A million bucks in a 401(k) doesn’t mean you have a seven-figure fortune to spend in retirement.

Unfortunately, Uncle Sam takes his tax cut. Suddenly, the $1 million sitting in a traditional retirement account isn’t as well fortified as you thought.

“One million dollars in a 401(k) isn’t really worth a million dollars,” said David Schneider, a certified financial planner and president of Schneider Wealth Strategies.

It’s important for retirees and workers still saving for retirement to keep that in mind. And to plan accordingly.

We’re not knocking 401(k)s. They’ve made many American workers millionaires, thanks to features like automatic savings, low-cost investments, employer matching contributions and tax-deferred growth.

But 401(k)s come with a tax downside once you start taking money out.

Drawbacks Of 401(k) Retirement Accounts
Every dollar withdrawn from traditional 401(k)s, which are funded with pretax dollars and come with an up-front tax deduction, is taxed at one’s ordinary income tax rate. So, once the IRS (and the states with income tax) deducts the tax owed to them, a retiree’s after-tax take-home pay from a distribution shrinks.

As the old saying goes, it’s not what you have, but what you keep. Consider a retiree in the 32% tax bracket with a $1 million nest egg. Here’s how the math works.

“The 401(k) is a $1 million asset with a $320,000 liability attached to it,” said Schneider. “Only $680,000 of that is really yours to keep, since you can’t access any of your traditional 401(k) without triggering a taxable event.”

The Money Is Not All Yours
It’s not a good feeling when you face a tax bill to access your money.

“It’s sort of like that feeling when you’re getting ready to write a check to the IRS on April 15,” said Schneider.

This is the conundrum older generations like baby boomers and Gen Xers face in the “decumulation phase” who didn’t grow up with tax-free Roth savings options. The bulk of retirement savings held by older Americans sits in traditional 401(k)s and IRAs.

That’s why so-called “asset location,” a strategy of placing investments in the most tax-efficient accounts, matters. Roth retirement accounts, which are funded with after-tax dollars, don’t give you a tax deduction when you put money in, but allow tax-free withdrawals. Taxable brokerage accounts benefit from lower capital gains tax rates, ranging from 0% to 20% depending on your taxable income. Traditional 401(k) and IRA accounts tax withdrawals at regular income tax rates, which range from 10% to 37%.

“Asset location is huge,” said Matthew Smart, director of financial planning and portfolio analysis at WWM Investments. “It’s a huge part of our planning conversations in today’s world.”

Spread Your Retirement Money Around
Having money spread around in different tax buckets is the best way to diversify a portfolio from a tax perspective. Unfortunately, many Americans still have most of their assets invested in traditional retirement accounts.

So, what can a retirement saver with the bulk of their savings in a traditional 401(k) do to decrease and better manage their tax obligations?

For people in their mid-60s on the cusp of retirement, there are tactics they can employ. But planners stress that there’s far less wiggle room for this group due to their age and shorter time horizon.

“There are situations where there’s not a lot you can do,” said Smart.

You might convert traditional retirement dollars to a Roth. If you have the cash on the sidelines to pay the taxes on the conversion amount, moving some money to a Roth to benefit from tax-free withdrawals later in retirement can provide withdrawal flexibility.

Consider A Roth Conversion
The best time to do a Roth conversion is in years when your income is lower, so the income from the conversion amount doesn’t bump you up to a higher tax bracket. Doing conversions make most sense in trough income years, such as after you retire or in a year where taxable income is lower than normal due to some event, such as a large business loss.

A good window for a conversion is between the time you retire and the time when you’re required to take Social Security or RMDs, according to Schneider. Those are typically years when you’ll be reporting less income to the IRS, so you can fill up lower tax brackets with the extra income from the Roth conversion.

You’ll also benefit from moving money out of a traditional retirement account to do the conversion before age 73, when most people must start taking RMDs. Distributions from a 401(k) will enable you to withdraw money at a lower tax rate now and lower your account balance so that you’ll face lower RMDs when they kick in.

Check The Numbers For Retirement
But before you do a Roth conversion, run the numbers to see if it is worth it. One drawback is you can’t withdraw Roth earnings tax-free and penalty-free until you reach 59 ½ and the account has been open for at least five years.

And if you don’t have cash outside of the retirement account to pay the conversion tax bill and must use assets in the account to pay the IRS, the conversion won’t pay off as you’ll have fewer assets moving into the Roth that can benefit from tax-free withdrawals in future years.

You also want to make sure that the income from the conversion isn’t big enough to result in unintended consequences. “A lot of the time, it doesn’t make sense for folks (to do a Roth conversion),” said Smart.

Mind Your Thresholds
You don’t want to boost your income, for example, to a level that puts you over income thresholds that result in a higher premium for Medicare Part B and Part D, adds Schneider. The so-called IRMAA (Income-Related Monthly Adjustment Amount) is a surcharge charged to higher-income folks. IRMAA is based on your modified adjusted gross income (MAGI) from your tax return two years prior.

“If you do a big Roth conversion when you’re 63, you could be faced with higher Medicare premiums in that first year when you take Medicare,” said Schneider.

Still, Schneider stresses that having to pay taxes on withdrawals in a $1 million 401(k) is a good problem to have.

Many retirees, though, have trouble with the notion of taking withdrawals and drawing down an account after a lifetime of savings. Many people must draw down a 401(k) even with the tax hit.

“It is a huge shift in psychology, and it’s very difficult for a lot of people,” said Schneider. “They think they’re doing something wrong or irresponsible. They’re scolding themselves because they don’t think that they should be taking money out. I have to remind them that that’s why they’ve spent a whole life saving.”

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