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Ever since the 401(k) option was added to the U.S. tax code in 1978, employer-sponsored retirement savings plans have been a fundamental element of any smart investment portfolio and a vital financial safety net for most retirees’ golden years.
However, some retirees are finding that a strong 401(k) balance can actually cost them money — specifically, higher taxes on Social Security benefits. Read on for more details.
‘Social Security Clawback’ attack
According to a recent analysis of 247volcentRetirees who have more than $800,000 in their 401(k) accounts may find themselves hit with higher taxes. Essentially, required minimum distributions (RMDs) for taxpayers over age 75, when combined with Social Security benefits, can inflate a retiree’s income to the point where 85% of those Social Security benefits become susceptible to taxation – what 247Wallace calls the “Social Security Clawback.”
How to Avoid Surprising Social Security Taxes
David Byrne of 247WallSt recommends that retirees execute Roth conversions during the period between when retirement begins (typically around age 65) and when RMDs are due (about a decade later) and do so at lower marginal tax rates. This can reduce future RMDs, thereby reducing Social Security taxation.
Evan Mills, Financial Analyst scholars are giving adviceagreed when speaking to GOBankingRates. “The best thing to look at is a Roth conversion, taking money out of those pretax accounts and moving it into a Roth. It’s going to lower your RMDs in the long run,” he said.
“Now once you’re in the RMD years, it becomes a little different. At that point, if you’re able, something like a qualified charitable distribution (QCD) can help. You’re sending those RMDs directly to a charitable organization, which reduces your taxable income and can help reduce how much of your Social Security is actually taxed,” Mills explained.
“Another part of it is asset location,” Mills said. “Typically you want low-growth assets in those pretax accounts to help keep RMDs low over time. And then your higher growth assets, those are better suited to Roth accounts or even taxable accounts, where the capital gains treatment may be more favorable than ordinary income. That helps moderate the impact of RMDs over the long run.”