Trouble Ahead
John Yeigh | Feb 6, 2025
TED BENNA IS OFTEN called the “father of the 401(k).” In 1980, he implemented the first 401(k) plan based on his somewhat bold interpretation of the Revenue Act of 1978. He certainly couldn’t have envisioned the $11.4 trillion in “defined contribution” 401(k) and 403(b) accounts that we have today.
Individual retirement accounts also took off in the early 1980s, and traditional IRAs now hold an additional $11.3 trillion. Combined, that’s an impressive $23 trillion in tax-deferred retirement assets. On top of that, Roth IRAs hold an additional $1.4 trillion.
The catch: Other than Roths, these accounts come with significant embedded income-tax bills. Perhaps as much as 30% of the total will eventually be paid to Uncle Sam and the 37 states that tax retirement-account distributions.
This “ticking tax bomb” is particularly onerous when the distributions are taxed at higher rates than when the original contributions were made. The risk of steep tax bills in retirement was often little discussed—if it was discussed at all—when today’s retirees started funding their 401(k)s decades ago.
Here are 10 tax-bomb realities that weren’t on my wife’s and my radar screen when we excitedly started contributing to 401(k)s and IRAs in 1982:
- Our marginal federal tax rate when we take required minimum distributions (RMDs) in a few years will be higher than the rates at which we deducted our contributions during our early working years. Throughout our early working years, financial advisors regularly reassured us that “your tax rate will be lower in retirement.” We and they didn’t foresee the impact of tax-bracket creep—the rising marginal rate we’d pay as our income grew.
- No early advisors recommended some balance of taxable accounts and retirement accounts. The 1980s and 1990s playbook was to max, max, max 401(k) savings.
- Taxable-account investments have three advantages that don’t get enough attention. First, any appreciation is taxed as capital gains, rather than at the usually higher ordinary income-tax rate. Second, investors get to determine when to take capital gains—and potentially also offsetting losses—rather than being forced by RMD rules. Third, heirs can avoid tax on the embedded capital gains, thanks to the step-up in cost basis upon death.
- RMDs can result in hefty taxes on Social Security benefits. To make matters worse, the thresholds at which Social Security gets taxed aren’t adjusted for inflation, so half of retirees now pay income tax on their benefits. Nine states also tax Social Security.
- RMD income can also trigger the Medicare premium surcharge known as IRMAA, or income-related monthly adjustment amount. IRMAA now hits some 8% of Medicare recipients. The cost can be as much as $6,000 a year for individuals and $12,000 for married couples.
- When retirement-account assets reach a level where future RMD income might put folks in, say, the 22% or 24% tax bracket, savers may want to back off contributions above what’s necessary to get the employer match. For married couples, the alarm bells might ring when their traditional retirement accounts reach perhaps $1 million or $2 million.
- A booming stock market has made the tax bomb significantly worse. We never anticipated that the market would nearly triple in the eight years since we retired. Even more modest returns might cause retirement savings to double over the 10 or 15 years between retirement and when RMDs start.
- Once RMDs begin, tax-bracket creep may continue if retirement savings grow faster than the sum that’s required to be withdrawn each year.
- When the first spouse dies, the surviving spouse must take similar RMDs, but pay taxes using half the standard deduction and less generous individual tax brackets.
- We funded retirement accounts for four decades assuming that our children could “stretch” withdrawals from the accounts that we’ll bequeath them over their lifetime. But that stretch was nixed by the 2019 Secure Act. Our children must now drain inherited tax-deferred accounts over 10 years, handing them additional taxable income when they’re already in their peak-earning years.
For retirees with large traditional retirement accounts, Roth conversions before RMDs begin may be the only way to defuse the tax bomb. Meanwhile, thanks to the advent of Roth 401(k)s, Roth IRAs and health savings accounts, younger generations can avoid getting ensnared in these tax-bomb traps. These younger workers should favor Roth accounts while their marginal tax rate is low, while also making the most of health savings account if they’re eligible.
Finally, we retirees should advise our children and grandchildren about the benefits of saving in all three tax buckets—taxable accounts, traditional retirement accounts and tax-free accounts. That tax diversification should help defuse the tax bomb caused by focusing too much on traditional 401(k)s and IRAs.
John Yeigh is an author, coach and youth sports advocate. His book “Win the Youth Sports Game” was published in 2021. John retired in 2017 from the oil industry, where he negotiated financial details for multi-billion-dollar international projects. Check out his earlier articles.
