Unfortunately, retirees face a surprising reality about taxes. Many assume tax bills decrease in retirement, but the opposite often happens.
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Tyler End, certified financial planner and CEO of retirement advisory company Retirable, and Lance Morgan, founder and CEO of College Funding Secrets, identified common tax mistakes that drain retirement income.
The biggest misconception is that retirement means lower taxes. “What many consider before they retire is that their retirement savings will be in taxable form,” Morgan said. Tax-deferred retirement accounts like 401(k) plans and IRAs contain taxable dollars that were deferred with the understanding they would be taxed when withdrawn.
When required minimum distributions start, retirees discover their tax rates have increased. Higher tax rates lead to higher Medicare premiums and higher taxes on Social Security benefits.
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One of the biggest opportunities for retirees with different account types is taking a thoughtful approach to where withdrawals come from. “Relying on a simple rule-of-thumb strategy like pulling from taxable, then tax-deferred, then tax-free accounts can lead to unnecessary taxes and missed chances to optimize tax brackets,” End said.
This becomes especially problematic for individuals without a plan for required minimum distributions. Strategic placement of high-risk and low-risk investments in different accounts based on distribution timing provides major leverage.
Healthcare costs represent a huge blind spot for seniors. IRMAA Medicare Part B premiums often come as an unpleasant surprise. “Retirees who delay IRA withdrawals as long as possible may end up with larger RMDs later on, pushing income above IRMAA thresholds and triggering higher Medicare premiums,” End said.
Big withdrawals from retirement accounts increase Medicare premiums beyond standard rates. The tax tail shouldn’t wag the dog, but healthcare costs deserve consideration in withdrawal planning.
Roth conversions work as a powerful planning tool, especially during lower-income years. However, some retirees overdo it. “Some retirees overdo it, creating large upfront tax bills in an effort to avoid potential future taxes,” End said.
Since no one knows how tax rates or markets will change, going all-in can backfire. A dollar today is worth more than a potential dollar tomorrow. “Treat Roth conversions as a hedging strategy, not an all-or-nothing decision,” End said. Partial conversions over several years provide flexibility without creating unnecessary tax pressure.