How much do you need to retire comfortably? It’s a tricky question to answer, but according to a survey from Schwab Retirement Plan Services, on average, Americans believe they need to have $1.9 million saved for retirement.

A seven-figure 401(k) balance is certainly an achievement, but it can come with some tax challenges in retirement when it’s time to withdraw and face those inevitable tax bills.

The Myth of a Lower Tax Bracket in Retirement

You might assume you’ll be in a lower tax bracket in retirement. After all, many people do. But while that’s true for some, it isn’t guaranteed—especially if you’re a diligent saver and investor. In fact, between required minimum distributions (RMDs) and Social Security, you could end up with a taxable income in retirement that’s closer to (or even higher than) what you’re accustomed to. Plus, tax brackets and rates change over time, making it hard to predict exactly what your tax picture will look like years from now.

Here’s why that tax bracket matters.

401(k) Distributions Are (Usually) Taxable

When you take money out of a traditional 401(k), it’s generally considered taxable income. This applies to each dollar withdrawn unless your employer offers a Roth 401(k) and you took advantage of its tax-free growth.

For most of us with traditional 401(k)s, however, each withdrawal in retirement is taxable as ordinary income, just as if you were receiving a paycheck.

You Can’t Skip Out on RMDs

Don’t assume you can leave your money in your 401(k) and live off other income because you’ll need to start taking RMDs eventually.

By age 72 (73 if you reach age 72 after December 31, 2022), the IRS requires you to start taking money out of your 401(k) whether you need it or not. The amount you must withdraw is based on your account balance and a life expectancy factor the IRS publishes in Publication 590-B.

With a $1 million 401(k), your RMDs can add up to significant taxable income each year.

Tax Planning Strategies for a Million-Dollar 401(k)

To help manage the potential tax burden, there are some tax-efficient strategies to discuss with your financial advisor.

Invest in a Tax-Efficient Way

A tax-efficient investment strategy includes paying attention to how much of your income comes from tax-exempt interest, qualified dividends, and long-term capital gains and the types of accounts you invest in. So, a big part of tax efficiency is putting the right investments into the right accounts.

You might want to hold the following assets in taxable brokerage accounts:

• Individual stocks you plan to hold for more than one year
• Tax-managed index funds and exchange-traded funds (ETFs)
• Stocks and mutual funds that pay qualified dividends
• Municipal bonds

Meanwhile, tax-advantaged accounts like 401(k)s and IRAs are ideal for:

• Individual stocks you plan to hold for one year or less
• Actively managed funds that may generate significant short-term capital gains
• Taxable bond funds
• Real estate investment trusts (REITs)

Consider Converting to a Roth IRA

If you’re still a few years away from retirement, consider whether a Roth conversion might work for you. Converting part of your 401(k) to a Roth IRA means paying taxes on that portion now, potentially at a lower rate, while allowing it to grow tax-free for the future. It’s a strategic way to lessen the tax impact of RMDs in later years.

Just keep in mind that Roth conversions can trigger a hefty tax bill, so it’s a good idea to save them for years when your taxable income is low and discuss them with your financial and tax advisors.

Make Tax-Efficient Withdrawal Decisions

Having a strategy for how and when to take money from different accounts can make a big difference when withdrawing in retirement. You may want to tap taxable accounts first to allow your tax-deferred accounts to keep growing.

Once RMDs kick in, take advantage of any flexibility you have to avoid bumping into a higher tax bracket.

Don’t Forget the Importance of Professional Advice

Investing and tax decisions are complicated. That’s why it’s essential to work with financial and tax advisors who can help you make the most of your retirement funds while avoiding unnecessary tax headaches. A financial advisor can help you evaluate the right mix of investments and timing withdrawals, while a tax advisor can help you evaluate Roth conversions to reduce your overall tax burden.

If you need help, contact NewWay Accounting. After all, you worked hard to build your nest egg. A little proactive tax planning now can ensure it lasts as long as you need it without an unexpected tax bill waiting around the corner!