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The goal should not be to “minimize lifetime taxes” rather it should be to maximize lifetime returns net of taxes. There is a big difference between the two.
rather than complain about these tax “problems” you are having you ought to be thankful for how well you have done. a problem like this is much better than not having saved enough or otherwise being poor.
Doesn’t sound like complaining to me. Rather, it sounds like John and others want to figure out the best strategy to minimize lifetime taxes. “Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury, there is not even a patriotic duty to increase one’s taxes” — Judge Learned Hand
Labeling it a “tax bomb” and complaining about the “booming stock market making it worse”…sounds like a glass half full mentality to me.
I think its safe to say, expect major changes to tax law.
1. The first job I had with a 403(b) matched the first 10%.
My current job matches 7%.
These matches are free money. I wouldn’t get this money, which exceeds my nominal salary, without contributing pre-tax to the 403(b).
2. I couldn’t put as much into a Roth IRA as I can into a 403(b).
Therefore, the 403(b) beats Roth.
Before I got married 7 years ago which bumped our income too high to contribute to a Roth IRA, I also maxed out a Roth with posttax dollars, and I put my kids in Roth IRAs when they started having earned income. For the reasons we agree on regarding taxes and inheritance.
This year my employer started a Roth 403(b). It sounds like this is what you’d advocate using. Pay taxes up front, get the match, and no taxes later.
This article is right on point for my situation. I contributed as much as I could to my TSP as a federal employee. I now file single, after losing my wife to illness, and am faced with paying higher marginal rates on the RMDs compared to the marginal rates when I was working. As noted below, it is a good problem, but I do believe I planned poorly. (TSP is similar to a 401K for federal workers.)
How about increasing Roth conversion efficiency? I’m contemplating splitting my IRA into conservative and speculative half’s. For the speculative side something like, medical equipment supplier Stryker. This approach may offer a dual benefit for retiree’s, better tax efficiency within the conversion and potential improved long term gain. It’s a win win if you hold the draw-down stock to recovery in the Roth.
Fleeb – I do believe Roths are the account that should be most aggressively invested but not in individual stocks so they reduce risk with some diversification – otherwise maybe we should all bet the farm on Nvidia. My Roth is invested in roughly 65% tech/growth index funds (VGT and VUG) and 35% S&P 500 (VOO). My Roth increased 31% last year.
On the other hand, one of our IRAs was up just 12% last year as this account contains essentially all of our bond allocation.
“Trouble Ahead”
?
Good trouble to have.
Jeff – Yes indeed, good trouble to have. As to the title, I’ll leave it to our Humble Editor to respond.
The robust and positive discussions below indicate that plenty of Humble Dollar readers do tax manage among their three tax buckets – after-tax, traditional tax-deferred, and Roth tax-exempt. I suspect most are either in or are approaching the 22% or 24% marginal tax brackets, with perhaps a few paying 32% or higher. Still there is no shame for folks to minimize overall tax obligations and IRMAA premiums even if blessed with relatively high incomes.
Hopefully, the article demonstrates that sometimes we make these decisions without fully understanding the potential implications four decades down the line. For example, in an earlier article I showed how a married couple of super-savers could realistically reach $10 million in their 401(k)s which results in a 35% or higher tax rate when their RMDs kick in. These are the reasons why I so strongly advocate that the young contribute to Roths while in their lowest tax-rate years. Compounding and inflation can result in surprisingly big numbers:
https://humbledollar.com/2023/02/a-path-to-10-million/
First off, if you have a “tax bomb” to worry about, thank yourself for winning the game. There is no doubt that one is better off with retirement accounts (of whatever type) than without them. This is an optimization problem, how much Roth should I have invested in, Roth conversions, etc. The whole Roth question – I suspect that after we have the data on many full retirements, both with and without Roth, that the results will be inconclusive. For some it will have been a good financial move, others no. Results will vary by individual circumstances. The only general consensus is that “a mix of retirement accounts is likely a good financial move.”
I suspect Humble Dollar readers have much higher incomes and savings than the typical American. According to Guardian Life, the median household retirement savings for Americans age 65-74 is $200,000. The average SS benefit is $23,000/year. Say we have a couple with $46,000 in SS. Their first RMD would be $7,547 giving them a household income of $53,547. I don’t think a Roth IRA would confer any advantages.
I started work in 1972 – before IRA’s (traditional or Roth) and 401K plans. We were offered a traditional pension benefit plan, which would only amount to much if we spent a large portion of our working career with the same employer. Nevertheless, as other options became available, I participated fully and when retirement arrived, was well prepared, but most of what I accumulated ended up in a traditional IRA.
