Reconsider Growing Your Pre-Tax 401(k) or IRA

Building up a substantial amount of savings in your 401(k) or IRA may serve as an indicator of a job well done in saving for retirement. But what soon-to-be retirees need to realize is that if the majority of your retirement savings is in pre-tax dollars, taxes will eventually be owed while in retirement. And depending on your tax situation and the tax laws in place at that time, these large account balances may cause a tornado of taxation that you weren't expecting, which can cause you to have to rethink your retirement strategy altogether.

[00:01:01]:
Hello and welcome to the Retired-ish Podcast. Cameron here. Before we get started, I wanted to take a quick moment and say happy holidays to you and your family. I hope you take this time of year to spend that extra special time with friends and family. And because it's the holiday season, I also have a little gift for you. In the episode show notes for today's episode, we have provided the link for a free download of our 2025 important numbers guide that gives you 2025 tax rates, brackets, schedules, important Social Security and Medicare figures, and more that you can refer to for your own financial planning and decision-making, all in one spot if needed. So be sure to get to the website and get your gift. It may be especially useful to reference after today's episode.

[00:01:51]:
So, let's get to it. Today I want to have a serious discussion about those of you age 50 and over and why you should consider slowing down on making the effort to grow your large pre-tax IRAs and 401(k)s. Many people in their 50s are stuck in the status quo, focusing on maxing out their pre-tax 401(k)s and IRAs while working and continuing to build up very large pre-tax balances in these retirement accounts. This might sound like you; however, you'll want to know that this can come back to bite you in retirement. And that's because these accounts are looking more and more likely to be subject to higher future taxes on those large balances.

In addition, large withdrawals later in life, when you start to spend some of this money that you've worked so hard to save, can cause additional tax issues, such as causing more of your Social Security benefits to be taxed and substantial increases to your Medicare premiums causing a tornado of high taxes. Now, we have talked about some of these shadow taxes in a previous episode, so in case you missed it or you want to refer back, we will include a link to it in the episode show notes. If these pre-tax balances are left untouched to keep growing, these accounts are silently accruing these big future tax bills, which may also be paid at higher tax rates down the line. The sad thing is that many people won’t realize this until it's too late, and they are already well into retirement and there won't be much of anything that they can do about it.

So you and your advisors, if you have one, should be having serious conversations to see what is best for your particular situation and your family's estate plan to make sure that you're preserving as much money in those accounts as possible. Because right now, the IRS and possibly the state tax authorities have their hands all over the cookie jar and there might be some opportunities to hold on to more of the money that you've been saving your whole life. You can't rely on someone like your tax preparer to plan for that and point that out for you ahead of time.

[00:04:02]:
It likely won't ever happen, and if your spouse deals with the retirement investments and or the taxes, don't assume they realize this issue and will magically take care of it, either. You simply cannot ignore this buildup. It won't go away. These taxes will have to be paid at some point, whether that be by you, your spouse, or your kids in other heirs.

Only charities can avoid the taxes entirely on these types of accounts and if they aren't being paid by you, that means you're not enjoying and using the money you've saved. Just imagine that the taxes will be paid by you at some point over the remainder of your lifetime. Therefore, it's not if you will pay the taxes on the money, but when. And the when is what you want to be in control of. In that case, I would suggest that if you and or your spouse will have multiple income sources in retirement, that could be income from rental properties, pensions, Social Security, other investment income, business income, or working part-time in retirement, whatever, and you already have a pretty substantial pre-tax 401(k) or IRA balance, don't continue to add to your 401(k) on a pre-tax basis to get the tax deduction today in this current environment, unless you are absolutely positive that you are in the highest tax bracket and you know for certain that that will change once you retire. And for those of you who contribute to a 401(k) at work, you might ask, what about the company match? Will I lose that if I stop contributing pre-tax to my 401(k)? And the answer is no, not necessarily. The company will still match you even if you contribute, let's say, to the Roth account in your 401(k), although typically, this match does go in on a pre-tax basis.

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So even if you're contributing to the Roth account in your 401(k) if that's available and your employer matches you, usually that dollar amount that they're matching goes into the pre-tax account. And again, depending upon your employer's plan document, they may be able to match those dollars with Roth money instead. And this is a relatively new rule that just came into play within the last couple of years. However, be aware that a Roth employer match would be taxable in the year you receive it. So, you may need to adjust your income tax withholding on your paychecks if that starts to happen.

