If you are an investor with a meaningful amount of your savings in pre-tax retirement accounts (either employer plans like 401ks or Individual Retirement Accounts (IRAs)), you have some to-do’s to consider as you near retirement (which were imbedded in a question I received from a client this week)

The reason for this stems from the very structure (and initial incentive) of these accounts – tax-free contributions. When you put money into these accounts yourself, you received a tax deduction (ie: you didn’t pay tax). When your employer put in matching funds, you did not pay tax on those funds either. As the funds appreciated over time (via dividends, income, and/or appreciation and capital gains), you did not pay taxes on that activity either. There’s no free lunch that lasts forever – and taxes will be due on all sources when you take withdrawals from these pre-tax account (at ordinary income tax rates). Even more impactful, at a certain age, you will not have complete discretion over the timing and level of those withdrawals

Distribution Rules – Pre-Tax Accounts

Once you reach age 59.5, you can begin to take distributions from your retirement accounts without penalty (any distributions taken prior to that time are subject to a 10% excise penalty). Again, distributions from pre-tax retirement accounts will be added to your taxable income. However, with distributions being optional when they first begin at 59.5, you can manage the dollar level and frequency on the distributions. This does not last forever – starting at age 73 (this age is increasing to 75 in 2033), the IRS requires investors to take a certain amount of money out each year. This is known as a Required Minimum Distribution (RMD) and essentially forces distribution of your entire account over your remaining expected lifetime.

Why are there minimum distributions? Simply put – it forces you to pay taxes on these funds!

Many investors may not be aware of the impacts of RMDs until it’s too late. If no actions are taken before RMD age, you may be unpleasantly surprised by how much you need to withdraw annually and the ancillary impact that has on other financial matters at an age and life stage where surprises are not very welcome – such as marginal tax brackets, capital gain tax brackets, Medicare Part B premiums, and Net Investment Income Tax surcharges.

Pre-Tax Retirement Account Strategies

If you have a meaningful amount of pre-tax retirement savings, there are a few strategies you may wish to consider to help mitigate these future surprises (as always, all of these strategies are highly dependent on your own situation so consult with your own tax and financial advisors)

Switch to Roth Contributions – If you are still working and contributing to retirement plans, it may be worth considering switching to Roth contributions if your plan allows. While you won’t get a current tax deductions, diversity in the nature of retirement savings can be useful and may allow you to keep RMD levels in check. Again – this is highly dependent on your situation so proceed with caution.

Spread out Distributions – As noted above, you can start taking funds penalty free from pre-tax retirement accounts at 59.5. It’s worth considering the tax impact of taking some level of distributions at that age, even if you don’t “need the money.” You of course need to pay attention to marginal tax brackets and other implications of doing so, but a reduction in the pre-tax balances before RMD age will lessen that future potential burden

Roth Conversions – Investors with funds in pre-tax accounts have the ability (at any age, not just after 59.5) to convert their pre-tax dollars into Roth dollars. Upon conversion, you will pay tax in the current year on the converted amount (to maximize Roth funds, it’s wise to pay the tax with other money and not from the converted funds). However, after that time, the funds grow tax free, there are no required distributions, and distributions are not subject to income tax.

Roth conversions can be done strategically over many years/decades. Again, the converted amount is added to current income so you need to evaluate that tax impact versus your future likely tax impact of pre-tax withdrawals. A few example times to consider a conversion in our opinion include: use them to “fill up” a lower marginal tax bracket, complete them in years in which you have lower income or higher deductions, or complete them if there is a sudden market downturn and value of account declines.

In most cases, some level of Roth conversion will likely be beneficial for many reasons, including but not limited to – allowing tax free growth of those funds, diversity in retirement funding (allowing you to manage tax brackets), and reduces RMDs when that time comes. But again, talk with your advisors about your own unique fact pattern.

Important note: Some investors wrongly assume they can count a Roth conversion amount against their RMD requirement. While that would be nice, the IRS does not allow for this. If you are of RMD age, you must first process a distribution from your pre-tax IRA to satisfy your RMD. After that is done, you can process a Roth conversion in the same year as well – but understand the tax impacts of that. You can also use the distributed RMD dollars to contribute to a Roth IRA directly (if you happen to still have earned income and are otherwise eligible to do so)

Qualified Charitable Distribution – QCDs are a way to reduce future RMDs and satisfy current year RMDs. We’ve written about this in the past so you can revisit that post for details. Quick summary – starting at age 70.5, you can use IRA dollars to make charitable donations (currently up to $105,000 per year). Any amounts donated right from an IRA are not subject to income tax but will count towards your RMD total once you reach that age – as well as help you lower pre-tax dollars that will be subject to RMD in the years between 70.5 and RMD age

If you’ve made it this far in the article, you will certainly agree with my sentiment that sometimes savings for retirement can seem easier than spending/managing those accumulated funds. I appreciate the complexity but with careful planning and guidance, you can navigate these times!