Do you have a 403(b), a DCP account, or a Plan 3 account through your school district job? If so, you are sitting on what we like to call a “tax bomb.” It is not going to explode today. It might not explode for another 20 or 30 years. But when it finally does go off, it could leave you owing tens of thousands, or even hundreds of thousands, of dollars in taxes.
That sounds scary, and it should get your attention. But this is not a reason to panic. It is a reason to understand exactly how these accounts work, so you can plan around the tax bomb instead of getting caught by surprise. In this post, we will walk through why this happens, using a real, worked-out example with real numbers, and talk about what you can do about it.
What Do 403(b), DCP, and Plan 3 Accounts Have in Common?
If you work for a Washington school district, you have probably put money into a 403(b), a DCP (Deferred Compensation Program), or a Plan 3 account. All three of these have one big thing in common: they are “pre-tax” accounts. That means when you put money in, you get to skip paying income tax on it right now.
Think of it like this. Normally, the government takes its tax bite out of your paycheck before you ever see the money. With a pre-tax account, the government says, “Go ahead, keep that bite for now, put it to work, and we will collect our share later, once you take it back out.” You are not avoiding the tax. You are only delaying it.
That deal sounds great on paper. You get a tax break today, while you are working and earning a paycheck. The thinking goes that once you retire, you will be making less money, so you will land in a lower tax bracket, and you will pay less tax on that same money later. It is a nice story. Unfortunately, it is often not true, and that is exactly why we call these accounts a tax bomb.
Why “I’ll Be in a Lower Tax Bracket Later” Might Not Be True
Here is the part most people never stop to think about: your tax bracket is only half of the equation. The other half is the tax rate itself, and tax rates can go up for everybody, no matter what bracket you are in. If the whole tax code shifts higher, a “lower” bracket in the future could still mean a bigger tax bill than a “higher” bracket does today.
And there are real reasons to think tax rates are heading up over time, not down. The government has pumped trillions of dollars of stimulus money into the economy over the years. That money did not appear out of thin air. Someone has to pay it back eventually, and the only real tool the government has to raise money is taxes.
Add in a national debt that is well into the tens of trillions of dollars, and it is not hard to see where this is headed. It would be pretty naive to assume tax rates will just stay flat, or drop, forever. So even if your income drops in retirement and you technically fall into a lower bracket, that bracket could still tax you at a higher rate than you are paying today.
The RMD Rule: The Government Eventually Makes You Take the Money Out
There is a second problem hiding inside these pre-tax accounts, and it is arguably the bigger one. Accounts like your 403(b), DCP, and Plan 3 are the only kind of accounts in the entire U.S. tax code that force you to take money out, whether you want to or not, and whether you need it or not.
This forced withdrawal is called a Required Minimum Distribution, or RMD. Under today’s rules, once you turn age 72, the IRS requires you to start pulling a certain amount out of these accounts every single year, so it can finally collect the taxes it has been waiting on. Skip it, or forget it, and the penalty is severe: 50% of the amount you were supposed to withdraw.
Picture an alarm clock that the government sets for you, decades in advance. You do not get to hit snooze. At 72, it goes off, and you have to start pulling money out and paying tax on it, year after year, whether that fits your life or not. And because the account has usually grown so much bigger than what you put in, you end up owing tax on money you never even contributed.
A Real Example: How $155,000 Turns Into a Tax Bill on Over $1.1 Million
Numbers make this much easier to see, so let’s walk through a real example, step by step. Picture someone who starts saving at age 35. They put away $5,000 a year into a pre-tax account, which is not a huge amount, and they average a 7% return every year while they are still working. That is a realistic, middle-of-the-road scenario for a lot of school district employees.
By the time this person turns 65, they have been saving for 31 years. Add it up, and they have contributed a total of $155,000 of their own money, 100% of it pre-tax. But because that money has been growing at 7% a year the whole time, their account balance at age 65 is not $155,000. It is $528,000. That is the power of compounding growth, and it is exactly why we save early in the first place.
