Are you ready for retirement taxes? How to avoid a 'Tax Bomb'

Good savers who take full advantage of their 401(k) plans and other tax-deductible retirement plans could be setting themselves up for unnecessarily high tax bills in retirement. This tax bomb could be set off because the retiree's withdrawals will be taxable, and required minimum distributions could even force them into a new, higher tax bracket — and cause them to pay higher Medicare premiums to boot. Thankfully, there are ways to prepare before this happens. Younger savers should consider tax diversification strategies, and older ones may want to look into Roth conversions.

"My parents didn't want to move to Florida, but they turned sixty and that's the law."

- Jerry Seinfeld, comedian/actor

So good savers, beware. The money in retirement accounts has to be withdrawn someday.

Experts say if you're not strategic about how you save, you could face unnecessarily high tax bills and inflated Medicare premiums in retirement. Even designated heirs could be hit with higher taxes.

The earlier you start defusing this potential tax bomb, the better. But even people in their 60s or early 70s may have opportunities to lessen the potential damage.

"You do not want to be in the position as some clients are that all of their funds are inside of a tax-deferred account," said Pam Ladd, senior manager of personal financial planning at the Association of International Certified Professional Accountants.

Tax breaks now could cause problems later

Most retirement accounts offer a tax break when you put money in.

Eventually, though, Uncle Sam always gets his cut. Required minimum distributions, also known as RMDs, start at a certain age. The age is currently 75 for people born in 1960 or later.

Retirement withdrawals usually are subject to regular income tax rates.

The rules still work for most retirees because their tax bracket will usually be lower in retirement than when they were working.

People who don't spend a large chunk of their savings early in retirement may find that required minimum distributions push them into higher tax brackets.

Higher incomes mean higher Medicare premiums as well, due to the income-related monthly adjustment amount, also called IRMAA, which is based on income from two years ago.

Most people will pay $164.90 per month in 2023 for Medicare Part B, which pays for doctor visits.

Medicare recipients whose 2021 modified adjusted gross income exceeded $97,000 (for single filers) or $194,000 (for married couples) pay $230.80 to $560.50 monthly, depending on their income.

The IRMAA surcharge for Medicare Part D coverage, which pays for prescriptions, can add $12.20 to $76.40 per month, depending on income. A couple with a $250,000 income in 2021 could end up paying surcharges totaling $4,711.20 for their Medicare coverage in 2023.

The tax bill doesn't stop there. If you leave retirement money to your kids or anyone other than your spouse, they're typically required to empty the accounts by the end of the 10th year following the year of your death. Required minimum distributions from inherited retirement accounts will probably put heirs into higher tax brackets.

How to defuse the Tax Bomb

Predicting who will face a future tax bomb can be tough, particularly if you're decades away from retirement.

Most people would be smart to have a portion of their money in accounts that aren't subject to taxes or required minimum distributions. These include Roth IRAs, Roth 401(k) plans, and Roth 403(b) plans. That's according to retirement experts.

Paying now Vs. Paying Later

Paying taxes now versus later can make sense when you're young and expect to be in a higher tax bracket in retirement, tax pros say.

However, some older people may find a conversion can help lessen the tax impact of future required minimum distributions.

Late-in-life conversions should be handled carefully because like required minimum distributions, they can end up inflating your tax bracket and Medicare premiums.

Given the financial stakes, consulting a tax pro or financial planner who can provide individualized advice is always a smart move.

In conclusion, avoiding a tax bomb in retirement requires careful planning and a proactive approach to managing your finances.

It's essential to understand the tax implications of your retirement savings and investments and to make strategic decisions that can help minimize your tax burden. By utilizing tax-advantaged retirement accounts, creating a diversified investment portfolio, and monitoring your taxable income, you can take steps to reduce the impact of taxes on your retirement savings. Ultimately, by taking a long-term perspective and working with a qualified financial advisor, you can create a retirement plan that meets your financial goals while minimizing the risk of a tax bomb.