For decades, millions of Americans have done exactly what they were told to do: save for retirement.
We contributed to traditional 401(k)s, IRAs, 403(b)s, and other tax-deferred retirement accounts. We received a tax benefit along the way, watched our accounts grow, and felt good knowing we were building a retirement nest egg.
And we should feel good about saving.
But there is an important piece of the retirement puzzle that many people were never taught:
The taxes were deferred—not eliminated.
That distinction could become increasingly important as more Americans enter retirement with substantial balances in tax-deferred accounts.
The Retirement Savings Strategy We Were Taught
For many years, the basic retirement strategy was straightforward:
Work → save in a traditional retirement account → retire → withdraw the money.
The reasoning made sense. You may have been in a higher tax bracket while working, so taking a tax deduction today and paying taxes later in retirement could potentially save you money.
But retirement has changed.
People are living longer. Retirement accounts have had decades to grow. RMD rules have changed. And some retirees may have significantly more taxable retirement income than they anticipated.
The question isn’t simply:
“How much have I saved?”
It’s also:
“How much of my retirement savings will eventually be taxable—and when?”
Your Retirement Balance May Not Be 100% Yours to Spend
Imagine you have accumulated $1 million in a traditional IRA or 401(k).
Seeing $1 million on your statement can feel like you have $1 million available to spend.
But that entire balance isn’t necessarily spendable after taxes.
Traditional retirement accounts generally contain tax-deferred money. When you withdraw funds, the taxable portion is generally taxed as ordinary income.
The actual amount you keep will depend on your tax situation when the money comes out.
The same applies to a $2 million or $3 million tax-deferred portfolio.
The larger the balance becomes, the larger your potential future required distributions—and potentially your tax bill—may become.
That doesn’t mean saving too much for retirement is a bad thing.
It means where you save your money matters.
RMDs: When the IRS Requires You to Start Taking Money Out
One reason this issue deserves attention is Required Minimum Distributions (RMDs).
RMDs are withdrawals that the IRS generally requires you to take from certain tax-deferred retirement accounts once you reach the applicable starting age.
The RMD rules have changed several times over the years.
The starting age was originally 70½, then increased to 72, and is currently generally 73 under current law. For individuals born in 1960 or later, the applicable RMD starting age is scheduled to be 75.
That increase may sound like good news because you can leave your money invested longer.
And it can be.
But there’s another side to the equation:
The longer your tax-deferred money stays invested and grows, the larger your future RMDs could potentially become.
Your RMD isn’t necessarily based on how much money you actually need to live on.
It’s generally calculated using your account balance and IRS life-expectancy tables.
You might only need $50,000 a year from your retirement accounts, but eventually you could be required to withdraw significantly more.
You don’t necessarily have to spend the money. You can generally invest what remains after taxes.
But the taxable distribution can increase your income and potentially affect other areas of your financial life.
Your RMD Could Affect More Than Your Income Tax
A larger taxable retirement distribution can have a ripple effect.
Depending on your circumstances, higher taxable income may result in:
- A larger federal or state income tax bill
- More of your Social Security benefits becoming taxable
- Higher Medicare premiums through IRMAA (Income-Related Monthly Adjustment Amount) surcharges
- Less control over when taxable income occurs
- A larger future tax liability
- Potentially less tax-deferred money available for heirs
This is why retirement income planning needs to go beyond simply determining how much you can withdraw each year.
It’s about managing the tax consequences of those withdrawals, too.
The 4% Rule Doesn’t Tell the Whole Story
You’ve probably heard of the 4% retirement withdrawal rule.
The basic concept is that a retiree may withdraw approximately 4% of their portfolio in the first year of retirement and adjust future withdrawals for inflation, based on assumptions about a roughly 30-year retirement.
It’s a useful starting point for retirement-income discussions—but it doesn’t address every tax issue.
There’s a big difference between:
“How much do I want to withdraw?”
and
“How much might I eventually be required to withdraw?”
If most of your retirement portfolio is held in tax-deferred accounts and continues growing, your future RMDs could eventually exceed the amount you would have voluntarily withdrawn.
That’s where tax planning becomes especially important.
Think in Tax Buckets, Not Just Account Balances
Most people understand the importance of investment diversification.
Don’t put all your investments in one stock.
But there is another type of diversification that deserves attention:
Tax diversification.
Instead of relying almost entirely on tax-deferred retirement accounts, consider building retirement assets across different tax buckets.
Tax-Deferred
Traditional 401(k)s, 403(b)s, and IRAs can provide valuable tax benefits today. However, withdrawals are generally taxable as ordinary income, and RMDs generally apply once you reach the applicable age.
