Saving as much as possible in tax-deferred retirement accounts such as traditional 401(k)s and IRAs is often considered a smart retirement strategy. Contributions may be made with pretax dollars or may be deductible, while tax-deferred growth allows investments to compound without current-year taxation.
However, more tax deferral isn’t necessarily better for everyone. For some taxpayers, building an exceptionally large balance in traditional retirement accounts can create significant tax consequences later in life.
The right retirement strategy often involves finding a balance between traditional tax-deferred accounts, Roth accounts and taxable investment accounts.
Why Too Much Tax-Deferred Savings Can Become a Problem
The traditional argument for tax-deferred retirement accounts is straightforward: You receive a tax benefit while you’re working and pay the taxes when you withdraw the money in retirement.
The assumption is that you’ll have less income after you retire and therefore pay taxes at a lower rate.
That may be true for many people. But it isn’t guaranteed.
Future tax rates could be higher than today’s rates. And even if your tax bracket is lower during retirement, other sources of income and required distributions can create unexpected tax consequences.
As a result, someone who has accumulated a very large traditional retirement balance may eventually find that the tax bill associated with withdrawals is larger than expected.
Retirement Distributions Are Taxed as Ordinary Income
Traditional 401(k) and IRA distributions are generally subject to ordinary income tax rates.
That’s important because certain investment income held in a taxable account can receive more favorable tax treatment. For example, qualifying long-term capital gains and qualified dividends may be taxed at lower rates than ordinary income.
This means that the same investment growth could potentially have a different after-tax result depending on whether the investment is held in a traditional retirement account or a taxable investment account.
With a traditional retirement account, the eventual distribution is generally taxed as ordinary income rather than receiving the preferential long-term capital gains rate.
Early Withdrawals Can Trigger Additional Taxes
Traditional retirement accounts also have rules that can make accessing your money before retirement age expensive.
In general, withdrawals from traditional IRAs and other retirement accounts before age 59½ may be subject to a 10% additional tax, unless an exception applies.
That means you could potentially owe both ordinary income tax and an additional 10% tax on an early distribution.
Although there are exceptions, taxpayers who want greater flexibility to access their investments before age 59½ may benefit from having some retirement savings outside traditional tax-deferred accounts.
Required Minimum Distributions Can Increase Taxable Income
Another consideration is required minimum distributions (RMDs).
Traditional retirement accounts are generally subject to RMD rules once the account owner reaches the applicable starting age. Failure to take a required distribution can result in a substantial penalty, although the rules and penalty amounts have changed in recent years.
RMDs generally count as taxable income. If your traditional retirement accounts have grown significantly, your required distributions could be large enough to push your taxable income into a higher tax bracket.
Higher taxable income can also affect other parts of your financial situation, including deductions, credits and the taxation of Social Security benefits.
This is one reason why having a very large traditional retirement balance can create tax-planning challenges later in life.
Roth Accounts Offer a Different Tax Profile
Roth retirement accounts can provide an important counterbalance to traditional tax-deferred savings.
With a Roth account, contributions generally don’t provide an upfront tax deduction. Instead, qualified withdrawals can generally be taken tax-free, including investment growth.
Roth accounts owned by the original account holder also aren’t subject to lifetime RMDs under current federal rules.
Roth IRAs do have income-based contribution limitations. However, employer-sponsored Roth accounts, such as Roth 401(k)s, don’t have the same income limitation on contributions.
For taxpayers who expect to face higher tax rates later, paying taxes now in exchange for potentially tax-free qualified withdrawals in retirement can be an attractive strategy.
Consider Putting Some Retirement Savings in a Taxable Account
If you’ve already maximized your Roth opportunities, or if you’re unable to contribute directly to a Roth IRA, another option is investing some retirement savings in a taxable brokerage account.
Taxable investment accounts don’t provide the same upfront tax advantages as traditional retirement plans, but they offer greater flexibility.
Depending on the investments and holding period, long-term capital gains and qualified dividends may receive preferential tax treatment. You also aren’t subject to the contribution, withdrawal and RMD rules that apply to retirement accounts.
For some investors, that flexibility can be valuable when managing taxes and cash flow during retirement.
Consider a Roth Conversion
Another strategy is converting some or all of a traditional IRA to a Roth IRA.
A Roth conversion moves money from a tax-deferred account into a Roth account. The amount converted is generally included in taxable income for the year of the conversion.
The potential benefit is that future qualified growth and withdrawals from the Roth account can be tax-free, while the converted assets are no longer subject to traditional IRA RMD requirements during the original owner’s lifetime.
However, a Roth conversion can result in a significant tax bill in the year it occurs.
Before converting, consider your current marginal tax rate, the amount being converted, your other taxable income and whether the additional income could push you into a higher tax bracket or affect other income-based tax provisions.
Consider Taking Distributions Earlier in Retirement
For people age 59½ or older, another strategy may be to take distributions from traditional retirement accounts before RMDs are required.
Taking withdrawals earlier can allow you to spread taxable income over several years rather than waiting until RMDs potentially become larger.
After paying the applicable taxes, you could potentially invest the remaining funds in a taxable account. Future long-term gains and qualified dividends may then receive preferential tax treatment.
However, taking larger distributions isn’t automatically beneficial. The additional income could increase your current tax liability or trigger other tax consequences.
Careful planning is important before making significant withdrawals.
Four Ways to Create More Tax Diversification
If you believe you have accumulated too much in traditional tax-deferred accounts, consider whether one or more of these strategies makes sense:
1. Increase Roth Contributions
Consider directing at least some future retirement contributions toward Roth accounts, if available.
You generally won’t receive an upfront tax deduction, but qualified withdrawals can be tax-free and Roth accounts aren’t subject to lifetime RMDs for the original owner.
2. Invest in Taxable Accounts
If you’ve maximized your Roth savings or don’t have access to a Roth option, consider allocating some additional savings to a taxable investment account.
This can provide greater flexibility while potentially allowing qualifying long-term gains and dividends to receive preferential tax treatment.
3. Consider Roth Conversions
Converting portions of a traditional IRA to a Roth IRA can shift future growth from tax-deferred treatment to potentially tax-free qualified withdrawals.
Because the converted amount is generally taxable in the year of conversion, conversions are often most effective when carefully planned around your current and expected future tax brackets.
4. Evaluate Earlier Retirement Withdrawals
Once you reach age 59½, consider whether taking some distributions before RMDs begin could help manage your future taxable income.
The goal isn’t necessarily to withdraw as much as possible. Instead, it may be to strategically spread taxable retirement income across multiple years.
Tax Diversification Can Be Just as Important as Asset Diversification
Retirement planning isn’t only about how much you’ve saved. Where your retirement savings are held can also have a major impact on your future tax bill.
Traditional retirement accounts, Roth accounts and taxable investment accounts each have different tax characteristics. Having money in multiple account types can provide greater flexibility when deciding where to take income from each year.
Whether you have too much, too little or an appropriate amount in tax-deferred accounts depends on factors such as your current tax rate, expected retirement income, anticipated future tax rates, account balances and retirement goals.
There isn’t a one-size-fits-all answer.
We can help you evaluate your retirement savings strategy and determine how traditional, Roth and taxable accounts can work together to support tax-efficient wealth accumulation.
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