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When Oversaving in Your 401k is A Bad Thing And What Else To Do
By Jordan Rosenfeld,
4 hours ago
CatLane / Getty Images/iStockphoto
Experts frequently advise people to save aggressively for retirement in their tax-advantaged accounts, such as 401(k)s, for its tax advantages and high growth potential. However, it is possible to save too much in these accounts.
For one thing, the Social Security Administration raised the required age at which retirees must take required minimum withdrawals (RMDs) to 73. This could mean that some retirees end up with so much money that it bumps them up to a higher tax bracket.
Experts explain why you might want to spread your retirement dollars around into other retirement accounts.
Chad Kennedy, a partner at Lighthouse Financial , agreed that the 401(k) does come with some limitations. He said, “Traditional 401k’s do not provide much flexibility. If you would like access to your cash prior to 59 1/2, you will have to pay a 10% penalty and income tax on your withdrawals,” Said Kennedy.
Concentrating all retirement savings in a 401(k) means withdrawals will be taxed as ordinary income, according to Kami Adams, a financial advisor and founder at Creative Legacy Group .
Abid Salahi, co-founder Of FinlyWealth shared an example from his practice in which a client had amassed over $4 million in his 401(k) by age 70.
“When RMDs kicked in, he was compelled to withdraw over $200,000 annually, catapulting him into the highest tax bracket and effectively reducing his retirement income by nearly 40%,” he explained.
This scenario underscores the critical need for strategic retirement savings diversification.
Contribution Limits May Be Too Tight
Another concern is that annual contribution limits for 401(k) plans may not be sufficient for all retirement goals, Adams said. For 2024, the limit is $23,000 with an additional $7,500 for those 50 and older. That might not be enough.
“Utilizing other savings vehicles can help meet more ambitious retirement objectives,” she said.
Limited Investment Options
Another mark against the 401(k) is that these plans often have limited investment choices compared to IRAs or taxable accounts, Adams explained.
“By spreading investments across different accounts, individuals can access a broader range of options, including individual stocks, bonds, ETFs, and mutual funds, potentially enhancing overall portfolio performance,” she said.
Estate Planning Considerations
RMDs for 401(k) accounts can also complicate estate planning, Adams said. Roth IRAs, on the other hand, don’t have RMDs during the account holder’s lifetime, offering more flexibility for passing wealth to heirs, Adams said.
“Additionally, taxable accounts benefit from a step-up in basis at death, reducing the tax burden on beneficiaries,” she said.
State Tax Implications
In addition to federal taxes on RMDs, retirees need to be aware of how state taxation on their retirement income varies, Adams said.
“Diversifying retirement savings across different account types can provide opportunities to minimize state taxes, depending on retirement location and financial situation,” she said.
Taxable Brokerage Accounts
While nobody should stop saving in a 401(k) if they have one, retirees should consider adding taxable brokerage accounts, which Kennedy called “the most overlooked investment accounts.”
He added, “While they do not offer the tax deferral benefit that 401(k)s and other retirement accounts provide, they do provide much needed flexibility. Money in these accounts is liquid and accessible prior to age 59 1/2.”
So, in the case of emergencies or early retirement, these accounts can be incredibly valuable.
Roth 401(k)
Not all employees have access to the Roth 401(k) option, but those that do should certainly consider utilizing it, Kennedy suggested.
While the traditional 401k is subject to RMD rules, the Roth portion will not be subject to mandatory distributions, he said.
“Roth 401k’s also offer tax free growth and flexibility to withdraw the principal prior to 59 1/2 without penalty,” noted Kennedy.
Roth IRA
Roth IRA’s are individual retirement accounts, so they are not a part of your employer’s retirement plan, Kennedy said. Roth IRA’s allow for tax free growth and the ability to withdraw principal without penalty before 59 1/2.
“While they offer superior tax benefits, there are restrictions for high income earners to utilize these accounts,” he warned.
According to Salahi, a Vanguard study showed that Roth IRA conversions can increase after-tax wealth by up to 11% over 30 years for some investors.
When it comes to retirement savings, diversification is key to having liquidity and flexibility so you don’t encounter any unpleasant, or costly, surprises in retirement.
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