For decades, you have been encouraged to save for retirement, contribute to your workplace plan, and allow your investments to grow tax-deferred.
Building a substantial traditional IRA or 401(k) is an important achievement. But as retirement approaches, the focus begins to shift. It is no longer only about how much you have accumulated. It is also about how those savings may be taxed when you begin taking withdrawals.
For some affluent retirees and pre-retirees, a large balance in tax-deferred retirement accounts may eventually generate more taxable income than expected. Required Minimum Distributions, Social Security benefits, pension income, investment income, and realized capital gains can all become part of the retirement tax picture.
The question is not whether you have done a good job saving.
The question is whether your retirement accounts are structured to provide the flexibility you may want during retirement.
Why a Large IRA May Create Future Tax Challenges
Traditional retirement accounts can provide valuable tax benefits during your working years. Contributions may be deductible or made with pre-tax income, depending on the account and your circumstances, and investment growth generally remains tax-deferred while it stays inside the account.
The tradeoff is that distributions from traditional IRAs and pre-tax retirement plans are generally included in taxable income, except for amounts representing after-tax basis or another applicable exclusion. [irs.gov], [irs.gov]
Over several decades, contributions, employer matches, and investment growth can produce a substantial account balance. That may provide meaningful retirement resources, but it can also create a larger source of taxable income later.
This becomes especially important when Required Minimum Distributions begin.
What Are Required Minimum Distributions?
Required Minimum Distributions, commonly called RMDs, are minimum annual withdrawals that generally must be taken from certain tax-deferred retirement accounts once the account owner reaches the applicable starting age.
Under current federal rules:
- Individuals born from 1951 through 1959 generally begin RMDs at age 73.
- Individuals born in 1960 or later generally begin RMDs at age 75.
- Traditional IRAs, SEP IRAs, SIMPLE IRAs, and many employer retirement plans are generally subject to RMD rules.
- Roth IRAs do not require lifetime RMDs for the original account owner.
- Designated Roth accounts in 401(k) and 403(b) plans are also not subject to lifetime RMDs for the original owner under current rules. Beneficiaries may still be subject to distribution requirements.
For traditional IRAs, the first RMD may generally be postponed until April 1 of the year following the year the owner reaches the applicable RMD age. However, postponing the first distribution can result in both the first and second RMD being taken in the same calendar year because subsequent RMDs are generally due by December 31.
Some workplace retirement plans may allow individuals who are still employed to delay RMDs from that employer’s plan until retirement. That exception generally does not apply to someone who owns more than 5% of the business sponsoring the plan. It also does not delay RMDs from traditional IRAs.
Because the rules vary by account type and personal circumstances, investors should confirm their required beginning date with a financial or tax professional.
How RMDs May Affect Retirement Taxes
Many people assume their tax rate will automatically fall after they retire. That may happen for some households, but it is not guaranteed.
Retirement income may come from several sources, including:
- Required Minimum Distributions
- Social Security benefits
- Pension income
- Taxable investment income
- Realized capital gains
- Part-time employment or consulting income
- Rental or business income
RMDs from pre-tax accounts are generally included in taxable income. As those mandatory distributions grow, they may contribute to a retiree’s overall taxable income even when the money is not needed for current spending. [irs.gov], [irs.gov]
Whether an RMD changes someone’s tax bracket depends on the individual’s full financial situation, including other income, deductions, filing status, and applicable tax law.
That is why retirement tax planning should consider more than the size of an IRA. It should evaluate how all income sources may interact over time.
Could RMD Income Affect Medicare Premiums?
For some retirees, higher modified adjusted gross income may result in an Income-Related Monthly Adjustment Amount, commonly referred to as IRMAA. IRMAA is an additional amount charged for Medicare Part B and Part D when income exceeds applicable thresholds.
An RMD does not automatically increase Medicare premiums. However, because taxable RMD income may increase modified adjusted gross income, it can contribute to whether an individual crosses an IRMAA threshold.
