Tomorrow's Tax Problem
- Travis Tsukayama, CFP® CFA
- Jul 10
- 5 min read
Updated: Oct 1
Meet Bob.
Bob is 62. He's worked hard his whole adult life and is finally looking forward to retirement. It is something he feels prepared for mentally and financially.
He maxes out his 401k annually, receives a generous employer match, and invests in an appropriate target date mutual fund. His nest egg has grown steadily and now with both kids off the payroll, he and his wife are planning to go on cruises and play more pickleball.
He is set for the retirement he dreamed of. Good planning and commitment got him this far.
But retirement planning doesn't end when you retire.
A good plan requires maintenance and occasional adjustment to continue smoothly. Sometimes your personal situation does not change, but tax laws, Social Security, and investments do.
One of the most overlooked pieces of the retirement puzzle for Bob and many like him?
The impact of taxes on your retirement income.
The Tax Torpedo
Having a large amount of your retirement fund in accounts that are yet to be taxed like traditional IRAs and 401ks can create a hidden retirement risk.
Ed Slott, a nationally recognized expert on IRAs and retirement, calls this concept a tax torpedo.
This happens when withdrawals from tax-deferred accounts increase your taxable income and can result in a higher than expected tax liability, especially when combined with Social Security benefits, pension income, and interest and dividend income.
Unless there is a plan in place to mitigate this, the higher tax burden can quietly erode your nest egg and damage an otherwise sound retirement strategy, reducing its chances of success.
How We Got Here
This tax issue catches many people by surprise.
Conventional financial advice has encouraged people to save as much as possible during their earning years to be well-prepared for retirement. Diligent savers have done exactly that and have accumulated a significant balance in their retirement savings, mostly in tax-deferred accounts.
For today’s retirees, the 401k has been the primary savings vehicle.
How it works: contributions go into 401k and qualify for a tax deduction in that year. The money in 401k grows tax-deferred and is taxed as ordinary income when it’s withdrawn in retirement. For most savers, it is the most effective way to build a nest egg over time, especially when savings and investing are automated.
An alternative is the Roth 401k, where you pay taxes on your contributions upfront, but future withdrawals are tax-free. The Roth option in 401k did not become available until 2006.
A 2023 study from Vanguard found that although 80% of 401k plans allow Roth contributions, only 17% of participants take advantage of them. Most 401k contributions are made on a tax-deferred basis, not Roth.
The result? Today’s retirees are starting their retirement years with a substantial tax-deferred account balance and a sizable tax burden ahead of them.
The Impact of Taxes - By the Numbers
Taxes can erode your retirement in two ways:
A future tax liability reduces the real balance available for your use.
Withdrawals add to your taxable burden each year and can present unexpected challenges.
Let’s look closer at the numbers.
Bob has $1 million in a Traditional 401k.
He will receive Social Security income and a small pension. He expects to fall into the 22% federal tax bracket in retirement.
For every $1 he withdraws, he will owe 22 cents in federal taxes.
There is a $220,000 tax liability waiting in his 401k.
His $1 million balance is really worth closer to $780,000 after taxes are considered.
If Bob lives in a state with income tax, that will lower his after-tax value further.
The Unwelcome Tax Surprise
Withdrawals can also negatively impact your annual tax bill.
Money taken from a tax-deferred source counts as ordinary income in the year of withdrawal. If a large withdrawal is taken for a home renovation, dream vacation, or new car, that can cause a jump into a higher tax bracket.
If you are unintentional about your tax planning and recognize more taxable income than intended, you may run into:
Higher Part B & Part D Medicare premiums (IRMAA)
Additional 3.8% Net Investment Income Tax
Phaseout from certain tax credits and deductions
More of your Social Security benefits becoming taxable
Higher taxes on long-term capital gains and qualified dividends
Being pushed into a higher income tax bracket
Underpayment penalties if estimated taxes weren’t adjusted
Nearly every CPA and Enrolled Agent I’ve spoken with say that surprises are their biggest pet peeve and can derail a tax plan. If most of your retirement savings are held in tax-deferred accounts, the chances of an unwelcome tax surprise increase significantly.
What You Can Do
The good news is that most people have options to improve their tax situation in retirement.
If you are still working and contributing to a retirement plan, check whether Roth contributions are available. If you expect to be in a higher tax bracket later, consider shifting some or all of your contributions to Roth instead of continuing to fill up the tax-deferred bucket.
Converting pre-tax balances to Roth continues to be a staple of our tax conversations with clients. Take advantage of gap years when income may be lower and before Social Security benefits and required minimum distributions start to convert more to Roth at a lower tax rate. Review your tax picture every year to determine how much you can convert without bumping into a higher tax bracket.
Finally, the order in which you withdraw from your accounts can significantly reduce your lifetime tax bill. For example, tapping into taxable accounts first can keep your ordinary income low and create more room for Roth conversions. Delaying Social Security can also increase your benefit and give you more control over your tax strategy in the early retirement years.
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