As financial advisors one of our primary goals is to coach our clients to save and invest, while directing those savings to the most beneficial accounts possible.
In the modern era that typically means saving as much in your 401k or employer sponsored plan as possible. While pre-tax 401k contributions can save you significant dollars now while also providing the benefit of tax deferred growth, often times a high contribution rate means making some sacrifices on the spending side now. So the question arises, can making these deferrals now actually lead to a problem later on?
Is a Large 401k Problematic?
I recently read an article that described one of the issues associated with a very large 401k.
The main problem that can arise is when you turn 70 ½ and Required Minimum Distributions must begin. If you have other significant sources of retirement income such as pensions and Social Security, you may not even need these RMDs to make ends meet. Regardless, the IRS requires you to take out a predetermined amount every year and pay tax on it. This has the potential to push you into a higher tax bracket. This is true, but for most of us saving in 401k plans today, we will not have a defined pension benefit, so we will be heavily reliant on what we have saved in our 401ks. The best strategy to reduce taxes in the post 70 ½ years is to plan for them prior to and throughout retirement.
This is why it requires continuous attention to monitor your overall financial situation and tailor strategies accordingly. Ideally during your working years, you will be saving in multiple different types of accounts:
- Traditional and Roth IRAs
- Employee Stock Ownership Plans (ESOPs)
- taxable brokerage accounts
- deferred compensation arrangements
Having multiple types of accounts with varying tax ramifications gives you the ultimate flexibility for retirement income planning.
Saving diligently in your 401k and other accounts may even allow you to retire early or scale back your workload, which can present additional tax savings opportunities. When retiring prior to drawing Social Security, there is the potential for your tax bracket to plummet. This is a huge opportunity for long term tax optimization.
These years are an ideal time to convert some of those pre-tax 401k and IRA savings to Roth and/or realize long term capital gains at a lower tax rate. Roth conversions in these years will reduce the size of those tax deferred accounts which will also reduce the tax implication described above. Even after age 70 ½, if you still don’t need your full RMD to live on, there may be the opportunity to avoid taxation by directing that amount to a charity through a Qualified Charitable Distribution (QCD).
There are of course some downsides with 401ks which we have pointed out in the past, but I always worry that focusing on the negative aspects of the plans discourages people from saving and investing. In most cases the 401k plan is the most effective wealth building tool at your disposal. If you have questions about your savings, investment, or retirement income strategy, please contact us to discuss the best path for your personal situation.
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