Here's How to Avoid a 'Tax Time Bomb' in Retirement

Follow these steps to minimize taxes when you’re living on your retirement savings
Updated July 18, 2024
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Saving money is never a bad idea. Founding Father Benjamin Franklin coined the well-known phrase “a penny saved is a penny earned.” That advice holds true today, of course, hundreds of years later.

But as you approach retirement, especially if you have a hefty amount of savings, there are a few things you need to be aware of — namely, that all the money you’ve socked away could cause you tax pain in your golden years.

Here’s what you need to know to avoid a “tax time bomb” in retirement and not waste the money you’ve saved.

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The problem

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IRAs and 401(k)s are a great way to save for retirement while you’re working, especially if your employer matches contributions. In addition, these savings vehicles provide some tax benefits, but here’s the rub: Your pre-tax contributions to these types of accounts are tax-deferred, not tax-free.

Any withdrawals you make later will be subject to taxes, because they count as income. You can put those taxes off for a while, but not forever. Eventually, the taxman cometh. And the more you and your employer contribute, the bigger your tax liability.

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RMDs

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Required minimum distributions (RMD) are pretty much the definition of “the taxman cometh”: No matter how long you try to put off dealing with your liabilities for pre-tax contributions to IRAs and 401(k)s, the IRS won’t let you keep that money in your accounts forever.

RMDs are defined as “the minimum amount you must withdraw from your account each year” and it starts April 1 the year after you turn 73. That minimum changes every year and is defined by how much you have in your accounts as well as your age.

And beware: If you don’t take out the minimum, you’ll have to pay a whopping 50% excise tax on the outstanding amount.

What retirement accounts are subject to RMDs?

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Most workplace retirement accounts are subject to RMDs. The beneficiaries — not the initial account holder — are liable for any Roth IRA withdrawals. The IRS lists them as:

  • Traditional IRAs
  • SEP IRAs
  • SIMPLE IRAs
  • 401(k) plans
  • 403(b) plans
  • 457(b) plans
  • Profit-sharing plans
  • Other defined contribution plans
  • Roth IRA beneficiaries

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How to lessen your RMD tax burden: Take money out early

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If you withdraw money from your retirement accounts too soon, you get smacked with an added 10% tax fee, but that ends when you turn 59 1/2. These early withdrawals may help reduce your future RMDs and, thus, your taxes.

Taking money out early can also help you put off taking Social Security benefits, which in turn increases your benefit amount, because the longer you wait, the more you get.

Consider converting your accounts

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Converting pre-tax retirement accounts to Roth IRAs can help avoid future tax increases, especially with rates slated to rise in 2026. By paying taxes now — you pay when you convert — you can secure tax-free growth and withdrawals for life.

Conversions can be spaced out over several years to lessen the immediate tax impact. Roth IRAs also eliminate RMDs. This tactic might not be right for everyone, so consulting with a tax professional or financial advisor is the right way to figure out if it’s right for you.

Don’t overlook HSAs

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Health savings accounts can be a valuable addition to your retirement savings if you have an eligible high-deductible health plan. Contributions lower your taxable income within annual limits, and investments grow tax-free.

You also avoid taxes on withdrawals for qualified medical expenses. After age 65, nonmedical withdrawals are taxed as ordinary income, but HSAs are exempt from RMDs. HSAs offer a versatile way to save for both health care costs and retirement.

If you’ve got the money, check out brokerage accounts

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If you’ve maxed out other savings options, you might look to a traditional brokerage account. While your income here is taxable, you can enhance tax efficiency by holding investments for over a year to benefit from lower long-term capital gains rates (0% to 20%), limiting trades, and choosing tax-efficient investments like ETFs and index funds.

Municipal bonds are another option, especially for those in high tax brackets, since their interest is typically exempt from federal, state, and local taxes.

Give to charity

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The IRS offers a host of tax breaks for charitable contributions, but it’s also an excellent way for those with traditional IRAs to directly transfer up to $100,000, tax-free, each year, through qualified charitable distributions (QCD).

Not only is giving to charity a good thing to do, but the great news here is that QCDs count toward your RMDs if you’re 73 or older.

You can work longer

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This is probably one of the least fun options when it comes to lessening your tax burden, unless you really love your job. But, if you're still employed, you don't need to take RMDs from your current workplace retirement plan.

Be aware that this doesn’t apply to accounts from former employers or IRAs. Still, by continuing to work, you may reduce the total RMDs. It’s also a way to postpone Social Security benefits, potentially increasing your overall retirement income.

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Bottom line

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No matter your age, it’s important to check your retirement readiness so you can make the best of your golden years.

These strategies can help lower your retirement taxes. While RMDs can't be avoided indefinitely (except with a Roth IRA), it's essential to balance tax reduction with enjoying your retirement.

Author Details

Will Vitka Will Vitka is a D.C. area reporter and writer. He previously worked for WTOP, The New York Post, Stuff Magazine, and CBS News.