B, which pays for doctor visits. But Medicare recipients whose 2021 modified adjusted gross income exceeds $97,000 (for married couples) or $194,000 (for married couples) pay between $230.80 and $560.50 a month, depending on their income : IRMAA’s premium for Medicare Part D, which pays for prescriptions, can add up to $12.20 to $76.40 a month, depending on income. A couple earning $250,000 in 2021 could pay a total of $4,711.20 in premiums for their Medicare coverage in 2023.
Paying taxes may not be limited to that. If you leave a pension to your children or someone other than your spouse, they usually have until the end of the 10th year after the year of your death to empty the accounts. Required minimum distributions from inherited retirement accounts can push your heirs into higher tax brackets or cause other financial complications.
PlusWhat’s the best way to leave your home to your heirs?
How to defuse the tax bomb?
Predicting who will hit a future tax bomb can be difficult, especially if you’re decades away from retirement. But most people would be smart to have at least some money in accounts that are not subject to taxes or required minimum distributions, such as Roth IRAs, Roth 401(k) plans, and Roth 403(b) plans, to better control their taxes. bills in retirement, Ladd says.
With Roths, contributions are non-deductible, but withdrawals in retirement are tax-free. You’re not required to use a Roth IRA during your lifetime, and legislation passed late last year eliminates required minimum distributions from workplace Roths starting in 2024. Non-spousal heirs are required to draw down the account within 10 years, just like regular retirement plans, but withdrawals are not taxed.
SeeAll About Roth IRAs
The ability to contribute to a Roth IRA phases out from modified adjusted gross income of $138,000 to $153,000 for singles and $218,000 to $228,000 for married couples. But many 401(k) plans and 403(b) plans now offer Roth options, and these workplace plans have no income limits, Carcone notes.
Another option is to convert existing retirement savings into a Roth account, which usually requires paying income tax on the conversion. Paying taxes now and later can make sense when you’re young and expect to be in a higher tax bracket for retirement, tax experts say. But some seniors may find that a rollover can help reduce the tax impact of future required minimum distributions, Carcone says. Rollovers from recent years should be handled carefully because, like required minimum distributions, they can inflate your tax bracket and Medicare premiums, he says.
Considering the financial stakes, Carcone recommends consulting with a tax professional or financial planner who can provide one-on-one advice.
“It’s never too early to start working with a financial advisor and start implementing that planned roadmap,” Carcone says.
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Liz Weston, CFP® writes for NerdWallet. Email: lweston@nerdwallet.com. Twitter: @lizweston.
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