There’s an easy and effective way savers can minimize the damage of a retirement tax bomb. It all starts with making a simple change to your retirement savings contributions.
Editor’s note: This is part five of a seven-part series. It dives deeper into the first strategy for mitigating a retirement tax bomb, which is to shift retirement savings from pre-tax accounts to after-tax accounts, including Roths and HSAs. If you missed the introductory article, you might find it helpful to get started here.
If you’re facing a retirement tax bomb, there are three main strategies to defuse it: shift retirement savings from pre-tax accounts to Roth and HSA accounts, implement asset allocation, and run Roth conversions.
I consider shifting your savings to be the first line of defense, because it’s the easiest solution to implement. However, to really get the job done, you’ll probably need to implement all three strategies.
There are two flavors of switching savings, one uses Roth retirement accounts, while the other uses health savings accounts (HSAs).
Switch retirement plan contributions from pre-tax to Roth
Perhaps the easiest solution to implement is to simply switch your retirement plan contributions from pre-tax to Roth. You will lose the tax deduction in the current year and may need to explain to your accountant why you made the change. However, any company match is tax-deferred, so even if you switch to 100% Roth, the employer match and the return on your investment means the tax-deferred account will continue to grow.
Many of my clients don’t know they have a Roth option on their 401(k)/403(b), or mistakenly think they can’t contribute to one due to income limits, but that’s not true. Only Roth IRAs have an income limit. So find out if your retirement plan offers a Roth option.
Let’s look at the impact of this single action in more detail through the lens of our 40-year-old example couple who were previously maxing out their 401(k) before taxes each year (currently $20,500 each until age 49, then $27,000 from age 50 to 64), plus $6,000 employer contribution each. If the couple switched all pre-tax contributions to a Roth 401(k), only the $12,000 of the combined employer contribution remains as a pre-tax contribution.
The impact is massive.
- His pre-tax savings at age 65 drop from $7.3 million to $3.6 million (50.2% less). His first year RMD at age 72 drops from $435,820 to $215,281 (a 50.6% decrease), while his lifetime RMD through age 90 drops from $15.6 million to $7.7 million (also a 50.6% less).
- Your Medicare means surcharges for tests up to age 90 drop from $1.5 million to $730,483 (a 51.5% decrease).
- Inherited IRAs that are passed on to your two children at age 90, which are taxed at the children’s ordinary tax rates, drop from $16.1 million to $8 million (also down 50.6%).
- Your tax-free savings increase to $3.6 million at age 65. If they never have to withdraw money from tax-free accounts in retirement (RMDs don’t apply to Roth accounts and they’ll have plenty of tax-deferred RMD money), their tax-free savings would increase to $20.4 million at age 90 . While your heirs will have to fully deplete the inherited Roth accounts for 10 years, none of those withdrawals are taxable.
For younger investors, the best way to defuse a retirement tax bomb, both in terms of impact and ease of execution, is to simply switch pre-tax retirement plan contributions to Roth. This strategy will have less of an impact (but still be worth it) for those closer to retirement because they have fewer years for the effects to compound.
Invest using health savings accounts
If you have a high-deductible health plan, for 2022 married couples can contribute up to $7,300 ($3,650 if single) to the associated health savings account (HSA). Seniors age 55 and older can make an additional $1,000 “catch-up” contribution.
An HSA is like a turbocharged IRA, because it’s the only account that gives you a tax deduction on the contribution (like a pre-tax 401(k) or traditional IRA), while withdrawals are considered tax-free. taxes (such as a Roth IRA) if used to pay for qualified medical expenses. Unlike a Roth IRA, an HSA has no income limits. So anyone with a high-deductible health plan who isn’t already enrolled in Medicare can contribute. HSAs should be the top funding priority after capturing your 401(k)/403(b) match (the “free” money). Some employers even contribute to HSAs on behalf of their employees.
