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It’s no secret that contributing to a tax-deferred 401(k) is a great way to build a robust retirement portfolio. You defer taxes on your contributions, letting your investments grow tax-free until retirement, when you start withdrawing the money. However, while having plenty of savings is always a good thing, there are potential downsides to having too much of your retirement wealth locked up in a tax-deferred 401(k).
For example, let’s say you’ve amassed $2 million in your 401(k) out of a total retirement portfolio of $2.2 million. While this shows financial discipline and long-term planning, having the bulk of your wealth tied up in a tax-deferred account can create some challenges down the line. Here are some of the key drawbacks to consider:
1. Significant Tax Burden in Retirement
The most notable downside of having a large portion of your retirement wealth in a tax-deferred 401(k) is the tax liability when you start withdrawing the money. When you take distributions in retirement, every dollar you withdraw is treated as ordinary income, and taxed at your marginal tax rate.
If you have a significant amount saved, such as $2 million, your required withdrawals could push you into a higher tax bracket. This means that rather than enjoying low taxes in retirement, you may end up paying a substantial amount in federal and possibly state taxes on your withdrawals each year.
For example, if you’re required to withdraw $100,000 or more annually to cover living expenses, this amount will be added to your taxable income, potentially bumping you into higher tax brackets and increasing your overall tax bill. This reduces the amount of income you actually get to keep for spending in retirement.
2. Required Minimum Distributions (RMDs)
Once you reach age 73 (under current law), you’re required to take Required Minimum Distributions (RMDs) from your 401(k) if you're no longer working, whether you need the money or not. The IRS mandates that you withdraw a certain percentage of your balance each year, based on your age and life expectancy .
For someone with $2 million in their 401(k), these RMDs can quickly add up to substantial amounts. If you don’t need the money to cover your living expenses, you could be forced to withdraw funds just to meet the RMD requirements, triggering taxes on income you don’t necessarily need. And if you fail to take your RMDs on time, you could face a hefty penalty—up to 50% of the amount you should have withdrawn.
Having too much in a tax-deferred account means you may have less control over your income in retirement and could be forced to take withdrawals and pay taxes on money you would rather leave invested.
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3. Limited Tax Flexibility
Another downside to having most of your savings in a tax-deferred 401(k) is the lack of flexibility in managing your tax liability in retirement. With a tax-deferred account, you don’t have the option to withdraw funds tax-free, as you would with a Roth IRA or Roth 401(k). This limits your ability to control your tax situation based on your needs each year.
For example, if you had a large portion of your retirement savings in Roth accounts or taxable investment accounts, you could strategically withdraw funds from different accounts depending on your tax situation in any given year. By having more diversity in your account types, you could pull from tax-free accounts in years when your taxable income is high or rely on taxable investments for long-term capital gains tax rates, which are typically lower than ordinary income rates.
Having too much in a tax-deferred 401(k) restricts this flexibility, making it harder to minimize taxes in retirement.
4. Impact on Social Security and Medicare Costs
One of the lesser-known issues with large 401(k) withdrawals is how they can impact Social Security taxation and Medicare premiums. Up to 85% of your Social Security benefits can be subject to income taxes if your income exceeds certain thresholds, and as we've already discussed, withdrawals from a tax-deferred 401(k) count toward your income.
Additionally, large 401(k) withdrawals can increase your Medicare Part B and D premiums, which are income-based. If your adjusted gross income (AGI) is too high, you may have to pay significantly higher premiums for Medicare. For a couple in retirement, this could mean thousands of dollars in additional healthcare costs each year, further reducing the overall value of your withdrawals.
5. Estate Planning Challenges
When you leave a tax-deferred 401(k) to your heirs, they’ll inherit the tax burden associated with it. Under the SECURE Act , non-spousal beneficiaries must withdraw all funds from inherited retirement accounts within 10 years, which can result in a significant tax bill for your heirs. If your beneficiaries are in their prime earning years, being forced to take large withdrawals from your 401(k) could push them into higher tax brackets and cause them to pay more in taxes than they expected.
In contrast, if you leave a Roth IRA or other after-tax accounts to your heirs, they can withdraw those funds without facing the same tax consequences. This makes estate planning more difficult if most of your wealth is tied up in a tax-deferred 401(k), as it could reduce the net inheritance for your beneficiaries.
The Importance of Tax Diversification
While contributing to a tax-deferred 401(k) is a great way to save for retirement, having too much of your wealth in a 401(k) can lead to challenges related to taxes, RMDs, and estate planning. That’s why tax diversification is critical. By spreading your savings across different account types—such as tax-deferred (401(k)), tax-free (Roth IRA), and taxable investment accounts—you can give yourself more flexibility and control in retirement.
If you find yourself in a position like having $2 million of your $2.2 million in a tax-deferred account, it might be worth speaking with a financial advisor to explore strategies like Roth conversions, diversifying future contributions, or developing a withdrawal plan that minimizes taxes and optimizes your income in retirement. While saving for retirement is always a good thing, managing where and how your savings are invested can make a big difference in how much of that money you actually get to enjoy.
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