In this episode, we talk about the tax time bomb hiding inside retirement accounts for healthcare professionals. We focus on clinicians who have done everything right:.you saved consistently. You deferred income. You maximized our 403(b) and 457(b) plans. But we explain how those smart decisions can create large tax consequences later in retirement.
Here's the core issue. Decades of tax deferral during high earning years allow retirement accounts to grow substantially. Over time, those accounts often become the largest part of net worth. The problem is not the saving. The problem is what happens when required minimum distributions begin. These RMDs are not based on lifestyle needs. They are based on account size. The larger the balance, the larger the forced withdrawal. And those withdrawals are taxed as ordinary income. They stack on top of Social Security, pensions, deferred compensation, and sometimes part time work. That is how many clinicians end up in their highest tax years after they stop working.
The common assumption that taxes drop in retirement: it does not always hold true for prepared professionals. Retirement changes where income comes from, not necessarily how much income there is. Social Security taxation depends on total income. Medicare premiums increase when income crosses thresholds. Strong market growth can quietly increase future RMDs. Income can show up whether we want it or not.
The most valuable planning window often happens before RMDs and Social Security begin. Those transition years between retirement and age 73 can offer meaningful control. If income temporarily dips while net worth remains high, we may have opportunities to shift assets strategically.
What about Roth conversions? They are not about avoiding taxes. They are about choosing when to pay them. By moving money from traditional IRAs to Roth accounts during lower income years, we reduce future RMDs and create flexibility. Now, these conversions can feel uncomfortable because they increase short term taxable income and may affect Medicare premiums. But we emphasize that the real goal is to reduce sharp income spikes later.
Again, these tax issues are often the result of doing everything right. Flexibility matters more than perfect timing. Thoughtful planning today can prevent forced decisions later.
(00:00) Introduction
(00:51) How 403(b) and 457(b) Plans Create Future Tax Risk
(02:59) Why Taxes May Not Drop in Retirement
(04:36) Social Security and Medicare Income Traps
(07:01) The Transition Years Planning Window
(10:26) Understanding Roth Conversions
(14:46) How Early Planning Reduces RMD Pressure
(16:17) The Power of Tax Diversification
(18:21) Key Takeaways for Clinicians
ThimbleberryU 155 - The Tax Time Bomb in Your Retirement Accounts
Speakers: Jon Gay & Amy Walls
[Music Playing]
Jon Gay (00:07):
Welcome back to ThimbleberryU, I'm Jon Jag Gay. I'm joined as always by Amy Walls from Thimbleberry Financial. Amy, always great to be with you.
Amy Walls (00:14):
Jag, always great to be talking to you.
Jon Gay (00:16):
And if you work in healthcare, chances are you've spent years doing what responsible planning looks like. We've talked about that in the podcast. You saved consistently, you deferred income, you took full advantage of the 403(b) and of the 457(b) too.
What doesn't get talked about often enough is what happens later when all of that good savings starts turning into taxable income. For many clinicians, the biggest tax years, they don't show up during their career, they show up deep into retirement.
So, Amy, let's start at the beginning: what actually creates this tax issue for so many in healthcare? An area that I know you specialize in.
Amy Walls (00:51):
Many in healthcare spent decades deferring that income, like you alluded to. And they're doing that during their highest earning years. And in prior episodes, we've talked about that some folks in healthcare also are able to contribute to two retirement plans at once, doubling what they can do through their employer. And that's what makes sense at the time.
But over time, those 403(b) and 457 plan balances grow and grow and grow and often become the largest part of someone's net worth. And a large share of retirement assets ends up in those accounts and it's never been taxed.
That's not a mistake. So, listeners, if you are saying, “Whoa, I've done this,” what you're doing is not a mistake, it's how those plans are designed. The challenge, Jag, that you were alluding to that shows up later is when the IRS decides it's time for that income to come back out of those accounts, and that's with required minimum distributions.
Those RMDs (Required Minimum Distributions) force withdrawals based on account size. So, if it's a little account, a small amount's going to come out. If it's a big amount, a large amount's going to come out. So, it's not based on spending needs or lifestyle, and up until that point, from retirement until RMD start, it can be based on lifestyle, how much you need.
So, the thing to know for our listeners is these withdrawals are taxed as ordinary income, so just like a paycheck, and stack on top of social security pensions, deferred compensation, and sometimes for some of you, it's continuing work. So, the result is higher income later in life that just was not expected.
