Your 401(k) Could Create a Tax Problem in Retirement
Building a large 401(k) is generally considered one of the clearest signs that retirement planning has gone well. Workers receive a tax benefit for making traditional contributions, investments compound without annual taxation inside the account, and employer contributions can accelerate the growth. After several decades, a disciplined saver can arrive at retirement with $1 million, $2 million or considerably more.
The problem is that a traditional 401(k) is not entirely spendable money. Most traditional contributions went into the account before federal income tax was paid, and withdrawals are generally included in taxable income later. A retiree who accumulated nearly all of their wealth in traditional 401(k)s and IRAs may therefore discover that decades of successful saving created a different challenge: very little control over how much taxable income appears after required minimum distributions begin.
That does not make the 401(k) a bad retirement account or tax deferral a mistake. For many workers, the deduction received during high-earning years is extremely valuable. The more useful lesson is that tax diversification can become almost as important as investment diversification. Retirement is easier to manage when a household has traditional, Roth and taxable assets rather than having almost every dollar trapped behind the same tax rules.
A Traditional 401(k) Delays the Tax Bill Rather Than Eliminating It
Traditional 401(k) contributions generally reduce taxable income during the year they are made. Someone earning $150,000 who contributes $20,000 to a traditional 401(k), for example, may receive a valuable current-year income-tax benefit while the money grows tax-deferred inside the plan. Eventually, however, the government collects its share. Traditional 401(k) and IRA withdrawals are generally included in ordinary taxable income except to the extent the account contains after-tax basis. The retiree therefore has to consider not only how much is inside the account but how much can actually be spent after taxes.
That distinction becomes especially important with large balances. A household looking at a $2 million traditional IRA does not have the same flexibility as another household with $2 million divided among a traditional IRA, Roth IRA and taxable brokerage account. The second household can choose among accounts depending on the tax consequences of a particular year, while the first has fewer options whenever additional spending is needed.
Tax deferral works best when the taxpayer pays a lower rate on the money later than the rate avoided when the contribution was originally made. If the retiree ultimately faces a similar or higher marginal rate, some of the expected tax advantage can shrink. The outcome depends on future tax law, retirement income and the household’s overall account structure rather than simply whether the traditional 401(k) produced a deduction decades earlier.
Required Minimum Distributions Can Eventually Remove Some of Your Control
Congress generally does not allow money to remain indefinitely inside traditional retirement accounts. Required minimum distributions eventually force account owners to begin taking money out, whether they need the cash for living expenses or not. Under current law, the applicable RMD age is 73 for people who reach age 73 before 2033. SECURE 2.0 raises the applicable age to 75 for people who reach age 74 after 2032, which generally means people born in 1960 or later. The rules contain additional nuances for workplace plans, including circumstances in which someone still working can delay distributions from the current employer’s plan, so the starting age should not be treated as identical for every account owner.
The RMD is generally calculated by dividing the prior year-end account balance by an IRS life-expectancy factor. That means larger balances produce larger mandatory distributions. An account does not become problematic simply because it grew successfully, but a retiree with several million dollars in traditional accounts could eventually be forced to recognize substantially more taxable income than is actually needed for spending. That can create an odd outcome. During the accumulation years, the goal was to make the account as large as possible. In retirement, the size of the same account can reduce the taxpayer’s ability to decide when income appears on the tax return.
A Large RMD Can Affect More Than Your Income-Tax Bracket
The effect of a retirement distribution does not necessarily stop with federal income tax. Higher modified adjusted gross income can also increase Medicare Part B and Part D premiums through the income-related monthly adjustment amount, commonly called IRMAA.
For 2026, an individual with modified adjusted gross income of $109,000 or less, or a married couple filing jointly with $218,000 or less, pays the standard Part B premium of $202.90 a month. Above those levels, premiums rise through several income tiers. At the highest 2026 tier, the Part B premium reaches $689.90 monthly per person, and higher-income beneficiaries can also owe an additional Part D adjustment. Medicare generally uses income from two years earlier when determining the surcharge, subject to rules allowing certain life-changing events to be considered. That means a large taxable distribution today can potentially affect healthcare premiums later. For a married couple, crossing an IRMAA threshold can increase premiums for both spouses.
The interaction makes tax planning more complicated than simply asking whether a distribution fits within the 22% or 24% federal bracket. A withdrawal that pushes income slightly above an IRMAA threshold can have a larger effective cost once increased Medicare premiums are considered.
The Real Risk Is Having Every Dollar in the Same Tax Bucket
Imagine two retired couples who each have $2 million invested. The first has nearly everything in a traditional 401(k) and traditional IRA. The second has $900,000 in traditional accounts, $600,000 in Roth accounts and $500,000 in taxable investments.
