When you're nearing retirement and taking a look at your 401(k) balance, hopefully you're feeling pretty good about the savings you've amassed. Your 401(k) is probably going to be your primary source of income other than Social Security, so understanding how much your account is worth is vital to determining both if you have enough to retire and what your retirement income is likely to be.

The only problem is, when you look at that 401(k) balance, there may be one big thing you're not considering that could significantly reduce how valuable your account is: taxes. 

You'll not only have to pay taxes on money you take out of a traditional 401(k) but taking money out could also trigger other taxes, too. The impact of all of these taxes could significantly reduce the amount of income your 401(k) ends up providing you with. 

Colorful 401(k) letters next to piggy bank

Image source: Getty Images.

Why your 401(k) may provide less income than you think

When you take distributions from a 401(k), the money is taxed as ordinary income. This means you automatically lose a percentage of your withdrawn 401(k) money, with the amount based on your tax bracket. If you took a $20,000 401(k) distribution and were in the 12% tax bracket, you'd be left with just $17,600. 

And these may not be the only taxes you'll pay, either. Social Security benefits won't be taxed if your income is below a certain threshold, but taking 401(k) distributions could push you above that limit, so your benefits become taxable.

Your distributions could also raise your income high enough that your Medicare monthly premiums rise.

How could this impact your total income?

  • 50% of your Social Security benefits will become taxable if your income exceeds $25,000 for a single filer or $32,000 for married filers. Income for these purposes includes half of Social Security income plus all taxable income from other sources plus some, but not all, tax-free income.
  • 85% of your Social Security benefits will become taxable if your income exceeds $34,000 for a single person or $44,000 for a married person. 
  • If your modified adjusted gross income goes above $85,000 for single filers or $170,000 for married filers, your Medicare Part B premiums could be anywhere from $53.50 to $294.60 more per month than the standard premium, depending upon income. Part D Premiums could also increase anywhere from $13.30 to $76.20 above plan premiums.  

If your benefits weren't being taxed but will be after you take your 401(k) distribution, you'll substantially increase your total tax bill -- and your 401(k) contributions will provide much less additional spendable income since you'll have to use more of your money to pay the government. 

Is there anything you can do to avoid taxes eating into your 401(k)?

When you have a 401(k), you can't just leave the money invested to avoid taxes -- you have to comply with rules for required minimum distributions or else get heavily penalized by the IRS.

However, one option you have is to roll over the money in your 401(k) to a Roth IRA.

There's a big caveat: If you're rolling over money contributed to a 401(k) with pre-tax funds, you must pay taxes on the money rolled over in the year of the conversion -- which can mean a big tax bill. However, you could split the process up over several years to keep from pushing yourself into a much higher tax bracket and to limit the amount of taxes you must pay at one time. 

And, once the conversion is complete, as long as you follow rules for withdrawals, your distributions from your Roth 401(k) should be tax free -- and won't count as income for purposes of determining if you owe Social Security taxes. You also won't be required to take RMDs any more, so you can take out money on your own schedule instead of on a schedule the government has set for you. 

A Roth conversion isn't for everyone, especially because of the large tax bill that must be paid at the time of conversion. Still, if you're concerned about how much taxes will reduce the value of your 401(k) throughout your retirement and want to take care of tax issues in a lump sum, conversion may be a good option. 

Making your 401(k) last during retirement

If you're still young and you expect that your tax bracket will be higher during retirement than while you're working, you may wish to invest in a Roth 401(k) throughout your career -- if your employer offers one. You could also contribute to a Roth IRA, provided you're eligible, so you'd have money you could withdraw tax-free as a senior. 

If you're already nearing retirement, it's important to consider how much taxes will eat away at the value of your 401(k) -- either over time, or if you pay a big tax bill for a Roth conversion -- so you can decide if your account balance is really big enough -- after tax -- to sustain you during your golden years. 

The Motley Fool has a disclosure policy.