When many people think about retirement, they assume they mightpay less in taxes (finally!).
After all, the paycheck stops, so shouldn’t the tax bill shrink?
In reality, retirement can create amplified tax years. These are periods when income is concentrated into a shorter timeframe, causing a higher-than-expected tax liability or what we lovingly refer to as a “tax bomb.” For many retirees, this issue arises because of how and when certain types of income are taxed.
Let’s explore why this happens and how thoughtful planning can help manage it.
The Tax-Deferred Backlog
For decades, many investors have contributed to tax-deferred accounts like traditional IRAs and 401(k)s. These accounts offer upfront tax deductions and tax-deferred growth, which can be powerful allies during the wealth accumulation years.
But there’s a tradeoff. Every dollar contributed pre-tax represents income that has not yet been taxed. Over time, that creates a “tax-deferred backlog.”
Eventually, the IRS requires those sheltered funds to be taken out, at which point the dollars are no longer tax-deferred, but fully taxable.
Starting at age 73 (age 75 for those born in 1960 or later), Required Minimum Distributions (RMDs) begin. These withdrawals are taxed as ordinary income and MUST be taken, regardless of whether you need the money or not.
If the account balance is substantial, RMDs can be significant. This is especially true as you age because the percentage of the account balance that you’re required to distribute increases every year.
Once you reach 73 (or 75), RMDs will start showing up on your tax return alongside your other sources of income like Social Security, pensions, dividends, interest, and capital gains. The result? Income can really stack up in later years, rapidly filling tax brackets and increasing your tax liability.
Required Minimum Distributions Reduce Flexibility
Before RMD age, retirees have more flexibility to choose which accounts to draw from and how much income to recognize.
After RMDs begin, that flexibility can be greatly reduced.
Large RMDs can lead to:
- Higher marginal tax brackets
- Increased taxation of Social Security benefits
- Higher Medicare premiums (IRMAA)
- Reduced ability to manage taxable income year by year
Even retirees who feel their lifestyle hasn’t changed may find themselves unpleasantly surprised when tax time rolls around.
The 10-Year Rule for Inherited IRAs
Under current law*, most non-spouse beneficiaries who inherit a traditional IRA or 401(k) must fully liquidate the account within 10 years of the original owner’s passing. For adult children who are approaching retirement and are in their peak earning years, this can create a notable tax burden.
Instead of stretching distributions over their lifetime (the old IRS rule), heirs may have to withdraw large sums during some of their highest-income working years, effectively concentrating what could have been multiple decades of taxable income into a much shorter timeframe.
This legislative change doesn’t eliminate the value of inheriting pre-tax retirement assets, but it does drastically modify the timing of distributions and the potential tax burden.
Roth Conversions: Timing Matters
Roth conversions can play a helpful role in managing amplified tax years — but timing is key.
Converting funds from a pre-tax IRA into a Roth IRA accelerates income tax to the current year in exchange for tax-free growth going forward. When executed strategically, such as during lower-income years before RMD age, conversions may help reduce future required distributions (for account owners AND beneficiaries) and smooth income over time.
Unlike the tax due from the unexpected convergence of multiple income streams, the additional tax resulting from executing a Roth conversion is intentional. Developing a strategy allows you to plan appropriately for the taxes – preventing a surprise tax bill and the potential penalties and interest that could come along with it.
Short-Term vs. Long-Term Tax Planning
One of the biggest mistakes we see people make is focusing only on the current year’s tax return, oftentimes trying to pay as little tax as possible right now without considering the cumulative potential impact over future tax years.
Retirement tax planning should span the duration of retirement, not just a single year. Proper planning coordinates decisions related to:
- Social Security claiming strategies
- Portfolio withdrawals
- Capital gains realization
- Dividend reinvestment
- Roth conversions
- Charitable giving
- Gifting
- Estate planning goals
When income is evaluated over a 20 or 30-year retirement horizon, opportunities often emerge to spread taxable income more evenly, rather than allowing it to pile up in later years.
A More Proactive Approach
Strategies to consider may include:
- Evaluating Roth conversion opportunities
- Building tax diversification across investment vehicles and account types (pre-tax, after-tax, tax-free)
- Coordinating timing of Social Security with withdrawal needs
- Modeling multi-year income scenarios rather than single-year projections
- Donating to charitable organizations via Qualified Charitable Distributions and Donor Advised Funds
The goal of retirement tax planning isn’t to eliminate taxes. The goal is to manage when taxes are paid and how income is distributed over time, instead of having it forced upon you. The goal is to take back control.
Want to take control of your income and taxes in retirement? Reach out to a Blue Chip advisor at (248) 848-1111.
*See 26 U.S.C. § 401(a)(9)
Disclaimer: Individual views and opinions expressed in the podcast, article, or other media included herein may not necessarily reflect the views and opinions of Blue Chip Partners, LLC. This material has been prepared for informational purposes only and is not intended to provide and should not be relied on for individualized financial, tax, legal or accounting advice. You should consult your own professional financial, tax, legal, accounting, or equivalent professional prior to making any investment decision. All investments involve a degree of risk, including the risk of loss. Past performance is not indicative of future results.