Had I to do over again, I would opt early for contributions to a Roth IRA for as long as my income levels would allow. For the remainder, however, pre-tax vehicles would still be preferred.
That said, I completely agree with your advice on having three savings buckets. Having spent my working career in the wealth management business, one of the biggest problems that many retirees (especially self employed, and professionals) had was having a huge pre-tax retirement fund with way too little in after-tax savings. Absent any major need for a large chuck of funds, this result can work, but having a more balanced after-tax/pre-tax balance is still better.
As for the “burden” that my son will face in being forced to withdraw all of any IRA balance I may leave him in just 10 years, I somehow think he will be able to manage.
I have to disagree. We have social security, dividends from taxable brokerage accounts, and RMDs from a very large rollover IRA. We are well below IRMAA and our tax bracket is way below what it was when working and contributing to 401k and IRAs. As someone else said, if you are in the IRMAA category, you are making a lot of money and can afford it. IRMAA for a couple doesn’t start until you hit $212,000 in income. Just did our taxes, and last year we made over 6 figures, took the marital standard deduction and our tax bracket was 8%, well below what it was when working.
Boomers – just for clarification, if your married-filed-jointly income was “over 6 figures”, likely your marginal federal tax-rate was in the 22% tax bracket, plus any state income tax if applicable?
All good comments. Many of your points are infuriating, since they evidence the ever-greedy hand of government, at both the Federal and state levels. IRMAA effectively makes the social security/Medicare mechanism income-based. But I think the opportunity for a retirement nest egg to grow, for our generation at least, probably let us stay ahead of government’s grasping hands. A lot of those dollars on which the most financially-well off of us might be paying almost 50% income tax (say 37% Federal and 10% state) didn’t exist except through our investing for retirement, and so half or more of those new dollars still winds up in our pockets. At least until property, sales and estate taxes takes them, ha ha.)
IRMAA penalizes people for saving. It takes from people who saved and redistributes it to people who didn’t save in the form of lower Medicare premiums.
All excellent points but hard for most to not take advantage of 401K when you factor the company match.
I would also argue that if your RMD’s are in the 24% bracket or higher, your worries are in your mind and the good kind 🙂
Many of these “tax-bomb realities” are applicable to my wife and I and we are trying to manage them a bit with partial Roth conversions. That all being said, I prefer to look at this with a glass half full mindset and think of them as nice problems to have. I’m very grateful I had the opportunity to get a good education, pursue a career, and have a comfortable retirement which is at least partially enabled by tax-deferred retirement accounts and strong market growth. I also was fortunate to be able to put a decent chuck in after tax savings after maxing retirement accounts so that has really helped provide some balance.
Sighhhhh. I’m well aware of the “trouble ahead,” but our options for dealing with it are limited at this point.
As I’ve said here before, my husband and I were late bloomers as to earning and saving, but we started maxing out our 3-4 deferred comp vehicles in our mid-40s (403B/457 for both of us at first, but now my husband just has a 401K since he left state service). So that’s been about 20 years now, and the stock market has been very good for us. We didn’t really need the savings for retirement income because of pensions/SS, but we did need the tax break once we (finally)started making serious money.
In hindsight, it was shortsighted for all the reasons you outline here. Thanks to the latest version of the SECURE Act, we won’t have to take RMDs until we’re 75, 10 years from now, but we have a pretty limited window to do Roth conversions. I’ll have to read the book Stacey mentioned below and see if there are any good solutions I haven’t thought of yet.
I guess the good news is that this is a first-world problem for us. It’s nice to have enough savings to have to worry about the tax implications in ten years—or for our heirs.
“A booming stock market has made the tax bomb significantly worse.” I’d argue this has made things better. Sure, we want to minimize our marginal tax rate but still, the more gains the better.
Nonetheless-great article! Great considerations. Thanks
Doug – you are obviously correct. Gordon Gekko would probably state it simply as “Gains are Good.”
In a way, the article is not for retirees directly, but to remind us how compounding and accumulated taxes can work out over decades. Maybe we can help younger generations better diversify their savings and tax implications.
John, my kids, every year, seem to have a hard time deciding between Roth and Trad IRA contributions. Two of my boys max out their contributions every year and are tempted by the tax break on the Trad IRA. Would you recommend that, when in doubt, go Roth?
Patrick – Since your children are maxing out contributions, they are most likely in the upwardly mobile cohort, plus they will likely eventually be inheriting a Humble Dollar saver’s excess savings. For my children in the same situation, I have suggested they lean in to favor Roths.
