“How to Navigate Taxation on 401(k) Withdrawals and Retirement Income”

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Understanding the Retirement Tax Bomb

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 saved millions in tax-deferred 401(k) plans and traditional IRAs? You might still face significant tax bills after retirement. Distributions from these accounts create taxable income, and high-income retirees may also face additional taxes on Social Security benefits and Medicare premiums. This situation is often referred to as a “retirement tax bomb.”

What Is a Retirement Tax Bomb?

Retiring doesn’t mean you stop paying taxes. The taxes 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.

While the conventional wisdom suggests your tax bracket will drop in retirement, some super-savers face an avalanche of taxable income. Here are some common components of a retirement tax bomb:

• Taxable distributions: Distributions, including required minimum distributions (RMDs) from your 401(k) and traditional IRA accounts, are fully taxable.
• RMDs that rise over time: RMDs increase year-over-year as your life expectancy decreases.
• Other taxable income: Additional sources of taxable income include non-retirement investment income, business earnings, and taxable Social Security benefits.
• Income-related Medicare surcharges: A high income may trigger higher Medicare premiums, adding to your monthly expenses.

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. You’re subject to the same marginal tax rates and tax brackets, but a few new rules come into play.

To encourage retirement account holders to use their funds, 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.

Taking Stock of Additional 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

Meeting with a retirement financial planner or tax advisor can be a good place to start. A qualified professional can help you navigate tax laws and investment strategies to maximize your retirement funds and minimize your tax bill. Here are a few tactics that may help:

• Start Saving in a Roth: Consider funneling some of your retirement savings into Roth accounts instead of tax-deferred traditional IRAs and 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.
• 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).
• Think About Your Beneficiaries: Non-spousal beneficiaries have 10 years to distribute inherited IRA or 401(k) funds, which are taxable unless the money is in a Roth.

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 any mortgage service needs, call O1ne Mortgage at 213-732-3074. We’re here to help you navigate your financial future with confidence.

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