Good Retirement Saver? How to Reduce a 15%-to-25% Tax Bite
Even households below $1 million in savings face big levies
You saved well and the booming stock market multiplied your nest egg. A few years from retirement, you’re carefully planning how much to draw down annually so your savings last.
Better plan for taxes — and now.
Income from traditional 401(k)s and individual retirement accounts (IRAs) is 100% taxable, as is pension income and Social Security benefits.
How taxable, you're wondering? Using real-life data from more than 1,900 retiree households, the Center for Retirement Research at Boston College looked at how taxes due on 401(k)s, IRAs, Social Security retirement benefits, pensions and regular taxable accounts reduce the lifetime income for retirees. The analysis assumes a retiree only takes required minimum distributions (RMDs) from 401(k)s and IRAs and only collects interest and dividends on money in taxable accounts.
The researchers divided retirees into five groups based on their average income monthly earnings (AIME), which is Social Security’s mouthful for its calculation of your monthly lifetime earnings that determines your benefit.
The 20% with the highest AIME collected an average of $50,900 in Social Security benefits in their first year of retirement (that includes married couples with two benefits, as well as single beneficiaries), $25,900 in pensions, had 401(k)s/IRAs with an average balance of $325,400 and had other taxable accounts worth about $440,000. Annual tax bill: 10.7% for married couples, 17.3% for singles.
Granted, those households, relative to the population at large, have a boatload of savings, but those tax rates apply without even being a millionaire.
Even retirees whose Social Security benefit lands them in the top 5% aren’t necessarily millionaires. Their average 401(k)/IRA balances were $497,000 in their first year of retirement, and their regular investment account balances were nearly $456,000. Average tax bite: 15.8% for married couples, 24.8% for singles.
If you are still a few years from retirement and anticipate having a sizable tax bill, now is a smart time to consider huddling with a financial planner. There are many certified financial planners who work on an hourly or project basis. Potential strategies include:
—Roth 401(k): If your workplace offers one, consider doing some saving there.
You get no tax break on the contribution, but in retirement, withdrawals will be 100% tax free. The advantage of doing this now is that you stop adding money to your traditional accounts — where you will be required to take RMDs — thus reducing the potential size of taxable income in retirement.
—Roth IRA: If your employer doesn’t offer a Roth 401(k), you might be able to contribute to a Roth IRA. The maximum contribution in 2021 if you’re at least 50 years old is $7,000. To contribute the max, your modified adjusted gross income must be below $125,000 for single filers and $198,000 for married couples filing a joint return. Up to $140,000 (for single filers) and $208,000 (married) you can make a reduced contribution.
—Convert traditional 401(k) savings to a Roth: This is all about giving you some “tax diversification” in retirement: income that won’t count as taxable income. There’s a big upfront tradeoff you need to be aware of: Every dollar you move counts as taxable income in the year of the conversion. You want to avoid moving so much in one year it bumps you into a higher tax bill.
That said, this is a neat option to consider if you retire before age 72, when RMDs kick in. If you have years prior to age 72 when you (or a spouse) are working less or already retired, chances are your tax rate will be lower; those are good years to consider a conversion if you want tax-free income in retirement.
Your financial planner or tax pro can help you right-size the amount you convert in any given year.
—Bonus: having some retirement income that isn’t counted as taxable income. It may help you avoid higher Medicare Part B premiums. Once you’re enrolled in Medicare, you will owe a monthly premium for Medicare Part B. And that premium is based on your adjusted gross income.
In 2021, an individual whose 2019 tax return showed income of less than $88,000 and a married couple with joint income below $176,000 paid $148.50 per month per person. If your income is higher than that, Medicare Part B will cost you more. For example, a married couple with income between $176,000 and $222,000 will pay $207.90 per person, per month. And at even higher incomes, the premium is more.