The Tax Bomb Hiding In Your Retirement Account (Don’t Wait)

The 401(k) Tax Bomb (0:00)

Bo: The most common type of retirement account in the United States is a 401(k) and it comes with a built-in tax bomb. It goes off in your 70s and it can greatly increase the amount of taxes you pay in retirement. But there is something you can do about it. If you’re in your 20s or 30s, the window to diffuse this thing is open right now, but it closes a little more every year you wait. Today we’re going to talk about what this tax bomb is, what happens if you don’t plan for it, and more importantly, how do you protect yourself? If you’re close to retirement already, don’t worry. We’re going to cover strategies that can help shield your income right now.

What Is the Tax Bomb Hiding in Your 401(k)? (0:44)

Bo: You probably know that when you contribute to a traditional retirement account, you get a tax break on the front end. Money goes in pre-tax, it grows tax-deferred, and you don’t pay any taxes until you actually take it out. This goes for 401(k)s, traditional IRAs, SEP IRAs, SIMPLE IRAs, 403(b)s, and most other employer-sponsored retirement plans. And it’s a pretty sweet deal. But starting at age 73, the government requires you to start taking money out of those accounts every single year, whether you need to or not. Those mandatory withdrawals are called required minimum distributions, or RMDs. And that’s the tax bomb that can literally blow up your retirement income plan because your RMDs could push you into a higher tax bracket.

So how much do you have to take out each year? It’s calculated based on a formula that uses your account balance and an IRS life expectancy table. Take your retirement account balance as of December 31st of the prior year, then look up your age on the IRS table. Most people use what’s called the Uniform Lifetime Table. That table gives you a distribution period, which is basically just a life expectancy factor. And finally, you divide your account balance by that number. So if you had $100,000 in your 401(k) and the table gives you a factor of 25, your RMD would be $4,000 for the year. You can see how this can affect those of you who are diligent savers. After 30 or 40 years, your account balance can be substantial, which means the RMDs can be substantial. And it also means the tax bill can be substantial.

4 Ways Large RMDs Can Hurt You (2:20)

Bo: RMDs can affect more than just your taxes. Here are four ways that large RMDs can hurt you if you’re not prepared.

The first one is the most obvious. Let’s say you and your spouse retire and plan to live comfortably on $90,000 a year through a combination of Social Security and modest withdrawals from your retirement accounts. You’ve done the math, you’re in the 12% tax bracket, and life is good. But then you turn 73 and the IRS tells you that based on your account balance, you actually have to withdraw an extra $20,000 this year. You now have more taxable income and it just pushed you from the 12% bracket into the 22% bracket. That’s the first problem with RMDs: tax bracket creep. You think you’ve got your retirement plan figured out and then all of a sudden you’re writing a check to Uncle Sam that you didn’t even plan for.

The next problem with RMDs is one that really catches people completely off guard. It has to do with how much you pay for your Medicare. The government charges high earners more for Medicare Part B and Part D through a system called IRMAA, which stands for the Income Related Monthly Adjustment Amount. IRMAA is basically a series of income brackets just like tax brackets, but instead of taxes, crossing into a higher bracket increases your Medicare premiums. Large RMDs can shove retirees into these IRMAA brackets without any warning. Let’s say you’re single and your income is $105,000, so you’re below the IRMAA threshold of $109,000. But if you have to take an additional $10,000 RMD, now your total income becomes $115,000, which pushes you into the next IRMAA bracket. Now you have higher Medicare premiums. And here’s the kicker: Medicare looks at your income from two years prior. So by the time your premiums go up, it’s too late to undo what caused it.

The next problem with RMDs: more of your Social Security can be taxed. A lot of people are surprised to learn that Social Security benefits change in how they are taxed, and RMDs are one of the primary triggers. To determine how much of your Social Security benefit gets taxed, the IRS uses something called combined income, which is basically your adjusted gross income plus half of your Social Security benefit. Once that combined income crosses $32,000 for married filers, up to 50% of your Social Security benefit becomes taxable. Cross $44,000 and up to 85% is taxable. Again, a large RMD that you didn’t plan for can push your combined income above those thresholds and essentially create a surprise tax.

The next problem with RMDs has to do with long-term capital gains brackets. Long-term capital gains are taxed at preferred rates: 0%, 15%, or 20% depending on your income. A lot of retirees deliberately plan to stay in the 0% capital gains bracket, which is very doable for a number of people. In 2026, a married couple filing jointly can make $98,900 and still pay 0% on long-term capital gains. But if a large RMD bumps your ordinary income high enough, it can push your long-term capital gains into the 15% bracket. So that’s the fourth big problem with RMDs: they can lead to paying more taxes on your investment gains.

2 Ways to Diffuse the RMD Tax Bomb (5:40)

Bo: You can see how this one tax bomb can trigger four different consequences that separate you from your hard-earned money. But there is some good news. In 2033, the RMD age goes from 73 to 75, giving you a few extra years. But what’s even better is the fact that all of these problems are preventable with the right strategy. And the earlier you start, the easier it is. Here are two ways you can diffuse the RMD tax bomb.

The first strategy is to start or increase your Roth contributions. If you’re in your 20s or 30s, this is the most powerful thing you can do right now to offset future RMDs. You may have heard us talk about the three bucket strategy in retirement: your taxable brokerage account, your tax-deferred account like a 401(k), and your tax-free account like Roth IRAs or Roth 401(k)s. The goal is to have meaningful balances in all three so that in retirement you have flexibility and can draw from different buckets depending on your tax situation and the year. And that Roth bucket is the antidote to RMDs. If your employer offers a Roth 401(k) option, take advantage of it. Or if you’re eligible to contribute directly to a Roth, open one up and aim to max it out every year. Roth IRAs have no RMD requirements during your lifetime. Start filling that Roth bucket alongside your traditional accounts.

The second strategy to diffuse RMDs: strategic Roth conversions. If you’re getting close to retirement or you already have a large IRA or 401(k) balance, this is where Roth conversions come in. A Roth conversion is exactly what it sounds like. You take money out of a traditional IRA, pay the income tax on it now, and move it into a Roth IRA where it can grow tax-free. It’s one of the most powerful tax-saving strategies available. You’re essentially prepaying your tax bill on your own terms at a rate and timeline that you control, instead of letting the IRS dictate it for you. The ideal window for Roth conversions is typically in the years between your retirement age and the age you have to start RMDs. That’s often a period of lower taxable income, which means you can likely convert significant amounts while still staying in a low tax threshold.

The bottom line: if you have money in a traditional 401(k) or IRA, you need to have a plan for what happens at RMD age because the IRS has a plan whether you do or not. The earlier you start building your Roth bucket and thinking about strategic conversions, the more options you’ll have. And options in retirement are everything. And as always, keep building towards your great big beautiful tomorrow.