Their net worth is identical, but their tax flexibility is not. If each couple needs an additional $50,000 for a large purchase, the first couple may have to generate roughly $50,000 of additional taxable retirement-account income. The second couple may be able to use cash, taxable-account basis or qualified Roth withdrawals depending on what produces the most favorable tax result. That flexibility can become especially valuable in years with unusual expenses. A new vehicle, home renovation or large family gift may require far more money than the household ordinarily spends. The ability to select which account provides the cash can help prevent one large purchase from unnecessarily pushing taxable income into a higher bracket or Medicare surcharge tier.
This is the retirement equivalent of investment diversification. Investors diversify among stocks, bonds and other assets because they do not want one investment outcome controlling the entire portfolio. Tax diversification reduces dependence on one future tax treatment.
Roth Accounts Change the RMD Equation
Roth accounts operate differently because qualified withdrawals generally are not included in federal taxable income. Roth IRAs also do not require lifetime RMDs for the original owner, and SECURE 2.0 removed lifetime RMDs from designated Roth accounts in 401(k) and 403(b) plans as well.
That makes Roth money particularly useful later in retirement. A retiree who needs an additional $30,000 but is already close to an IRMAA threshold may be able to take a qualified Roth withdrawal without increasing modified adjusted gross income in the same way a traditional IRA distribution would. The tradeoff is that Roth contributions do not provide the same upfront federal income-tax deduction as traditional contributions. Choosing between traditional and Roth therefore requires comparing the tax benefit today with the expected value of tax-free withdrawals later.
Younger workers in relatively low tax brackets may find Roth contributions especially attractive, while high-income workers may receive more immediate value from traditional contributions. For many households, the answer is not choosing one permanently but deliberately accumulating both.
Retirement Can Create a Valuable Tax-Planning Window
One of the most useful periods for managing a large traditional 401(k) can occur after the paycheck stops but before Social Security, RMDs and other taxable income have fully arrived. Suppose someone retires at 62, delays Social Security and will not begin RMDs until 75. Salary may disappear immediately, creating more than a decade in which taxable income could be substantially lower than it was during the working years. That period can provide an opportunity to withdraw or convert traditional retirement money at deliberately chosen tax rates.
A Roth conversion moves money from a traditional retirement account into a Roth account. The taxable portion of the conversion is generally included in gross income for that year, so the strategy is not about escaping tax. It is about choosing when to pay it. Someone might deliberately convert enough each year to use a targeted tax bracket without moving into a substantially higher one. Over several years, those conversions can reduce the traditional account balance that will later generate RMDs while increasing the pool of Roth assets available for tax-free qualified withdrawals.
A Roth Conversion Is Not Automatically a Tax-Saving Strategy
The phrase “Roth conversion” is sometimes presented as though moving money into a Roth account is inherently beneficial. It is not. A conversion can be a poor decision if the taxpayer pays a high rate today and would otherwise have paid a much lower rate on the same money later. Consider a retiree who converts $200,000 in a single year and pushes a large portion of that income into a substantially higher federal bracket. The conversion could also increase Medicare premiums two years later and affect the taxation of other income. Converting more is not automatically better.
The relevant comparison is the marginal tax rate paid on the conversion today versus the expected marginal rate avoided in the future. That analysis should include RMDs, Social Security, pensions, Medicare surcharges, state taxes and the potential tax treatment of heirs. For some households, that leads to relatively aggressive conversions during early retirement. For others, it may mean converting only modest amounts or doing nothing at all. The strategy should solve an identifiable future tax problem rather than follow a rule that every traditional account eventually needs to become Roth.
RMDs Are Not Automatically Bad Either
A large RMD often gets described as a retirement tax disaster, but that can overstate the problem. Required distributions usually become large because the investor accumulated substantial wealth, which is generally preferable to having too little money.
If someone received a deduction at a high tax rate during their career and later withdraws the money at a lower rate, the traditional account may have worked exactly as intended. Even if RMDs eventually generate significant tax, the investor also received decades of tax-deferred growth.
The concern should therefore be concentrated RMD exposure rather than the existence of RMDs themselves. A retiree whose mandatory distribution already exceeds annual living expenses has less control over taxable income. A retiree whose RMD is easily absorbed within ordinary spending may have little reason to worry. Good planning begins by projecting the size of the future distribution and then deciding whether it actually creates a problem worth solving.
Taxable Brokerage Accounts Provide a Third Kind of Flexibility
Taxable investment accounts are sometimes treated as inferior because they do not provide the immediate deduction of a traditional 401(k) or the potential tax-free qualified withdrawals of a Roth. That overlooks the flexibility they can provide. Money in a brokerage account can generally be withdrawn whenever needed without retirement-account distribution rules. When investments are sold, only the gain above basis is potentially subject to capital-gains tax, rather than the entire withdrawal automatically being treated as ordinary income.