Now, I'm not saying all pre-tax money is a bad thing. What I'm saying is that you should strongly consider slowing down the rate at which you are building up these pre-tax accounts. In the case of an employer match, free money is free money. So whether it's pre-tax or Roth, just make sure that you're getting it. This also means that if you and a spouse are in a similar situation to the one I just mentioned, don't beef up your pre-tax 401(k) contributions, as the maximum limits rise each year either. Or after you reach age 50, when you can start making what are called the catch-up contributions, those are those extra dollar amounts that once you reach age 50, you can actually contribute a little bit more to your 401(k) plan or the like. And actually, starting in 2025, there's an even higher catch-up contribution limit for those between the ages of 60 and 63.

[00:07:33]:
So why do we not want to continue making larger pre-tax contributions? Well, again, you're just adding to the future tax problem. We don't want to be short-sighted here and not look at the big long-term tax planning picture. In other words, how can we reduce the total tax bill paid over our entire lifetimes if we just look at it today and think, hey, I save a bunch of money in taxes because I max my pre-tax 401(k) or my IRA every year, but then in retirement, it causes what I call the tax tornado, and you end up paying more taxes at that time? In that case, did you really win? Yes, you can get a tax deduction that could reduce your tax bill this year, but that's a short-term gain that will be paid for in potentially future higher taxes. And yes, I will say that because of the concept known as the time value of money, tax savings today can be more advantageous because a dollar today is worth more than a dollar in the future because it can be invested and due to inflation.

But I would argue that that all depends on what you do with that tax savings. And I'll tell you what. 99% of people do not calculate the tax savings that they get from their 401(k) contributions and invest that money elsewhere on a consistent basis. So I'd argue that the time value of money concept for a tax deduction today from your 401(k), especially at today's historically low tax rates, is dead in the water. And by the way, the “deduction” is not even a real deduction that you get to keep. It's really just a temporary gain. It's essentially a loan that you are taking from the government that likely you or your spouse will pay back at probably the worst time in retirement when balances and tax rates may be much higher.

Now, this can get really bad in some circumstances because if tax rates end up being higher when you start to withdraw some of this money, you will need to make larger withdrawals from your retirement portfolio or your account to meet your expenses net of things like taxes and inflation. And the higher the rate of your withdrawal, the more risk you need to take with your investments, and the higher the chance you run out of money too early. And this is exactly what we don't want.

[00:10:00]:
This is exactly what we try to avoid when deciding to save for retirement to begin with. I would argue that the better option in the current tax environment may be to forego the tax deduction today and these temporary tax savings and instead put the funds into something like a Roth 401(k) if your employer offers it or a Roth IRA, preferably both. And if you're choosing between funding a Roth IRA versus a traditional IRA because you don't have access to an employer plan like a 401(k), but you're still working and earning an income, I would strongly consider the Roth IRA.

If you're no longer working, or you have a year or two with lower income due to going on leave or changing jobs or something like that, you might start to strongly consider what are called Roth conversions as an alternative way to start getting money out of your pre-tax accounts into a Roth account that can offer tax-free growth in the future. The benefit of doing this is that you get to control how much tax you pay since you can decide how much to convert based on your marginal tax rates in your financial situation. It's totally up to you. And once required minimum distributions, aka RMDs, come into play in your 70s, that control is largely gone because you are then forced to withdraw the funds.

Those RMDs not only must be taken unless you want to pay additional taxes via penalties but they cannot be converted to Roth, so the RMDs themselves cannot be converted, so you end up with a tax bill that's out of your control, with no benefit of moving the funds to a Roth IRA, which could be looked at as a wasted opportunity. That's why it's so important to start doing this stuff now, or at least thinking about it now. That is, of course, unless you love burning money. The key point of all of this is to preserve more of your money from potentially higher taxes in the future.

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But why are tax rates likely to be higher in the future, especially in retirement? Well, there is no guarantee that your taxes will be higher when you need to start withdrawing the money from these accounts. However, due to the surmounting national deficit and spending and the trend of recent retirement and tax laws that have been put into place over the past few years, the writing is on the wall. The government needs money. And the primary way the government gets money, other than issuing more debt or printing more money, is through taxation. So, do you see the endless cycle here? Currently, in 2024 and continuing at a minimum through next year in 2025, we have historically low tax rates. And for reference, in the show notes, I've included a chart that shows historical federal tax rates so you can see for yourself. And do you think your particular state's taxes will go down in the future? Likely not.

So, we have historically low tax rates, a recent explosion of the US deficit, which is now a multi-trillion dollar number, and the government is not going to just stop spending, of course. When you put all of that together, it's not hard to imagine higher tax rates in the future.