Tax-Free
Roth IRAs and Roth 401(k)s are funded with after-tax dollars. Qualified withdrawals can generally be tax-free, and Roth IRAs are not subject to lifetime RMDs for the original owner.
Taxable
Taxable brokerage accounts don’t provide the same upfront tax deduction as traditional retirement accounts, but they can provide another source of retirement income and flexibility. Depending on the investment and circumstances, income may come from interest, dividends, capital gains, or the sale of investments.
The goal isn’t necessarily to have equal amounts in each bucket.
The goal is to have options.
Having multiple tax buckets can give you greater flexibility in deciding where your retirement income comes from each year.
Roth Conversions: One Potential Way to Manage Future Taxes
One strategy some people consider is a Roth conversion.
A Roth conversion moves money from a traditional tax-deferred retirement account into a Roth account.
The amount converted is generally included in taxable income for that year.
So why would anyone voluntarily pay taxes today?
Because there may be years when your taxable income is temporarily lower.
For example, consider the years between:
Your last paycheck → and → the beginning of RMDs
You may have stopped working, but you haven’t started Social Security yet. You may not have RMDs yet. Your taxable income could temporarily be lower than it was during your working years because you are no longer saving.
That window may create an opportunity for some retirees to convert a portion of their traditional retirement savings to a Roth account.
The objective isn’t necessarily to convert everything.
It may be to gradually move some money from a future taxable bucket into a potentially tax-free bucket while managing your current tax bracket.
Roth Conversions Aren’t Automatically the Answer
There is no one-size-fits-all retirement tax strategy.
A Roth conversion creates taxable income today, so it needs to be evaluated in the context of your entire financial picture.
Depending on your circumstances, you may need to consider:
- Your current and projected future tax brackets
- State income taxes
- Future RMDs
- Social Security taxation
- Medicare IRMAA thresholds
- Charitable giving
- Estate planning
- Your expected retirement income
- Your goals for leaving money to heirs
For some people, paying taxes now may make sense.
For others, it may not.
That’s why a Roth conversion should be viewed as a tax-planning strategy—not simply a retirement-account transaction.
Don’t Wait Until RMDs Force Your Hand
One of the biggest retirement-planning mistakes can be waiting until RMDs begin before looking at the tax implications of your retirement savings.
By then, some opportunities may be more limited.
If you’re still working, start looking at the tax diversification of your retirement savings now.
If you’re approaching retirement, pay particular attention to the years between your last paycheck and the beginning of RMDs.
And if you’re already retired, don’t simply wait for your RMD notice each year.
Model what your future RMDs could look like.
Look at your projected income.
Look at your tax brackets.
Look at your Social Security.
Look at Medicare.
Then ask whether there are strategies that could give you more control over your taxable income over time.
Retirement Planning Isn’t Just About How Much You Save
For years, the focus has been on accumulating as much as possible for retirement.
And accumulation is important.
But eventually, you have to transition from saving money to using money.
That’s where retirement income planning becomes critical.
Instead of asking only:
“How much do I need to retire?”
also ask:
“Where should my retirement savings be held?”
“How will my retirement income be taxed?”
“When should I begin withdrawals?”
“What can I do today to create more tax flexibility later?”
A $2 million retirement portfolio can look very different depending on whether that $2 million is entirely in a traditional IRA or divided among traditional, Roth, and taxable accounts.
The account balance may be identical.
The tax flexibility isn’t.
Start Planning Before the Tax Bill Comes Due
The goal isn’t necessarily to pay the least amount of tax every single year.
Sometimes paying a little more tax today can help reduce future tax exposure.
The bigger goal is to manage your lifetime tax burden while maintaining the flexibility to use your retirement savings when and how you need them.
Your retirement account statement tells you how much you’ve accumulated.
But your tax strategy helps determine how much of that money you may actually get to keep and use.
The “tax time bomb” doesn’t have to explode.
The key is recognizing that tax planning is part of retirement planning—and the earlier you start, the more options you may have.
A Final Thought
Most of us were taught how to save for retirement.
Far fewer of us were taught how to turn those savings into retirement income efficiently.
You don’t have to wait until retirement to start asking these questions.
Understanding your tax buckets today can help you make more informed decisions about your retirement tomorrow.
Your retirement plan should include more than a savings goal. It should include a strategy for getting your money out, too.
This article is for educational purposes only and is not individualized tax, legal, or investment advice. Tax laws and retirement-account rules can change. Consult with your qualified tax, financial, and/or legal professionals before making decisions about Roth conversions, RMDs, or other retirement strategies.
Positive Balance LLC
Helping you build a stronger financial foundation—so you can get out of debt, build wealth, and plan for the future.