If your children have incomes approaching the cusp of the 24 to 32% tax-rate breaks, maybe a mix of Roth and tax-deferred savings will hedge their long-term outcomes. For the young with career potential in a marginal 24% tax-rate or below, Roths will probably work out. If your children have incomes already above the 24% tax-rate, I’d lean toward tax-deferred.
Keep in mind that if they have access to HSAs, contributions to HSAs win regardless of the contribution tax-rate versus future tax-rate when paying any medical expenses or premiums.
Thanks John. Very helpful.
Agreed, it’s best to think about these things as adjustment knobs not all or nothing.
My biggest concern is large RMDs after one of us passes, the change in marginal brackets is so extreme it behooves one to make sure those amounts project to stay reasonable.
It’s not easy though, many variables, very easy to make mistakes that will compound over time. As others have said, it’s a good problem to have.
If you IRA/401K is big enough to put you in the top tax bracket, then it’s pretty big. I know a retired fellow whose income is $700K – he says screw it, just pay the taxes and be happy. The government will get 40% of your estate when you die anyway, so you might as well enjoy it.
The government is only going to get 40% of your estate if it is extremely large. ’The estate and gift tax exemption will be $13.99 million per individual for 2025 gifts and deaths, up from $13.61 million in 2024. This increase means that a married couple can shield a total of $27.98 million without having to pay any federal estate or gift tax.’
Just as the stretch IRA rules changed, Roth IRA withdrawal rules could change too. For example, the tax on a Roth distribution could be based on AGI. The tax code is written in pencil. I think it’s a good idea to have traditional, Roth and taxable accounts..
When your retirement income pushes you into the 22% or 24% bracket, Roth conversions take a sharper pencil and more critical thinking. I finally stopped thinking about Roth vs. no-Roth before RMDs and began thinking about how much of the trad. IRA to convert so we have a mix, as you suggest, John. For us, the benefits are a hedge for future tax law changes and to benefit the kids.
Wow, you covered the bases well. In the 80s when my employer implemented the 401k, I was married with 2 kids. Between having 4 exemptions, child tax credits, itemized deductions, and a stay at home wife I’m sure my taxable income kept me within 15%. The deferred tax on my 401k contributions really did not do me much good. Too bad I didn’t have a ROTH option back then.
What’s with the shouting when talking about Roths?
No, really, it’s not an acronym; it’s a last name.
Dan, the child tax credit didn’t start until 1997.
LOL, you got me!
Dan – while the tax arbitrage for early-year 401(k) contributions may have been marginally disadvantaged, the routine savings and investment growth has paid off to provide us all with comfortable retirements.
Without a doubt we are way better off thanks to our 401K.
Excellent review John.
You wrote, “Taxable-account investments have three advantages that don’t get enough attention. First, any appreciation is taxed as capital gains, rather than at the usually higher ordinary income-tax rate. Second, investors get to determine when to take capital gains”
I have a very limited portion of my portfolio in a taxable account. Regarding number 2: I have noticed from reading many HD participants comments that almost universally they seem reticent to sell their taxable assets due to their exposure capital gains taxes. So it seems that this is a source of income that many/most are not utilizing.
I’m retired but my wife still works. We’re starting to sell off taxable assets at the 0% capital gains rate to fund her mega backdoor Roth and traditional 401(k). We’re also doing Roth conversions up to the top of the 0% capital gains bracket so that our marginal rate is 12%. This would jump to 27% if we were to get into the 15% capital gains bracket.
David – Indeed, capital gains tax-rates will likely be lower than tax-deferred withdrawal tax-rates, so folks shouldn’t necessarily be reticent to sell capital gain assets for living expenses.
However, cashing out capital gains eliminates the potential for heirs to capture the tax-free step up basis. When we first retired; we drained all our low capital-gains assets within taxable accounts to pay living expenses or Roth conversion taxes. We still retain a few highly-appreciated capital-gain assets.
In addition, folks may be reluctant to sell taxable-account assets because of the impact to taxable income and resultant impacts to Roth conversions, Medicare IRMAA premiums and taxes. Also, some may prefer withdrawing pre-RMD monies from their IRA\401(k) rather than selling after-tax assets as this reduces future RMDs plus all tax-deferred assets will eventually be taxed anyway due to the RMDs.
Once both RMDs and Social Security start, I suspect most saving-oriented Humble Dollar readers may be sufficiently funded that they do not need to sell after-tax assets.
One way to get income without selling in a taxable account is to not reinvest dividends. Then you can take whatever income you need without having to make a taxable sale. You are going to pay taxes on the dividends anyway, and most will probably be qualified dividends, so you can avoid having to pay a tax again if you had to sell.
