If you’re facing a retirement tax bomb, there are three main strategies to defuse it: shifting retirement savings from pre-tax accounts to Roth and HSA accounts, implementing asset location, and executing Roth conversions.
I consider shifting your savings to be the first line of defense, because it’s the easiest solution to implement. However, to really get the job done, you’ll likely need to implement all three strategies.
There are two flavors to shifting savings, one uses Roth retirement accounts, while the other uses health savings accounts (HSAs).
Shift Retirement Plan Contributions from Pre-Tax to Roth
Perhaps the easiest solution to implement is simply changing your retirement plan contributions from pre-tax to Roth. You’ll lose the tax deduction in the current year, and you may have to explain to your accountant why you made the change. However, any company match is tax-deferred, so even if you switch to 100% Roth, the employer match and your investment return means the tax-deferred account will still grow.
Many of my clients aren’t aware they have a Roth option in their 401(k)/403(b), or they mistakenly think they can’t contribute to one because of income limits, but that’s not true. Only Roth IRAs have an income limit. So find out if your retirement plan offers a Roth option.
Let’s look at the impact of this one action in more detail through the lens of our example 40-year-old couple who previously were maxing out their pretax 401(k)s each year (currently $20,500 each through age 49, then $27,000 from age 50 to 64), plus a $6,000 employer match each. If the couple switched all contributions from pre-tax to a Roth 401(k), only the $12,000 in combined employer match remains as a pre-tax contribution.
The impact is massive.
- Their pre-tax savings at age 65 falls from $7.3 million to $3.6 million (down 50.2%). Their first year of RMDs at age 72 falls from $435,820 to $215,281 (down 50.6%), while their lifetime RMDs through age 90 falls from $15.6 million to $7.7 million (also down 50.6%).
- Their Medicare means testing surcharges through age 90 fall from $1.5 million to $730,483 (down 51.5%).
- The inherited IRAs that pass to their two children at age 90, which are taxable at the children’s ordinary tax rates, fall from $16.1 million to $8 million (also down 50.6%).
- Their tax-free savings grow to $3.6 million by age 65. If they never have to withdraw money from the tax-free accounts during retirement (RMDs don’t apply to Roth accounts and they’ll have lots of money from tax-deferred RMDs), their tax-free savings would balloon to $20.4 million at age 90. While their heirs will have to completely drain the inherited Roth accounts over 10 years, none of those withdrawals are taxable.
For younger investors, the best way to defuse a retirement tax bomb, in terms of both impact and ease of execution, is to simply shift retirement plan contributions from pre-tax to Roth. This strategy will be less impactful (but still worthwhile) for those nearer retirement because they have fewer years for the effects to compound.
Invest Using Health Savings Accounts
If you have a high-deductible medical plan, for 2022 married couples can contribute up $7,300 ($3,650 if single) to the associated health savings account (HSA). People who are 55 and older can make an additional $1,000 “catch-up” contribution.
An HSA is like a turbo-charged IRA, because it’s the only account that gives you both a tax deduction on the contribution (like a pre-tax 401(k) or a traditional IRA), while withdrawals are considered tax-free (like a Roth IRA) if used to pay for qualified medical expenses. Unlike a Roth IRA, an HSA has no income limitations. So, anyone with a high-deductible medical plan who isn’t yet enrolled in Medicare can contribute. HSAs should be the top funding priority after capturing your 401(k)/403(b) match (the “free” money). Some employers even contribute to HSAs on behalf of their employees.
However, most clients I speak with about HSAs are using them wrong, either paying current medical expenses with the account, or the HSA account is sitting 100% in cash rather than being invested. They think an HSA works like a flexible spending account (FSA), which has a “use it or lose it” feature where funds not used by Dec. 31 are lost. Basically, HR departments slightly changed the acronym (from FSA to HSA) and promoted the use of the associated debit card to pay for medical expenses. Few employees truly understand why they should manage HSAs very differently.
Most savers who can afford to pay for current medical expenses out of pocket should do that and instead invest the HSA so it grows to fund medical expenses in retirement. It takes a few extra steps to open an associated investment account, move funds from the HSA bank account to the HSA investment account, and then invest it. But the benefit can be well worth the effort, especially for younger savers who have many years for the tax-free funds to grow. Incidentally, you typically should invest the HSA aggressively, something I’ll talk more about in my next article on asset location.
You’ll need the HSA in retirement. A 2022 study from Fidelity estimates that a couple retiring at 65 today will spend approximately $315,000 on medical expenses in retirement, not counting long-term care expenses. This Fidelity estimate assumes average health and average longevity. But if you live longer than average or your health is worse than average, your expenses likely will be higher.
Halt Tax-Deferred Contributions at the Match
If your retirement plan doesn’t offer a Roth option (shame on your employer and plan provider), and you’ve saved a lot in tax-deferred accounts already, you might consider contributing only enough to the tax-deferred account to capture 100% of the company match — but not beyond. If you do this, it’s critical to continue saving as much as possible in a taxable account to maintain a high savings rate. One easy way to do this is to schedule an automated monthly transfer from your bank account to a taxable investment account.
Investing in taxable accounts becomes more attractive when a portfolio is managed to minimize turnover (frequent trading generates taxes) and optimize asset location. For instance, low turnover and effective asset location can enable a taxable portfolio to have minimal “tax drag” and be 90% as tax-efficient as a tax-deferred account. That 10% loss in tax efficiency may be more than made up by avoiding a retirement tax bomb.
Make Roth IRA Contributions, if Eligible
If your income is low enough, many people can also save in a Roth IRA. For 2022, eligibility begins to phase out beginning at $204,000 of modified adjusted gross income for married filing jointly ($129,000 for single filers). If eligible, you can contribute up to $6,000 of earned income, and if you’re age 50 or older, you can add a $1,000 “catch-up” contribution. If your spouse doesn’t work and you have enough earned income to cover their contribution, you can contribute to their Roth IRA as well.
Don’t Make Non-Deductible IRA Contributions
The main benefit to tax-deferred accounts is the tax deduction you receive in the year of contribution. For 2022, eligibility to make a tax-deferred contribution to an IRA begins to phase out at $109,000 of modified adjusted gross income for married filing jointly ($68,000 for single filers). Many clients I meet who are not eligible to make deductible contributions still make after-tax contributions that are not deductible. I was guilty of this myself for many years. If you have a potential retirement tax bomb, this is simply throwing gasoline on the fire.
Reducing pre-tax retirement plan contributions flies in the face of conventional wisdom. But, as our example shows, shifting savings to tax-free Roth accounts can make a massive impact on your retirement security and after-tax wealth.
Today we looked at the first strategy for defusing a retirement tax bomb, which is shifting contributions from pre-tax to after-tax Roth accounts. My next article will examine the second strategy, implementing asset location.
