If you’ve spent years building your 401(k), you could be facing higher 401k taxes in retirement than you expected. In this episode of Wise Money, we explore whether it makes sense to keep funding a Roth 401(k), switch to pre-tax contributions, or use Roth conversions to reduce future taxes. You’ll also learn how tax diversification, IRMAA, required minimum distributions (RMDs), and long-term tax planning can impact your retirement income.
Season 11, Episode 49
Download our FREE 5-Factor Retirement guide
Read our blog!
Listen on Podcast
Subscribe on YouTube
This information is for general financial education and is not intended to provide specific investment advice or recommendations. All investing and investment strategies involve risk, including the potential loss of principal. Asset allocation & diversification do not ensure a profit or prevent a loss in a declining market. Past performance is not a guarantee of future results. This video may discuss estate planning concepts but does not constitute legal advice. Please consult an attorney for advice specific to your situation.
What Are Tax Shelters and How Can They Help Your Retirement Plan?
When you hear the term “tax shelter,” you might picture a complicated strategy reserved for the ultra-wealthy. In reality, you may already be using several tax shelters as part of your financial plan. Retirement accounts like a 401(k), Roth 401(k), and IRA are all designed to provide valuable tax advantages. The challenge is understanding how each one is taxed and how the decisions you make today could affect 401k taxes in retirement.
What Is a Tax Shelter?
A tax shelter is a financial strategy, account, or investment that can legally reduce or defer taxes. Some tax shelters provide an immediate tax deduction, while others allow investments to grow without generating a tax bill each year. Certain accounts can even provide tax-free withdrawals when specific requirements are met.
The goal isn’t simply to avoid paying taxes today. Good tax planning considers when you’ll pay taxes, what your tax rate could be at that time, and how your decisions fit into your overall financial plan.
Retirement accounts are some of the most common examples.
Traditional 401(k)s and Tax-Deferred Growth
A traditional 401(k) provides an upfront tax advantage. Contributions are generally made on a pre-tax basis, reducing your taxable income for the year. Once the money is inside the account, investment activity is tax-deferred, allowing the account to grow without annual taxes on dividends, interest, or capital gains.
The tradeoff comes when you withdraw the money.
Distributions from a traditional 401(k) are generally taxed as ordinary income. That may not seem like a major concern early in your career, but after decades of saving and investing, you could enter retirement with a significant amount of pre-tax money.
That’s where 401k taxes in retirement can become an important planning consideration. Large taxable withdrawals can potentially affect your tax bracket, how much of your Social Security is taxable, and your Medicare premiums through the Income-Related Monthly Adjustment Amount (IRMAA).
Eventually, required minimum distributions (RMDs) can also force money out of certain retirement accounts whether you need the income or not.
Roth Accounts Offer a Different Tax Shelter
A Roth 401(k) or Roth IRA essentially flips the traditional retirement account tax strategy.
You don’t receive an upfront tax deduction for Roth contributions. Instead, you pay taxes on that income today. In exchange, qualified withdrawals in retirement can be tax-free.
Having both pre-tax and Roth assets can create what is known as tax diversification. Instead of relying entirely on taxable withdrawals from a traditional 401(k), you may have different types of accounts available to fund your retirement.
That flexibility can become especially valuable when tax laws, your income needs, or your financial circumstances change.
Don’t Forget About Taxable Accounts
A brokerage account doesn’t offer the same tax shelter as a 401(k) or Roth IRA, but it can still play an important role in a tax-diversified retirement strategy.
Investments held in a taxable brokerage account may receive favorable long-term capital gains tax treatment when sold. Depending on your taxable income, some long-term capital gains may even qualify for a 0% federal tax rate.
Taxable accounts can also provide greater flexibility because they don’t have the same withdrawal restrictions as retirement accounts.
That’s why having money spread among pre-tax, Roth, and taxable accounts can provide more options when deciding where your retirement income should come from each year.
Roth Conversions Can Shift Your Tax Exposure
If you’ve already accumulated a large traditional 401(k) or IRA, Roth conversions may provide another planning opportunity.
A Roth conversion generally involves moving pre-tax retirement dollars into a Roth account and recognizing the converted amount as taxable income in that year. You pay taxes now in exchange for moving those dollars into an account that can potentially provide tax-free qualified withdrawals later.
That doesn’t mean Roth conversions are always the right choice. A large conversion could push you into a higher tax bracket or affect IRMAA and other income-based tax considerations.
The important question isn’t simply, “Should I do a Roth conversion?” It’s how much should you convert, when should you convert it, and what are the long-term tax consequences?
Build Tax Flexibility Before Retirement
The final years of your career can be an important tax-planning window. If most of your retirement savings are pre-tax, you may need to evaluate whether continuing pre-tax contributions, shifting toward Roth contributions, or planning future Roth conversions makes the most sense.
There’s no single strategy that works for everyone.
Your current and projected tax brackets, retirement date, Social Security strategy, RMDs, Medicare premiums, charitable goals, spending needs, and estate plan can all influence the decision.
Tax shelters are powerful tools, but the real value comes from understanding how they work together. Rather than focusing only on getting the biggest tax break today, consider building a mix of accounts that gives you choices in the future. Planning ahead for 401k taxes in retirement can give you more control over where your income comes from and how taxes fit into your overall retirement plan.
