If you’re nearing retirement with a large pre-tax 401(k) plan or individual retirement account balance, you need a plan for managing future levies, financial experts say.
Great savers could face a “tax time bomb” in retirement when required withdrawals kick in, said certified financial planner Scott Bishop, partner and managing director of Presidio Wealth Partners in Houston.
Starting in 2023, Secure 2.0, a $1.7 trillion legislative package signed by President Joe Biden in December 2022, raised the age that savers must start taking required minimum distributions, or RMDs, to 73. RMDs are typically tied to pre-tax retirement accounts, which incur regular income taxes for withdrawals.
Those RMDs could push some retirees into a higher tax bracket, according to Bishop, who is also a certified public accountant.
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Plus, the Tax Cuts and Jobs Act of 2017 temporarily reduced federal income tax brackets, with the top rate falling to 37% from 39.6%. Those lower rates are scheduled to sunset after 2025 without an extension from Congress.
Meanwhile, only three in 10 Americans have a plan to reduce taxes on retirement savings, according to a January 2024 study of roughly 4,600 U.S. adults from Northwestern Mutual.
However, once retirees reach age 59½, there’s no longer a penalty on most withdrawals from IRAs, which could offer tax planning opportunities, Bishop said.
Here are some key tax planning strategies to consider before RMDs begin.
Weigh ‘partial Roth conversions’
“The most obvious strategy is partial Roth conversions at lower tax rates,” said CFP George Gagliardi, founder of Coromandel Wealth Management in Lexington, Massachusetts.
Roth conversions transfer pretax or nondeductible IRA money to a Roth IRA, which begins tax-free future growth. But you’ll owe regular income taxes on the converted balance in the year you make the conversion.
The temporary 22% and 24% federal income tax brackets “offer the best opportunity” to convert large pretax balances to Roth IRA, Gagliardi said. Without action from Congress, those rates will revert to 25% and 28%.
Withdraw retirement funds sooner
If you retire around age 59½ and you’re in a lower tax bracket, you could also consider withdrawing pretax retirement funds sooner, said Bishop. Typically, investors can tap IRAs and 401(k)s without penalty for any reason at age 59½.
“You can use some of the lower brackets now versus hitting higher brackets with RMDs later,” he said.
The strategy could be appealing before collecting Social Security income, particularly between age 59½ and 63, since added income can impact Medicare premiums, experts say.
In some cases, higher income can trigger income-related monthly adjustment amounts, or IRMAA, for Medicare Part B and Part D premiums. Your IRMAA is based on so-called modified adjusted gross income, which is your adjusted gross income plus tax-exempt interest, from two years prior.