Other income-generating decisions may also affect modified adjusted gross income, including:
- Roth conversions
- Capital gains
- Taxable interest
- Dividends
- Pension income
- Certain Social Security income
The important distinction is that Medicare premiums are affected by income levels, not by the existence of an IRA or RMD alone.
For this reason, retirement distribution decisions should be coordinated with the individual’s broader tax and Medicare planning.
Tax Diversification May Provide Greater Flexibility
Most investors understand investment diversification. They may own a combination of stocks, bonds, cash, real estate, and other assets.
Tax diversification applies a similar idea to the taxation of retirement assets.
Retirement savings generally fall into three broad categories:
Tax-Deferred Accounts
Examples include:
- Traditional IRAs
- Traditional 401(k)s
- Traditional 403(b)s
Distributions from pre-tax balances are generally taxable as ordinary income.
Taxable Accounts
Examples include:
- Individual brokerage accounts
- Joint investment accounts
- Bank savings accounts
Interest, dividends, and realized gains may be taxable depending on the investment and the investor’s circumstances.
Potentially Tax-Free Accounts
Examples include:
- Roth IRAs
- Roth 401(k)s
- Roth 403(b)s
Qualified Roth distributions may be received free from federal income tax when applicable requirements are satisfied.
Having assets in multiple tax categories does not eliminate taxes. It may, however, provide greater flexibility when deciding where retirement income should come from in a particular year.
For example, a retiree may have more withdrawal options when managing taxable income, charitable giving, major purchases, or legacy objectives.
Could a Roth Conversion Help Reduce Future RMDs?
A Roth conversion moves funds from an eligible pre-tax retirement account into a Roth account. The taxable portion of the converted amount is generally included in income in the year of conversion.
Once converted, those assets are removed from the traditional account balance that would otherwise be considered when calculating future RMDs. Roth IRAs are not subject to lifetime RMDs for the original owner under current federal rules. [irs.gov], [irs.gov]
Depending on the individual’s circumstances, a carefully evaluated Roth conversion strategy may provide:
- Lower future RMDs
- Greater control over taxable retirement withdrawals
- More assets with the potential for tax-free qualified distributions
- Greater flexibility when coordinating income with Medicare thresholds
- Additional options when planning for beneficiaries
- In certain situations, lower lifetime taxes
These outcomes are not guaranteed. Paying tax on a conversion today does not automatically produce a better long-term result.
Whether a conversion makes sense depends on factors such as:
- Current and projected future tax rates
- The size of pre-tax retirement accounts
- Other retirement income
- Available funds to pay the conversion tax
- Medicare IRMAA considerations
- State income taxes
- Charitable intentions
- Estate and beneficiary goals
- Expected time horizon
Roth conversions create taxable income in the year of conversion and may affect an investor’s tax liability, Medicare premiums, taxation of Social Security benefits, and other financial planning considerations. Investors should consult qualified tax and financial professionals before implementing a conversion strategy.
When Might Roth Conversions Be Evaluated?
For some individuals, the years after retirement but before RMDs begin may provide an opportunity to evaluate Roth conversions and other tax-planning strategies.
During this period:
- Employment income may have ended or declined.
- RMDs may not have started.
- Social Security may not have been claimed.
- The retiree may have more control over taxable income.
This does not mean the period is automatically the ideal time to convert. Pension income, capital gains, health insurance subsidies, Medicare status, charitable giving, and other factors may materially change the analysis.
The appropriate amount is also highly individual. Converting too much in one year may increase the marginal tax rate or modified adjusted gross income. Converting too little may leave unused planning opportunities.
A year-by-year tax projection can help evaluate the tradeoffs.
Signs Your IRA May Deserve a Closer Look
A retirement tax review may be useful if:
- A significant portion of your wealth is held in traditional IRAs or workplace retirement plans.
- You are approaching retirement or your applicable RMD age.
- You expect income from a pension, Social Security, a business, or investments.