However, most of the clients I talk to about HSAs are misusing them, either paying for current medical expenses with the account, or the HSA is 100% cash instead of invested. They think of an HSA as a flexible spending account (FSA), which has a “use it or lose it” feature where funds not used by December 31 are forfeited. Basically, human resources departments slightly changed the acronym (from FSA to HSA) and promoted the use of the associated debit card to pay for medical expenses. Few employees really understand why they must manage HSAs very differently.
Most savers who can afford current medical expenses out of pocket should do so and instead invest the HSA to grow it to fund medical expenses in retirement. A few additional steps are required to open an associated investment account, move funds from the HSA bank account to the HSA investment account, and then invest them. But the benefit may well be worth the effort, especially for younger savers who have many years for tax-free funds to grow. By the way, you should normally invest your HSA aggressively, something I’ll talk more about in my next article on asset allocation.
You will need the HSA when you retire. A 2022 study from Fidelity estimates that a couple retiring today at age 65 will spend approximately $315,000 on medical expenses in retirement, not counting long-term care expenses. This Fidelity estimate assumes average health and average longevity. But if you live longer than average or your health is worse than average, your expenses are likely to be higher.
Stop tax-deferred contributions in the party
If your retirement plan doesn’t offer a Roth option (shame on your employer and plan provider), and you’ve already saved a lot in tax-deferred accounts, you might consider contributing just enough to the tax-deferred account to capture 100% of your savings. the coincidence of the company, but not beyond. If you do this, it’s critical to continue saving as much as possible in a taxable account to maintain a high savings rate. An easy way to do this is to set up an automatic monthly transfer from your bank account to a taxable investment account.
Investing in taxable accounts becomes more attractive when a portfolio is managed to minimize turnover (frequent trading generates taxes) and optimize asset placement. For example, low turnover and effective asset allocation can allow a taxable portfolio to have minimal “tax brake” and be 90% as tax efficient as a tax-deferred account. That 10% loss in tax efficiency can be more than offset by avoiding a retirement tax bomb.
Make contributions to the Roth IRA, if eligible
If your income is low enough, many people can also save in a Roth IRA. For 2022, eligibility begins to phase out starting at $204,000 modified adjusted gross income for married filing jointly ($129,000 for single filers). If you qualify, you can contribute up to $6,000 of earned income, and if you’re age 50 or older, you can add a “catch-up” contribution of $1,000. If your spouse doesn’t work and has enough earned income to cover her contribution, you can also contribute to your Roth IRA.
Do not make non-deductible IRA contributions
The main benefit of tax-deferred accounts is the tax deduction you receive in the year of contribution. For 2022, eligibility to make a tax-deferred contribution to an IRA begins to phase out at $109,000 modified adjusted gross income for married filing jointly ($68,000 for single filers). Many clients I meet who are not eligible to make deductible contributions still make after-tax contributions that are not deductible. I myself was guilty of this for many years. If you have a potential retirement tax bomb, this is just pouring gasoline on the fire.
Reducing pre-tax retirement plan contributions goes against conventional wisdom. But, as our example shows, switching savings to tax-free Roth accounts can have a massive impact on your after-tax wealth and retirement security.
Today we discuss the first strategy for defusing a retirement tax bomb, which is to shift contributions from pre-tax Roth accounts to after-tax Roth accounts. My next article will examine the second strategy, implementing asset allocation.
Partner, Financial Management Forum
David McClellan is a partner at Forum Financial Management, LP, a registered investment adviser managing more than $7 billion in client assets. He is also vice president and director of wealth management solutions at AiVante, a technology company that uses artificial intelligence to predict lifetime medical expenses. Previously, David spent nearly 15 years in executive roles at Morningstar (where he designed retirement income planning software) and Pershing. David is based in Austin, Texas, but works with clients across the country. His practice focuses on financial life coaching and retirement planning. He frequently helps clients assess and defuse retirement tax bombs.