Approximately 71% of non-retired adults are at least moderately worried about being able to fund their retirement, according to a 2023 Gallup poll. But what if you’ve diligently saved and accumulated a substantial nest egg in tax-deferred 401(k) plans and traditional IRAs? You might think you’re in the clear, but a significant tax bill could be looming in your retirement years. This phenomenon is known as the “retirement tax bomb.”

What Is a Retirement Tax Bomb?

Retiring from your job doesn’t mean you get to retire from paying taxes. The taxes you’ve deferred through pre-tax retirement contributions and tax-deferred earnings come due in retirement. If you’ve saved pre-tax money in a tax-deferred 401(k) or traditional IRA, you’ll pay regular income taxes on the full amount of your withdrawals when you retire.

The conventional wisdom is that your tax bracket will drop (or at least stay the same) in retirement, so squaring up with Uncle Sam won’t be so bad. However, some retirement super-savers face an avalanche of taxable income, leading to a retirement tax bomb.

How Are 401(k) Withdrawals Taxed?

When you retire, all the money you withdraw from traditional 401(k) and IRA accounts is taxed as ordinary income—the same as your wages during your working years. You’re subject to the same marginal tax rates and tax brackets, but a few new rules come into play.

Estimating Required Minimum Distributions (RMDs)

The IRS requires account holders to begin taking minimum distributions starting April 1 of the year after they either retire or turn 72 (or 73 if you turn 72 after December 31, 2022). The amount you pay as an RMD is based on average life expectancy. For example, at 73, the IRS estimates your remaining life expectancy at 26.5 years. To estimate your RMD, divide your retirement account balance by your life expectancy.

Additional Sources of Taxable Income

Unless your retirement accounts are your only source of retirement income, your tax liability doesn’t stop there. Your taxable income may also include:

• Investment income—capital gains, dividends, and interest
• Earnings or self-employment income
• Business income
• Gains from the sale of property
• Up to 85% of your Social Security benefits, if your income exceeds $34,000 as a single filer or $44,000 as a married couple

Factoring in Medicare Costs

High-income retirees may also be required to add an income-related monthly adjustment amount, or IRMAA, to their Medicare Part B and Medicare prescription drug premiums. If your most recent modified adjusted gross income (MAGI) shows you’ve made more than $194,000 as a married couple or $97,000 as an individual filer, you may be subject to higher premiums, based on a sliding scale.

How to Minimize Your Taxes in Retirement

For retirement super-savers, meeting with a retirement financial planner or tax advisor (or both) can be a good place to start. A qualified pro can help you navigate tax laws and investment strategies so you can maximize the money you get to enjoy in retirement—and minimize your tax bill, even if you can’t eliminate taxes entirely.

Start Saving in a Roth

If you’re still mid-career, consider funneling some of your retirement savings into Roth accounts instead of tax-deferred traditional IRAs and 401(k)s. Though you won’t get the same tax savings now, your money will grow tax-free in your account and won’t be included in taxable income when you withdraw it. Roth IRAs do not have RMDs and, starting in 2024, neither will Roth 401(k)s.

Consider Converting to a Roth

You can roll funds from a traditional IRA or 401(k) into a Roth IRA or 401(k), but your rollover will be taxed as regular income in the year you make the transaction. Weigh the pros and cons of converting all or some of your traditional retirement assets to a Roth.

Save Money in a Health Savings Account

If you have a qualifying high-deductible health plan, consider maxing out your contributions to a health savings account (HSA). Although HSA funds may only be used to pay for qualifying health care expenses, these expenses can be substantial in retirement. HSAs have unique tax benefits for retirement savers: You’ll get a tax deduction when you contribute to an HSA and won’t be taxed on your withdrawals—as long as they’re used to pay for qualifying health care expenses.

Think About Your Beneficiaries

Even death may not defeat your tax liability when you leave behind funds in a traditional IRA or 401(k). Non-spousal beneficiaries (like your adult children) have 10 years to distribute inherited IRA or 401(k) funds. These distributions are taxable, unless the money is in a Roth. If your estate’s value exceeds $12.92 million in 2023, your heirs may also owe federal and state estate taxes.

Meet With a Retirement Planner

Your retirement tax bill has many moving parts: 401(k) distributions, Roth and traditional IRA withdrawals, investment income, Social Security, Medicare surcharges, and more. An investment advisor can help you find ways to manage your funds to minimize your tax bill.

The Bottom Line

Although having too much income in retirement beats the opposite problem—having too little—tax considerations in retirement are serious, especially when you have substantial tax-deferred savings set aside. Whether you’re currently retired or doing some advance planning, now is a great time to get a handle on your post-retirement taxes. Finding out what your tax liability is likely to be, exploring ways to minimize your tax bill, and mapping out ways to pay can help make a retirement tax bomb less explosive.

For expert mortgage services and advice, contact O1ne Mortgage at 213-732-3074. Our team is here to help you navigate your financial future with confidence.