A Financial Samurai Forum member David is wondering whether it’s possible to have too much in his family’s 401(k) account. Here’s what he writes:My wife and I are both around 50 years old. We want to be able to retire at 55. We max our 401(k) contributions each year and have a pretty good chunk in 401Ks – approximately $2.5M currently.
We are in the max tax bracket, so reducing our income with 401(k) contributions is appealing.
We have about $700K in after-tax accounts and $100K in Roth IRAs.
My current thoughts are to convert at least some of the 401(k)s to rollover IRAs, then to Roth IRAs over time after we retire and have lower income.
For now – are we better to continue to max the 401(k)s, or stop making 401(k) contributions and start making Roth 401(k) contributions (which will cost us 37% tax on $52,000 of extra taxable income), but may benefit us in the future?
Save Too Much Or Too Little In Your 401(k)
For starters, congratulations to them on accumulating a $2.5 million combined 401(k) balance at 50. According to my recommended 401(k) guide, this couple is doing extremely well.
Over the years, I’ve received so much pushback from younger folks who think my 401(k) by age recommendations are unreasonable. But as these younger readers grow older, they realize what’s possible with time, compounding returns, and company matches.
So for all you young guns out there who are simply making excuses for why you’re not there or why you don’t want to save more, please get your heads on straight. Otherwise, you might wake up 10 years from now bitter you have no options given your lack of funds.
Not maxing out your 401(k) is something I never thought about before because I always believe more is better up until at least the federal estate tax limit. Currently, the federal estate tax limit is $11.4 million per person. Therefore, there’s plenty of room for most people to keep on accumulating before they have to pay a 40% federal death tax.
It’s much better to retire with a little too much versus a little too little. The last thing you want to do in your 60s and 70s is to have to go back to work.
But first, let’s hear a couple of great perspectives from two FS Forum members on this subject. Then I’ll conclude with my final thoughts.
Yes. You Can Save Too Much In Your 401(k)
Here’s a response from Money Ronin:
The answer is “yes, absolutely” although what counts as too much is dependent on your personal tax situation now and in the future.
The obvious downside is that you will eventually need to pay taxes and no one can predict future tax rates. Also, you will be forced to take a required minimum distribution (RMD) at 70-1/2 even if you don’t need the funds.
Finally, this is what really made me think twice about maxing out my 401(k) going forward. I met with a wealth advisor/estate planner. He mentioned everything I own gets a step-up in tax basis when I pass away, the 401(k) and traditional IRAs do not.
If retirement plans are funded with pre-tax dollars, they are 100% taxable to my heirs once they start tapping into the funds.
The estate planner’s advice was that if I planned to bequeath anything to charity, bequeath the 401(k) first and avoid the taxation issues.
Personally, I like to spread the taxation risk by putting my money in various retirement accounts, IRAs, 401(k)s and Roth IRAs.
I’m not a tax or estate planning professional so hopefully other people can confirm or deny this information.
No. You Can Never Have Enough In Your 401(k)
Here’s another perspective from Fat Tony:
Congrats on the great accumulation! I’m sure you know about the Roth IRA conversion ladder and all the associated calculators on the net.
If you plan to retire in five years, even given your current lopsided ratio of tax-deferred vs. tax-upfront savings, I would still make regular 401(k) contributions if you are in the 37% federal bracket.
Your $700K after-tax investments are unlikely to generate too much income and you will likely be in a super-low tax bracket after retirement to do plenty of 22% and 24% bracket Roth IRA conversions (2% dividend yield on stocks = $35K/year mainly qualified dividend income).
Tax brackets aren’t slated to go up until 2026, although who knows what the future holds – it’s just unlikely that married taxpayers under $100/150K get a huge hike to above 37%, so you should be fine doing Roth conversions for a while and come out ahead if you defer the taxes.
Tax diversification is useful, but I think this close to retirement and at the max bracket the calculation is simple. What is the tax risk you’re willing to bear vs. the amount you are willing to pay upfront?
You can try to create a simulation with various tax bracket outcomes throughout retirement, although this is going to be an exercise in crystal ball-ism.
Keep Contributing To The 401(k)
Based on these two well thought out responses, the wise move is for this couple to continue maxing out their 401(k)s. In five years, their 401(k)s will be bolstered by at least another $190,000 of pre-tax contributions that would have been taxed $70,300 if they didn’t contribute.
Once they retire at age 55, they can simply live off their $700,000 in after-tax investment accounts until 59 1/2, when they can start withdrawing from their 401(k) penalty-free. $700,000 will only generate $28,000 a year in income at a 4% rate. Therefore, the couple would likely need to eat into principal.
Alternatively, the couple could follow the “Rule Of 55” if they do not want to wait until 59 1/2 to begin taking money out of their plans.
The Rule of 55 allows an employee who is laid off, fired, or who quits a job between the ages of 55 and 59 1/2 to pull money out of his or her 401(k) or 403(b) plan without penalty. This applies to workers who leave their jobs at any time during or after the year of their 55th birthdays.
The Rule of 55 only applies to assets in your current 401(k) or 403(b)—the one you invested in while you were at the job you are considering leaving at age 55 or older. If you have money in a former 401(k) or 403(b), it’s not eligible for the early withdrawal penalty exemption.
Of course, if you’re smart and really need the money, you would simply combine your other 401(k) plans into your main plan before enacting the Rule of 55.
Another strategy to consider is Rule 72(t), also known as as the Substantially Equal Periodic Payment or SEPP exemption.
To use this type of distribution rule, you would start by first calculating your life expectancy and then using that figure to calculate five substantially equal payments from a retirement plan for five years in a row before the age of 59 1/2.
The final strategy is to negotiate a severance in order to provide a financial runway into retirement. With $2.5 million in their combined 401(k)s, it is likely this couple has been with their respective employers for a significant amount of time. If there is no company pension, then they are prime candidates to receive a severance due to their years of loyalty.
If you are going to quit your job anyway at 55 with no pension, then you might as well attempt to negotiate a severance. A severance package usually equates to 1-3 weeks of pay per year for each year worked.
If the couple together earned $700,000 a year and worked at their jobs for 20 years, they could potentially receive 25 – 75 weeks worth of salary equal to $269,230 – $807,692 plus subsidized healthcare.
Bottom line: Always max out your 401(k), especially if you are in a higher marginal income tax bracket. Take advantage of tax-deferred compounding and company matching. You have plenty of financial options before you face tapping your 401(k) early with a 10% penalty.