- You do not anticipate needing your future RMDs for living expenses.
- You are concerned about future taxable income.
- You want additional flexibility over retirement withdrawals.
- You are evaluating Roth conversions.
- Medicare premium exposure is part of your planning.
- You want to leave retirement assets to children or other beneficiaries.
No single account-balance threshold determines whether someone has a retirement tax problem. The analysis should be based on projected distributions, total income, tax circumstances, spending needs, and long-term goals.
Questions to Ask Before Making a Roth Conversion
Before converting traditional retirement assets to a Roth account, consider asking:
- What could my RMDs look like if I make no changes?
- What is my estimated marginal tax rate this year?
- What tax rate might apply after RMDs begin?
- How would a conversion affect my modified adjusted gross income?
- Could the additional income affect my Medicare premiums?
- Could it increase the taxable portion of my Social Security benefits?
- Do I have non-retirement assets available to pay the tax?
- How would state income taxes affect the decision?
- Would a partial, multiyear conversion be more appropriate?
- How would a conversion affect my estate and beneficiaries?
- What assumptions are being used in the long-term projection?
- Under what circumstances would the strategy produce an unfavorable result?
These questions can shift the conversation away from whether Roth conversions are broadly “good” or “bad” and toward whether a specific strategy fits the individual.
Common Mistakes to Avoid
Focusing Only on This Year’s Tax Bill
Minimizing current taxes is not always the same as minimizing taxes over an entire retirement. At the same time, paying more tax now is not automatically beneficial.
Both the current cost and the projected long-term outcome should be considered.
Converting Without a Tax Projection
A conversion adds taxable income. Before acting, investors should understand how that additional income may affect their marginal tax rate and other income-sensitive items.
Using Retirement Funds to Pay the Tax Without Evaluating the Consequences
Withholding taxes from the converted amount leaves less money in the Roth account. Depending on age and circumstances, amounts not properly converted or rolled over may also create additional tax consequences.
Overlooking Medicare
For individuals enrolled in or approaching Medicare, the impact on modified adjusted gross income should be evaluated before completing a large conversion.
Assuming Tax Laws Will Remain Unchanged
Long-term planning necessarily involves assumptions. Tax rates, Medicare rules, RMD requirements, and estate laws may change. A strategy should be reviewed rather than treated as a one-time decision.
The Goal Is Long-Term Flexibility
The objective of retirement tax planning is not simply to pay the least possible tax this year.
A more useful question may be:
How can my retirement assets support my income, tax, charitable, and legacy goals over time?
For some individuals, that may include Roth conversions. For others, maintaining a larger traditional IRA, using Qualified Charitable Distributions when eligible, or following a different withdrawal strategy may be more appropriate.
The right approach depends on the full financial picture.
Looking Beyond the Balance
Building a substantial IRA is a meaningful accomplishment. The next step is understanding how that account may affect future taxable income, RMDs, Medicare premiums, and the assets eventually passed to beneficiaries.
The earlier these issues are evaluated, the more time an investor may have to compare available strategies. That does not mean changes are always necessary. It means the decision can be made intentionally rather than after mandatory distributions have already begun.
Let’s Build a Tax-Smart Retirement Strategy
Could your retirement accounts create a future tax challenge?
Landmark Financial can help you evaluate projected RMDs, retirement income sources, and tax-diversification opportunities as part of your broader financial plan.
Schedule a conversation with a Landmark Financial advisor.
This material is provided for informational and educational purposes only and should not be considered investment, tax, or legal advice. Retirement plan rules, contribution limits, and tax laws are subject to change. Roth and traditional retirement strategies may not be appropriate for every investor. Converting from a traditional IRA to a Roth IRA is a taxable event. A Roth IRA offers tax free withdrawals on taxable contributions.
To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first-time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes. Investing involves risk, including possible loss of principal. Future results, tax outcomes, and retirement objectives cannot be guaranteed. Individuals should consult with their financial, tax, and legal professionals before implementing any strategy.