Some people enter retirement single, and are subject to a lower standard deduction and less favorable tax brackets from the start.
A lot of people enter retirement single, and just about everyone exits it single. I wish the tax code would treat single seniors more equitably.
Right. So if a young single person does some planning, and determines they will likely accumulate a million or more bucks in the 401K, the ROTH seems to me like the way to go. Eventual RMDs on that amount, combined with Social Security and other sources of income, would begin putting a chunk of the income into the 22% bracket. The same can be said for a widow/widower.
Unfortunately that wasn’t an option for me, but certainly would be prudent for people starting out today.
Important considerations, all. Thanks, John.
As a retiree, I have been shifting my non-Roth, tax-deferred investments to fixed income and my taxable investments to equities. Doing this means more qualified dividends and less interest income in my taxable accounts, which makes sense from a tax standpoint, as does lowering the potential for larger future RMDs. In my tax bracket and without heirs except for charities, Roth conversions don’t make sense.
Which is preferable, paying taxes or not having accumulated funds to pay taxes on? RMDs are needed income for most people aren’t they?
I pay ordinary income taxes on my pension that is the bulk of my retirement income. I also pay taxes on 85% of my SS and I pay on RMDs and IRMAA.
I avoid much of the RMD taxes by using QCDs I avoid taxes on much investment income by using municipal bond funds and lower rates using dividends.
I do fully agree a mix of investment types is the way to go.
Good article John. Roth IRA’s weren’t available in the 1st half of my career, and my company didn’t offer a Roth 401k until fairly late in my career. My company had a fairly attractive match that I always took advantage of, and we increased our savings as our incomes improved. I took advantage of a low income year after I stopped working full time to open Roth IRAs for me and my wife. We have done some conversions since then, trying to balance current taxes with expected future taxes.
If I were starting out today I would likely favor Roth’s at the beginning of my career, and balance my investments between Roth and Traditional accounts as my income rose.
Rick – I like your last sentence which nicely summarizes the playbook for the young with upwardly-mobile income or career paths.
I encourage HD readers to get their hands on Ed Slott’s latest book, The Retirement Savings Time Bomb Ticks Louder. Your library system will find a copy for you. It is an excellent read with many examples of what to do, or how to fix your IRA tax problems. The kibosh on most stretch situations is explored with many examples. Temporarily put the fiction book away and read a book that can help you choose a solid path forward.
A free reference on the Tax-Bomb from tax-deferred accounts is Craig Wear’s book “Paying the Piper” which is available from his website http://www.craigwear.com.
Craig runs a Roth conversion advisory service for those who have accumulated healthy IRA\401(k) accounts. His service runs Roth conversion cash flow and tax analysis scenario planning which includes the impact to Social Security taxation, Medicare IRMAA premiums, first spouse death, and through to heirs inherited taxes.
Executive summary – his analyses generally show that IRA millionaires can often save hundreds of thousands by Roth converting earlier, more dollars, and through a higher tax bracket than envisioned. Note, this is not an endorsement of his services which I have not used, but his book does highlight how Roth conversions can mitigate tax bomb impacts.
I just finished my latest thriller this morning, so now that I know whodunnit, I’ve downloaded the book. Thanks, Stacey!
I have read the book and it is excellent.
Agree, Ed & his team are very wise!
What you say is true about IRMAA, etc., but I’m still glad I socked away so much of my income in tax-deferred accounts back then. If I hadn’t put so much in my 401(k), I would have just spent the money. I don’t need the RMDs to live, so I use them to buy more shares of index funds in my taxable account. I’m way ahead of the game.
Good advice! Another tax trap for 401 or IRA owners, with much lower income, is to realize the true tax cost of withdrawals from your IRA. For example, compare the increasing cost to increasing withdrawals of the IRA or 401. My cost, because of losing the tax advantages of Social Security, quickly goes to 20%. This is my true cost of pulling taxable money out of the IRA. This high cost occurs even though my effective and marginal rates are very low. I would have been better off saving in taxable other than my wife’s 401k 50% match.
Thanks for writing about this important subject. I brought up this topic with a couple of high-earning younger relatives who I know are diligent investors, to encourage them to look ahead 25 years to the impact of taxes on their lives. My wife and I will probably wind up with 45-50% of our money in Roth accounts at retirement from full-time work, when we’ll have the opportunity for some conversion of our traditional accounts to increase our Roth money. The uptick in taxes after the death of the first spouse is considerable.
On the brighter side, for those who are concerned about a lack of taxes to pay for services provided to the boomers, we’ll be providing a hefty percentage of the bill from our traditional retirement accounts.