Jon Gay (02:48):
I see. And you're kind of answering this question already but let me ask it more pointedly. A lot of people assume that once they stop working, taxes are naturally going to go down. Why does that assumption break down, Amy?
Amy Walls (02:59):
This question subtly talks about if you're prepared versus not prepared. And Jag, I think for this conversation, and just who we work with, we are making the assumption that our listeners are very prepared for retirement. And we do know, unfortunately, that's not Americans in general.
So, that assumption that taxes would go down is often true in America for Americans because they are unprepared, but it's not true when people are prepared.
Jon Gay (03:34):
Okay, I see where we're going there. Yep.
Amy Walls (03:37):
So, first of all, let's address income. Earlier in life, income is something you choose. You choose it by your career; you choose it by the job choices that you make. Later in life, income often shows up whether you want it or not.
Jon Gay (03:58):
(Chuckles) Going back to those RMDs and other things, yeah.
Amy Walls (04:00):
Exactly. And that can create a sense of loss of control, and that's hard. The other thing I think we should address is that there are lots of assumptions people make about income taxes in retirement. Two truths that are different from common assumption outside of this one you've brought up is social security taxation depends on total income, not just the benefit.
What I mean by that (and this is a little bit of a squirrel as my family would say)-
Jon Gay (04:36):
Squirrel! (Laughter)
Amy Walls (04:37):
Is that social security, the taxation on that is going to be dependent on your entire income, not just the benefit you receive for social security. So, a lot of times when people start social security, they'll talk to us about how much tax withholding should I have on it, but they're looking at it in isolation versus the whole picture.
Another truth is that Medicare premiums increase when income crosses specific thresholds. So, the assumption is that Medicare premiums are a constant, it's just: the government sets the price and it's done. No, as your income goes up, your Medicare premiums also go up. And so, why I'm bringing this up is assumptions are common when it comes to retirement planning and these social programs that we have.
So, going now to kind of more of your question, retirement usually changes where income comes from, not necessarily how much income there is. So, required minimum distributions don't adjust for how much you actually need to spend. It's a set dollar amount based on the account balance. Strong market growth can quietly increase future withdrawals.
So, if you're 72, starting distributions at 73, and you're cheering on the market and because you've got enough, maybe you're still a fairly aggressive investor, you're cheering that on, and that's wonderful. And you may not be taking into account what that means for your distributions. And then people are often surprised by how large those distributions become or can become.
Jon Gay (06:36):
That actually makes sense when I think about it, Amy. The market's going up, that's great. You've got the accounts, the balance on the account’s going up, and then because the account balance is bigger, the RMDs become bigger, you're on the hook for more on the tax side. That actually makes a lot of sense.
So, with the heaviest tax years often coming later, when do clinicians and other healthcare contributors actually have the most control over this situation?
Amy Walls (07:01):
Well, control- isn't it an illusion? (Laughter) No, but to answer your question, control usually exists before required distributions and social security begin. And this is where some of the problem comes in as we wait until a thing is there, or that's when it comes to our attention and we've missed the opportunity. So, for many healthcare professionals, this control area shows up in transition years rather than with a clean retirement date.
So, perhaps, you are retiring at 66, let's just pick that. And social security for you is going to start at 70 and required minimum distributions are going to start at 73. Your prime years to control how this income is going to look for the remainder of your life is that 66 to 70 window. You still probably have a little bit from 70 to 73, but not as much as you do during that first batch of years.
And some of the ways that someone can control this include maybe working part-time, dropping call hours, it could be taking a sabbatical if you're still working, that can create opportunity – or shifting into teaching or administrative roles, just where income is different.
And so, essentially, what we're looking for in these control years or these years where someone can have more control is income is ideally dipping temporarily even though net worth remains high. We're looking for cash flow, set cash flow to shrink. Now, the problem with this, because I think that's we go, “Well, ah, I don't want less income, I want to spend what I want to spend.”
Jon Gay (09:01):
I'm thinking that as you were walking through that, yeah.
Amy Walls (09:03):
(Laughs) Yeah, it doesn't mean if you've saved in the right spots and have diversified where you save that cashflow can still be there, it's just taxed less. The issue becomes our emotions, those years can feel very uncertain emotionally. And I think it's one of the reasons that tax piece can be overlooked.
