Your 401(k) Has a Hidden Tax Bomb After 60

The balance on the statement is not the balance you keep

A 401(k) or traditional IRA balance looks like savings. It is savings with a liability attached. Every dollar in a pre-tax account went in before income tax and has grown without it, which means every dollar is taxed as ordinary income when it comes out.

The practical question is therefore not whether that tax gets paid. It is which year it gets paid in, and at what rate. Most of the planning in this area comes down to moving that tax into years where the rate is low, and out of years where it is high.

Withdrawals stop being optional at 73 or 75

For decades a pre-tax account can be left alone. Then, at a set age, the tax code requires money to start coming out every year, whether or not it is needed. These are required minimum distributions, and the amount is calculated from the account balance at the end of the previous year.

The age depends on when you were born. For anyone born between 1951 and 1959 it is 73. For anyone born in 1960 or later it is 75. The audience for this channel straddles that line, which is why the answer here is two numbers rather than one.

Missing a required withdrawal carries a penalty of 25 percent of the amount that should have come out, reduced to 10 percent if it is corrected promptly. The larger the balance, the larger both the withdrawal and the cost of missing it.

What makes the bill larger than it looks

A required withdrawal is not taxed in isolation. It stacks on top of everything else received that year, and two further effects follow from it.

First, it raises the combined income figure that decides how much of your Social Security is taxable. Up to 85 percent of the benefit can be included in taxable income, so a withdrawal is taxed and can also pull part of the benefit into tax with it.

Second, a high-income year can raise Medicare premiums. The surcharge is applied on a two-year delay, so the increase often arrives long after the decision that caused it.

Why it lands harder on women

Women generally outlive their husbands, and the tax code treats the surviving spouse very differently from the couple.

From the year after a husband’s death, a widow without a dependent child at home generally files as a single person. The brackets narrow and the standard deduction drops by roughly half. The required withdrawals from the same accounts continue unchanged. The same money is now taxed at higher rates, at exactly the point when one Social Security payment has also stopped.

That is the strongest argument for dealing with a large pre-tax balance while still able to file jointly, rather than leaving it for a single return later.

The window, and what to do with it

Between stopping work and the start of required withdrawals there is usually a stretch of years where income is much lower than it was and lower than it will be again. That stretch is the only period in which there is real control over the rate this money is taxed at.

A Roth conversion moves money from a pre-tax account into a Roth. Tax is paid on the converted amount in that year, and the money then grows and comes out tax-free, with no required withdrawals. Done in a low-income year, it moves future income out of a high bracket permanently.

Tiffani Lindstrom, CPA treats the size as the whole question. The method that tends to work is to establish where the top of the current bracket sits, subtract the income already expected that year, and convert roughly the difference, then repeat the following year with new numbers. Two further points matter. Paying the tax from money outside the retirement account keeps the full amount working in the Roth. And since 2018 a conversion cannot be undone, so the amount has to be right before it is sent.

If you give to charity

From age 70½, money can go directly from an IRA to a charity. It counts toward the required withdrawal and never becomes taxable income, which is generally better than taking the withdrawal and donating the cash.

It has to come from an IRA rather than a 401(k), so for anyone who already gives regularly and holds most of their savings in a workplace plan, rolling some of it into an IRA can be worth doing first.