Now let’s say this person does not actually need the money right away at 65. They have a pension and Social Security covering their basic expenses, so they decide to let the account keep growing, just more conservatively, at around 5% a year. By age 72, when RMDs kick in, the account has grown to $714,000, and the IRS now requires a forced withdrawal of $27,000 that very first year.
| Age | What Happens | Account Balance |
|---|---|---|
| 35 | Starts saving $5,000 per year, pre-tax, averaging 7% growth | $0 to start |
| 65 | Retires after 31 years of saving ($155,000 total contributed) | $528,000 |
| 72 | RMDs begin; forced withdrawal of $27,000 in the first year alone | $714,000 |
| 85 | 13 years of RMDs later, still has money left over | $518,000 already withdrawn and taxed, plus $681,000 still sitting in the account, untaxed |
Notice that even while this person is being forced to pull money out every year, the account is still growing, because 5% interest on a balance that size adds up fast. By the time they reach age 85, they have withdrawn, and paid tax on, a total of $518,000. And they still have $681,000 sitting in the account, which has not been taxed yet.
Add those two numbers together, the $518,000 already withdrawn and the $681,000 still waiting in the account, and you get over $1.1 million that the IRS gets to collect taxes on, eventually. All of that traces back to just $155,000 of contributions over 31 years. That is the tax bomb in action.
Same Story, Lower Tax Rate, Bigger Bill
Here is where the “I’ll pay less tax later” idea really falls apart. Let’s assume, just for the sake of argument, that tax rates actually go down in the future, the opposite of what we expect. Say this person paid a 25% tax rate while working, and only a 15% rate in retirement. Who really comes out ahead?
| Scenario | Tax Rate | Taxable Amount | Total Tax Bill |
|---|---|---|---|
| Taking the deduction while working | 25% | $155,000 contributed | $38,750 |
| Paying tax later, in retirement | 15% | Over $1,100,000 grown in the account | Over $165,000 |
Even with a lower tax rate in retirement, the tax bill is more than four times bigger, because it is being applied to a much, much larger pile of money. Would you rather pay 25% tax on $155,000, or 15% tax on $1.1 million? When you put it that way, the answer is obvious, and it is exactly why RMDs are such a big deal.
The “save now, pay less later” idea only works if you are only looking at the tax bracket and ignoring how much bigger the account balance has grown by the time the IRS finally gets its share. Once you factor in decades of compounding growth, the government often ends up taxing a number many times larger than what you ever put in.
What You Can Do About It
The good news is that none of this is set in stone. Once you understand how the tax bomb works, you can start building a plan around it, instead of being surprised by it at age 72. That usually means looking at ways to build tax-free or tax-diversified income sources, so you are not relying entirely on pre-tax accounts by the time you retire.
This can include things like Roth conversions, Roth accounts, or other tax-free strategies, done gradually over time and in a way that fits your specific pension, Social Security, and account balances. There is no single answer that works for everyone, which is exactly why a personalized plan matters so much more than a one-size-fits-all rule of thumb.
If you would like help thinking through your own numbers, you can schedule a personal meeting with our team to walk through your specific 403(b), DCP, or Plan 3 situation and talk about ways to reduce your future tax bomb before it ever goes off.
Frequently Asked Questions
What exactly is a “tax bomb” retirement account?
A tax bomb account is a pre-tax retirement account, like a 403(b), DCP, or Plan 3, that grows for decades without being taxed. The longer it grows, the bigger the eventual tax bill gets, since you owe tax on the entire balance, not just the amount you originally put in.
What is a Required Minimum Distribution (RMD)?
An RMD is the minimum amount the IRS requires you to withdraw from a pre-tax retirement account each year, starting at age 72 under today’s rules. The withdrawal counts as taxable income for that year, whether or not you actually need the money.
What happens if I do not take my RMD?
If you skip or forget your RMD, the IRS can charge a penalty of 50% of the amount you were supposed to withdraw. That is on top of the regular income tax you still owe on that money, so missing an RMD is an expensive mistake to make.
Will my taxes really be higher in retirement?
Not necessarily at the bracket level, but often yes in total dollars. Even if your tax rate is lower in retirement, RMDs can force you to pay tax on a much larger account balance than you ever contributed, which can add up to a bigger overall tax bill.
Is this only a problem for people close to retirement?
No. The earlier you understand this, the more time you have to plan around it. Someone in their 30s or 40s has decades to build tax-free savings alongside their pre-tax accounts, which can make a much bigger difference than trying to fix it right before retirement.
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