In fact, beginning in 2026, tax rates are supposed to be going back up to the rates in the brackets that were in place before 2018. It's already written into the law. However, with Trump returning to the White House, the likelihood of the lower rates we have currently continuing past 2025 is pretty likely, but these low rates can only go on for so long.

So again, it's not hard to imagine that ten-plus years into the future, you are subject to possibly an extra ten-plus percent in federal income taxes alone, and you'll have all of the other additional taxes on your required minimum distributions, Social Security and Medicare premiums to try to avoid as well.

[00:14:04]:
So it comes down to do I pay the devil I know and pay the current historically low tax rates today? That way, I know how much I will be paying, or do I leave all of it up to chance with a high likelihood of paying more in the future? Of course, you know your situation best. But this decision obviously requires some heavy thinking, lifting, and financial planning. The key is to start that planning today and start implementing strategy now before it's too late.

As I mentioned, the tax cuts are set to expire after 2025, but with this new administration, we may have several more years of these lower tax rates and large brackets that should be optimized. And I'm willing to bet that most people have no plan of action and think nothing needs to be done before 2026 since they believe that these tax cuts may be extended. But I would encourage you to think differently. You can use these extra years to trim these pre-tax balances down and move them into accounts such as Roths at potentially the lowest tax rates you may see for the remainder of your lifetime. More years to be able to do this is more years that low brackets will be available.

Any year where, let's say, a 10% or even a 24% federal tax bracket is not fully utilized could be a wasted opportunity to save on taxes in the long run. And God forbid you have pre-tax retirement account balances that are fairly large, but you have certain years where you don't end up owing any taxes, or you don't even have to file because your income is low enough.
In these cases, you're almost certainly wasting money.

As I've mentioned in previous episodes, not having a tax liability at the end of the year with these retirement accounts is not necessarily a good thing. That likely means that you've wasted some opportunities to shift some of this money over. These low brackets are too valuable not to take advantage of.

[00:16:06]:
You don't know when this low tax rate regime will end, but it's here now, and possibly for several more years before Congress may have to raise rates and compress the tax brackets due to the mounting multitrillion-dollar debt levels. On another note, if you're in your 50s or 60s and you are someone who stands to inherit some form of wealth from a parent, you need to be prepared for this as well. Your situation will just be a little bit more complicated, and here's why.

Most IRA or 401(k) beneficiaries other than a surviving spouse are subject to what is called the ten-year rule. This essentially means that the entire inherited IRA or 401(k) account balance will have to be completely withdrawn by the end of the tenth year following the original owner's death. If you are going to be one of these beneficiaries, you generally should not be waiting until year ten to take all of the money from these large accounts like an IRA or a 401(k).

Otherwise, you'll likely give way more than you need to the tax authorities. You need to have a plan to get the money out at the lowest possible rates, given your situation, and there's typically always a way to do that. Some beneficiaries are also subject to taking RMDs for years one through nine of the ten-year term if they inherited from an IRA owner who had already begun taking their own RMDs before they passed. But even here, those RMDs are relatively small because they are based on the beneficiaries' age, which in this case would be your age, which is much younger than, let's say, a parent.

[00:17:53]:
So, beneficiaries will still end up with a big tax bill in year ten because most of the accounts will still be intact. A better approach is to not waste those years one through nine by withdrawing nothing or just the smallest minimum amount required. Withdraw more to smooth out the overall tax bill over the ten years or strategically take more in certain low tax years. This can keep more money in your pocket. It's sort of like buying out the IRS's share of the cookie jar at a discounted rate.

Okay, so remember those Roth conversions I mentioned? Well, I want to help you avoid any potential estimated tax penalties on those Roth conversions that seem to bite a lot of people unexpectedly. Estimated taxes are usually paid in four equal installments, one for each quarter of the year, and an unexpected income spike from something like a Roth conversion late in the year could result in underpayments for the earlier quarters of the year. For estimated tax purposes, a Roth conversion or some kind of spike in income done, let's say in December, for example, is actually deemed income earned evenly throughout the year, not just in the fourth quarter. Assuming no other tax withholding, quarterly estimated tax payments, including the taxes due on the December conversion in this example, would actually be due for all four quarters of the year.

And if the income spike from the conversion is not accounted for, an estimated tax penalty, which is currently 8% of the underpayment by the way, could apply. So yikes! That can make a conversion really expensive. Think of that as an extra 8% in taxes on top of your marginal tax rate and potentially state taxes. So, this mistake can potentially have you paying over 50% in taxes.