One, it's understanding of a whole new scenario for a lot of people. Second, it comes with an emotional layer that has to be dealt with. And so, there's flight or fight (laughs), and this is one a lot of people choose to run the other way on. But my point is from a tax perspective, these are some of the most valuable planning windows.
Jon Gay (10:00):
Absolutely.
Amy Walls (10:01):
Jag, I think the last thing I'll say on this is the issue here isn't about predicting future tax law, and sometimes I hear people say that, “Well, let's try to predict what's going to happen there.” That's not the goal, because we can't predict all the ideas and changes that may come up. What it's about is planning for using flexibility before it disappears.
Jon Gay (10:26):
I like that. Alright, I've been dying to ask you this since we started talking today, Amy: Roth conversions. How do you think about Roth conversions in this context?
Amy Walls (10:35):
Well, first of all, for our listeners, Roth conversions are about shifting where income lives; it is not about avoiding taxes altogether. So, essentially, you're choosing when to pay tax instead of letting it be forced later.
And that is because money moves from an IRA into a Roth, and now, in the Roth it's going to grow tax free forever, assuming you meet all the requirements, age-wise and such. Future required distributions from this IRA are reduced or eliminated because you've removed part of the account ballots by getting it over into the Roth, which doesn't have required distributions.
Jon Gay (11:21):
The required distributions are to make you pay your taxes. And if you've moved it into a Roth, you've paid the taxes before it went into the Roth. The government's already got their piece.
Amy Walls (11:30):
Jag, have you considered being a financial advisor? (Laughter)
Jon Gay (11:32):
I'm going to leave that to the professional in this conversation, but thank you.
Amy Walls (11:36):
(Laughs) So, you're absolutely right. The other thing is that effective conversions rarely happen all at once. They're usually spread over multiple years like in those windows we talked about, and size to fit within specific tax brackets. So, again, the goal isn't to eliminate tax, the goal is to reduce the risk of what I'll call sharp income spikes later in retirement.
Jon Gay (12:06):
But I got to say Amy, as we're talking about this, even when that strategy makes sense, it can feel uncomfortable to people. Why does it feel uncomfortable to people?
Amy Walls (12:14):
Well, Jag, is it ever comfortable when money's going out?
Jon Gay (12:18):
(Laughs) Fair. I assume that's a rhetorical question.
Amy Walls (12:25):
(Laughs) Yeah, a little bit. Roth conversions increase taxable income in the short term, so that's no fun. That means less money is what it feels like. Then there's a tax bill. Other things that it's important to know with this that some of our listeners probably know about and some don't, which also can create the feeling (and I want to stress the word feeling here) of more money going out is those Medicare premiums are based on your income.
So, it doesn't take long for the extra income perhaps from a Roth conversion, especially a large conversion if that's what's needed to cause the Medicare premiums to go up. And that surcharge feels, I think, often for people who are subject to it immediate and a little bit personal, and like they've made a mistake.
Jon Gay (13:30):
I can see that.
Amy Walls (13:31):
And it can feel like the conversion created the problem. But what I've found is that in many cases, those income thresholds for Medicare would've been crossed later in life anyway because of the required minimum distributions.
And by doing the conversions, while you may pay them earlier than you would have otherwise, they may be at lower rates for the remainder of life than going to the top bracket or top two brackets for more years.
I think that's what's really behind the discomfort. And so, the important thing for you to remember is that starting earlier, if Roth conversions are the solution for you often means smaller increases spread out over more years.
Jon Gay (14:19):
Got it.
Amy Walls (14:20):
And the real discomfort Jag, despite me laying out that it's about money going out, the real discomfort isn't the money going out, it's the visibility of money going out, rather than long-term damage.
Jon Gay (14:35):
That makes sense. Let me play this out a little bit further with you, Amy. Once required distributions begin, how does the earlier planning we're talking about here actually help?
Amy Walls (14:46):
And it's a great question because I know conceptually, it would be great if we had graphics and things to show this. But earlier conversions reduce through the reduction in the IRA balance the size of future required distributions because required distributions are based on age and on size of the account on December 31st of the year before.
