Why $1M In a Retirement Account May Only Be Worth $700K And What To Do About It

Some retirees may be in for a rude awakening when they start taking distributions from retirement accounts like traditional 401(k)s or IRAs and incur large tax bills.

Investopedia spoke with Stephen Dissette, an investment advisor representative at Horter Investment Management, to discuss the steps people should take now to minimize taxes in their golden years.

The following interview has been edited for length and clarity.

INVESTOPEDIA: What should people know or plan for when it comes to the tax hit that they experience when withdrawing from a 401(k) later in life?

STEPHEN DISSETTE: There are four major threats to a successful retirement: taxes, stock market risk, longevity, and long-term care expenses.

A lot of advisors talk about diversifying investments—I talk about diversifying taxes as well. One of the best things people can do to supplement their retirement beyond a 401(k) is through a Roth IRA.

For Roth IRAs, you can contribute $7,500 if you’re less than 50 years old. If you’re over 50, an additional $1,100. There are limitations: if you make too much money, you can’t contribute. If you’re already retired, you can’t contribute because you need earned income.

I also think a lot of people do not understand the power of Roth conversions. I come across a lot of people who have seven-figure retirement accounts, but do they really have $1 million? They probably have $300,000 less [because that portion will go to taxes if in a 401(k) or tradition Roth account], so that’s why it’s important to diversify.

INVESTOPEDIA: Why do you like Roth conversions?

DISSETTE: The biggest advantage of a Roth account is that you have the ability to take withdrawals without having to pay Uncle Sam. The conversion is considered a taxable event.

There are a couple things to consider. We have historically low tax rates and people think when they do a conversion, they have to do it all, but you can do it all at one shot or you can spread it out [over years]. I look at someone’s income, see where they are in the tax bracket and then plan accordingly. I try to keep the conversions within their tax bracket. [The amount you convert is added to your taxable income.]

There are people that end up doing Roth conversions which generate significant tax consequences… What people don’t realize is you can withhold taxes just like you would withhold taxes from your paycheck. It [the tax money] is going to go to the government anyway. Why don’t you just have them [the government] keep their percentage and you won’t have to worry about coming up with significant amounts of money from your savings account?