[00:19:52]:
To avoid the estimated tax penalty on a Roth conversion that you might do late in the year, you need to be proactive. To do that, you want to inform the IRS that the income was earned only in the fourth quarter. And you can do that by filing Form 2210, which is an IRS form that you can file along with your taxes. And on that form, you would use the annualized income installment method. So, it has its own section on the form to do just that. And this can help eliminate the estimated tax penalty for the first three quarters of the year. And I will caveat this can be a complicated form to complete, so help from a tax professional is highly recommended.

To get the best bang for your buck when doing a Roth conversion, it's often more beneficial to pay the tax bill caused by the conversion itself from cash that is outside of the retirement account itself. So, when doing a conversion, try to make sure you have enough money set aside to pay the taxes. An alternative option to pay the taxes and avoid the penalty using Form 2210 is actually to take a distribution from the same IRA or maybe another IRA and have 100% of the distribution withheld for taxes. These withheld taxes are deemed to be paid equally over the year, which can level out any underpayments in the previous quarters.

So, the key thing to note here is that withholding is treated differently by the IRS than an estimated payment. And as I said before, this method will still require you to have the cash to actually pay the taxes owed from the conversion set aside elsewhere, as you will see right here in my example. But this method can help you avoid doing the pesky tax form. They don't teach you this stuff in school, of course, or even in any professional courses, by the way, but now you're going to be in the know.

[00:21:52]:
So here it goes. Here's my example. Based on his current income, Anthony anticipates a total annual tax bill of $40,000. And as such, he pays a quarterly estimated tax of $10,000 over the first three quarters of the year. Late in the year, in December, Anthony does a Roth conversion for which he had not planned to do earlier in the year. The income from the conversion doubles Anthony's total tax due for the year to $80,000. So, as a result, each of his first three quarterly estimated payments is $10,000 short. So, to cover that shortfall, Anthony decides to take an additional distribution from his IRA for $40,000, which is the extra tax shortfall, but he has the whole thing withheld for taxes. And yes, you can do that. The taxes withheld are deemed to be paid equally over all four quarters. So, this solves our penalty issue.

But wait, now we have a tax issue because he just pulled out another $40,000 from his pre-tax retirement account. Hold steady. This 100% withholding from the IRA brings the first three quarterly estimated tax payments up to $20,000, which covers the additional taxes due on his Roth conversion. Now, the final $10,000 is going to be applied to the fourth quarter, which isn't over yet in this example. Promptly after taking the extra $40,000, Anthony actually replaces those dollars in his IRA with the funds set aside in his checking account via what is called a 60-day rollover, thereby eliminating any taxes due on the $40,000 distribution because he put it back into the IRA using the rollover.

[00:23:51]:
One caveat of this method is that you can only do one 60-day rollover per year, so you need to be really careful. While neither method is what I would call simple, they both get the job done, and you will need to do some planning ahead of time to figure out how you will do your own Roth conversions and avoid unnecessary penalties.

That does it for today's episode. Remember to start planning today if you haven't already. And if you care about how much you pay in taxes today, then you are certainly going to care when you're no longer receiving a paycheck in the future. Make this planning a priority. The last thing you want is to try to fix this problem last minute.

If you find the strategies and information I provided in today's show actionable, valuable, and insightful, please subscribe to or follow the show on your podcast app. Also, be sure to check out the Retired-ish video newsletter to get more useful information on retirement planning, investments, and taxes once a month straight to your inbox.

And if you want to learn more about the topics I went over in the show today, or you want to ask a question to be answered on a future episode, you can find links to the resources we have provided in the show notes right there on your podcast app. Or you can head over to retiredishpodcast.com/59. Thanks again for tuning in and following along. See you next time on Retired-ish.

Disclosure [00:25:35]:
Securities and advisory services are offered through LPL Financial, a Registered Investment Advisor member, FINRA SIPC. The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision. Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion withdrawal, limitations from a Roth IRA, and income limitations for future contributions to a Roth ira. In addition, if you are required to take an RMD, a required minimum distribution, in the year you convert, you must do so before converting to a Roth IRA. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Neither LPL Financial nor its registered representatives offer tax or legal advice. Always consult a qualified tax advisor for information as to how taxes may affect your particular situation. Tax and Accounting Related Services Offered through Planet Business Services DBA Planable Wealth Planet Business Services is a separate legal entity and not affiliated with LPL Financial. LPL Financial does not offer tax advice or tax and accounting-related services.