Long-term capital gains can also receive lower federal tax rates than ordinary income depending on the taxpayer’s circumstances. Taxable accounts may allow tax-loss harvesting, charitable gifting of appreciated securities and other strategies unavailable in exactly the same form inside retirement plans. A household that reaches retirement with traditional, Roth and taxable money therefore has three different sources from which to construct annual cash flow. That can make tax planning far more precise than simply withdrawing everything from one traditional IRA.
Tax Diversification Should Begin Before Retirement When Possible
The easiest time to create multiple tax buckets is often while still working. Many employer plans now offer both traditional and Roth 401(k) contributions, allowing workers to divide future contributions between the two tax treatments. There is no universally correct ratio. Someone expecting much lower income in retirement may reasonably favor traditional contributions, while someone in an unusually low tax bracket today may prefer Roth. A worker unsure about future tax rates may decide that accumulating some of each provides valuable insurance against being wrong.
Taxable investing can become the next destination after appropriate retirement contributions, emergency savings and debt considerations have been addressed. It offers flexibility for goals occurring before traditional retirement age and creates another source of funds that can be strategically used after work ends. The objective is not to build three accounts merely for the sake of having them. It is to avoid reaching retirement with every spending decision producing the same tax consequence.
Inheritance Can Make the Traditional Account Even More Complicated
A large traditional retirement balance can also create tax consequences for heirs. Under SECURE Act rules, many nonspouse beneficiaries must empty inherited retirement accounts within 10 years, with additional distribution requirements depending on the circumstances of the original owner’s death and the beneficiary category.
That can be especially costly when adult children inherit traditional accounts during their own peak earning years. Large mandatory distributions layered on top of salaries and other income can cause inherited retirement money to be taxed at rates the original owner might have avoided through earlier withdrawals or conversions.
Roth accounts can also be subject to beneficiary distribution rules, so they are not necessarily allowed to remain untouched forever after death. The key distinction is that qualified Roth distributions to beneficiaries generally have much more favorable income-tax treatment. Estate goals can therefore change the Roth-conversion calculation. Someone intending to spend nearly all retirement assets personally may make a different decision from someone expecting to leave a multimillion-dollar traditional IRA to high-income children.
The Goal Is Control, Not Paying the Least Tax This Year
Tax planning often goes wrong because people focus on minimizing the current year’s tax bill. Deferring a withdrawal can make this year’s return look better while creating a larger traditional balance and a larger future RMD. Avoiding a Roth conversion can save tax today while causing more income to collide with Social Security and Medicare later.
The better objective is managing taxes over an entire retirement. Paying 22% voluntarily today can be a sensible decision if it prevents the same dollar from eventually being taxed at 32% while also triggering higher Medicare premiums. Conversely, paying 32% today merely because someone fears future tax increases can be an expensive mistake if the eventual withdrawal would have fallen into a much lower bracket.
That is why year-by-year tax projections are more useful than simple slogans about Roth accounts or RMDs. A good plan maps income from retirement through the beginning of Social Security and RMDs, then identifies the years in which taxable income is unusually low. Those are often the years when the retiree has the greatest control.
Your 401(k) Is Not the Problem
The traditional 401(k) remains one of the most effective wealth-building tools available to American workers. Employer contributions, high contribution limits, automated payroll deductions and tax-deferred growth can help households accumulate wealth that might otherwise never have been saved.
The problem appears when a successful saver mistakes account size for tax flexibility. A $3 million traditional 401(k) can fund an excellent retirement, but it also represents $3 million of assets whose future withdrawals are largely governed by ordinary-income tax rules and eventual RMD requirements.
A better retirement balance sheet can include multiple tax treatments. Traditional accounts can capture valuable deductions during high-income years. Roth accounts can provide tax-free qualified income and avoid lifetime owner RMDs. Taxable accounts can provide liquidity and capital-gains flexibility.
The years immediately after retirement can then be used deliberately. Rather than automatically leaving every traditional dollar untouched until RMDs arrive, retirees can evaluate whether strategic withdrawals or Roth conversions make sense while their tax rates are relatively low.
The goal is not to eliminate taxes. It is to avoid reaching your 70s with millions of dollars saved but almost no ability to decide when those taxes will be paid. A large 401(k) is a retirement success. Having enough different kinds of money to control the tax bill that comes with it can make that success much easier to enjoy.
Intended for educational purposes only. Opinions expressed are not intended as investment advice or to predict future performance. Past performance does not guarantee future results. Neither the information presented, nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Consult your financial professional before making any investment decisions. Opinions expressed are subject to change without notice.
IMPORTANT DISCLOSURES:
• Investment Advisory and Financial Planning Services are offered through Pure Financial Advisors, LLC. A Registered Investment Advisor.
• Pure Financial Advisors, LLC. does not offer tax or legal advice. Consult with a tax advisor or attorney regarding specific situations.
• Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.
• Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values.
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• Intended for educational purposes only and are not intended as individualized advice or a guarantee that you will achieve a desired result. Before implementing any strategies discussed you should consult your tax and financial advisors.