So, by bringing the account size down, what it really creates is flexibility instead of forced decision making. If I leave this account growing and growing and growing, and now all of a sudden, I'm at the age, I have no choice. I have to take what I'm told to take or I'm going to have penalties. If however, I look at this and say, “Gosh, I don’t know what tax laws are going to do,” because I can promise nobody knows what tax laws are going to do for sure in the future. But I say, “This balance is high, I could see a potential problem depending on which way this goes.”
So, I've got some wiggle room in these tax brackets. I'm willing to take that on in order to shrink this, have more tax-free income in the future, and have a smaller required distribution down the road also. And that's a win, that's a win for me from an income perspective, a flexibility perspective, and hey, it may even be a win for my heirs. Because now, money's in a Roth and they won't have to pay the taxes.
Jon Gay (16:16):
Got it.
Amy Walls (16:17):
The other thing is that income can be drawn from different tax buckets depending on the year. So, for example, let's say that you're retired. And what I know from our retired clients is most people who’ve retired don't want to have a car payment.
And you've got a great net worth, you can afford your lifestyle, you're buying a $100,000 vehicle in this year. Well, we can pull that money from an IRA all as a lump sum on top of expenses, that a hundred thousand dollars vehicle just became $135,000 just with federal taxes, higher potentially depending on state taxes. So, that vehicle just became a lot more expensive.
Or if we've got money in the right spot, we could take that from a brokerage account. Now, we're only paying capital gains on what we sold, which may not be all of that a hundred thousand, but let's assume it is, now we're talking $115,000, $120,000 for the vehicle (less expensive), or we could potentially take that money from the Roth and the vehicle cost (just) $100,000.
Now, I'm not saying this is exactly what we want to choose just for a vehicle, but it makes the point that for any year to figure out where cash flow is going to come from, we now have choice between these three areas.
And Jag, what I'm talking about here really goes back to our very first episode of this podcast, 155 episodes ago, talking about the tax control triangle. So, that's how flexibility happens.
Jon Gay (18:16):
Alright, well, that's probably a good place to leave it here Amy. As we wrap up, what are our key takeaways for clinicians listening to the show?
Amy Walls (18:21):
I think for any healthcare professional, the tax issue is usually the result of doing everything right, not doing something wrong. I want everybody to hear that because saving into your 403(b) and 457 and tax deferring when you're a high-end income isn't a problem, it just has a domino effect down the road.
Another thing I'd say is the most valuable planning often happens before retirement officially begins. Roth conversions are a tool, you know, we spend a lot of time talking about them. They are not the goal or the point, they survey purpose and here, they are a tool that could be used to offset higher income years.
Jon Gay (19:06):
One tool in the tool belt.
Amy Walls (19:08):
Exactly. Another thing I think for our listeners, I want them to think about is flexibility matters more than perfect timing. What we've just talked about; we don't know what the taxes are going to do, but if we put ourselves in a position to be able to choose where we draw money from at a preferential tax rate, we may have set ourselves up for success.
And last thing I'm going to say in the recap is thoughtful planning replaces forced decisions later. And that is about that thoughtful planning creating intentional decisions today.
Jon Gay (19:48):
This is “note to future self,” like I'm doing this for you later down the road, right?
Amy Walls (19:52):
Exactly.
Jon Gay (19:53):
Alright.
Amy Walls (19:54):
Yeah, that's a great way to say it.
Jon Gay (19:56):
There’s my mic drop moment, Amy. If somebody wants to contact you and your team at Thimbleberry Financial about this stuff or anything related to their financial future, how do they best find you?
Amy Walls (20:04):
Yeah, they can find us online at thimbleberryfinancial.com or by giving us a call at (503) 610-6510.
Jon Gay (20:14):
Great stuff as always. Amy, we'll talk again soon.
Amy Walls (20:16):
Yes, sounds great, Jag.
[Music Playing]
Jon Gay (20:19):
Securities offered through registered representatives of Cambridge Investment Research Inc, a broker dealer member of FINRA, SIPC. Advisory services through Cambridge Investment Research Advisors, Inc, a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.
Discussions in this show should not be construed as specific recommendations or investment advice. Always consult with your investment professional before making important investment decisions.
Securities offered through registered representatives of Cambridge Investment Research, Inc, a broker, dealer member FINRA, SIPC. Advisory services through Cambridge Investment Research Advisors, Inc, a registered advisor. Cambridge and Thimbleberry Financial are not affiliated.