Retirees With Only a 401(k) May Face This Expensive Tax Trap

For years, financial experts have encouraged workers to prioritize their 401(k)s, and for good reason. Traditional 401(k)s offer benefits such as tax-free contributions, tax-deferred growth, and, for many people, employer matches.

But there's a big downside to saving for retirement in a 401(k) you should know about. And if you make a traditional 401(k) your only retirement account, you could end up in a tough spot later in life.

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RMDs can create surprise tax headaches

The biggest issue with having only a traditional 401(k) for retirement is that once you turn 73 or 75, depending on your year of birth, you'll be forced to start taking withdrawals each year known as required minimum distributions, or RMDs.

At first, RMDs may not sound like a major issue. After all, withdrawing money from retirement accounts is the whole point of saving in the first place.

The problem with RMDs is that you can't control the timing. You're forced to withdraw a certain amount each year based on your life expectancy and account balance.

And if you don't need that full amount, too bad -- you have to take it and pay taxes on it. If you don't, you risk a 25% penalty on whatever amount you don't withdraw.

Not only can RMDs create tax headaches, but they could also have less obvious consequences. If RMDs raise your income enough each year, you could end up having your Social Security benefits taxed. And if your RMDs are on the larger side, they could drive your income up to the point where Medicare premiums cost you more.

Plus, because RMD percentages commonly increase with age, that tax burden could grow larger over time.

Tax diversification is key

There's nothing wrong with using a 401(k) to build retirement savings. But as you get closer to ending your career, you may want to look at diversifying so you don't have all of your money in that single account.

One option is to do a partial Roth conversion ahead of retirement. You'll pay taxes on the sum you move to a Roth IRA. But you'll then be able to enjoy tax-free gains and withdrawals from that account. Just as importantly, Roth IRAs do not impose RMDs.

If you already have a large 401(k) balance and still have a few years left until you're set to retire, you could start putting money into a taxable brokerage account, which doesn't have restrictions. In that case, you should still aim to contribute enough to your 401(k) to get your full workplace match. But a taxable account gives you more money you can control later.

A large 401(k) balance can absolutely be a good problem to have going into retirement. But if that's what you're looking at, take steps to branch out so you don't fall into the all too common RMD trap.