Is It Possible You’re Saving Too Much for Retirement?

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I recently sat down and had a conversation with my accountant. We talked about my family's retirement accounts and long-term investing goals. And we both came to the conclusion that my wife and I should focus on adding more to our taxable investments. That's because we already have a sizable nest egg in retirement accounts.

Although I don't plan on, really, ever formally retiring, it is possible to be lopsided and have too much in retirement accounts and not enough in taxable investments. With retirement accounts, it's possible you are saving money on taxes now only to get walloped with a bigger tax bill in the future.

I certainly believe that it's critical for your investing to be tax efficient. However, at the end of my post on that subject, I also said, “Keep in mind, like any part of investing, one should not invest solely for tax avoidance.”

Most personal finance books say you should put away the maximum possible in retirement accounts. What they don't talk about is when you have to start withdrawing money from your retirement accounts. They talk only about the accumulation phase, and all of the authors state that your expenses will be lower after you retire — another piece of Suze Orman-type financial advice that doesn't always apply to everyone.

Yes, income from a salaried position decreases, but keep in mind, for tax purposes, distributions from retirement accounts (except Roth accounts) are taxed at ordinary income rates. It's possible that your tax rate will be much higher when you retire.

Tax-deferred accounts do NOT mean tax avoidance.

I Have to Pay More in Taxes When I Retire?!

Let's use a hypothetical example. Let's say you're currently 40 years old and have $1 million saved for retirement. (That's a lot of money for that age, but it's not an impossible goal, especially if you are a married couple and you started saving for retirement right out of college.) You don't plan on retiring until at least 60 years of age, so you have 20 more years of investing with your retirement account. Assuming a 7% rate of return, and socking away an additional $25,000 annually, you'll have approximately $4.5 million by that time.

The problem with retirement accounts is twofold: You have minimum required distributions starting at age 70 1/2, and any money you do take out is taxed at ordinary income rates. Currently, long-term capital gains and dividends are taxed at a lower rate than regular income. While this may change in the future, historically, investment taxes have been at a lower rate than income taxes.

So let's assume you take out 4%, or $180,000, annually from that retirement account. At today's tax rates, that puts you in the 32% tax bracket. Obviously, this isn't accounting for inflation, so let's use the next lower tax bracket of 24%. That's still higher than if it were all investment income and/or dividends in a taxable account — currently taxed at 15%.

So while you'll save taxes when socking away this money, it's possible that you'll lose this advantage when you start taking it out. Especially if you need large sums of money in any tax calendar year. With state taxes included, it can be as high as a 50% total tax rate. Ouch!

Obviously, if you are going to invest in taxable accounts, you should use only tax-efficient investments, but they can be part of your total asset allocation. That means NOT using investments like REITs, bond funds or dividend-paying stocks (if possible). ETFs such as Vanguard's Russell 3000 Index ETF (VTHR), which cover the entire market, are pretty tax efficient. There are also other funds that are specifically designed to minimize taxes, as well as tracking various indexes. These are perfect investments to place within taxable accounts. What you are setting up is a blend of tax-deferred and taxable accounts.

Disadvantages of Retirement Accounts

  • Retirement accounts are much more restrictive. In most situations, you can only start withdrawing from them when you are 59 1/2 years old (55 in some situations). If you need the funds sooner, be prepared to pay a massive penalty.
  • They assume you'll be in a lower tax bracket when you retire. While this might be true for most people, it's not the case for everyone. Retirement accounts are taxed at regular income levels. As we all know, tax rates are going up and are not expected to go down for the foreseeable future.
  • Restricted investment selection. For example, I love real estate rental properties. While it's possible to invest in real estate with a self-directed IRA account, I don't consider that a viable option. Also, many retirement accounts have a poor selection of funds to choose from.
  • Required distributions. With the exception of Roth accounts, you are required to take money out of your retirement account starting at 70 1/2.
  • Taxed at ordinary income rates. This is perhaps the killer if you put money into only a retirement account. Depending on other sources of retirement income and the amount saved, it's possible you are in a higher tax bracket than before retirement. Also, your future taxes are an unknown.

Bottom line: It makes sense to have a mixture of tax-deferred and taxable accounts. This gives you much more flexibility when you retire. So while it makes sense to minimize your taxes while saving for your retirement, you should also be concerned after you retire. Obviously, I'm not suggesting that you stop putting money into your retirement account, especially if your company does matching.

What I am suggesting is that, once you get past some level of retirement savings, you may want to balance it out with taxable investments as well. With taxable accounts, you have not only more flexibility with investments, their intended use, but also more control over when you have to pay taxes and traditionally at a lower tax rate to boot!

Larry Ludwig

Larry Ludwig was the founder and editor in chief of Investor Junkie. He graduated from Clemson University with a bachelor of science in computers and a minor in business. Back in the ’90s, I helped create some of the first financial websites for firms like Chase, T. Rowe Price, and ING Bank, and later went on to work for Nomura Securities. He’s had a passion for investing since he was 20 years old and has owned multiple businesses for over 20 years. He currently resides in Long Island, New York, with his wife and three children.

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12 Comments

  1. This post is ignoring that a Roth IRA or Roth 401k is a retirement account and is 1000 times better than a taxable account. If someone doesn’t want to put much in a tax deferred account invest in Roth’s. Personally I max out my 401k and [email protected] of it goes in a Roth. My wife and I both max out our Roth IRAs. The only money I have going to a tax deferred is my 401k match plus my wife’s 401k which doesn’t have a Roth option. In total more than 60% of combined contributions go to Roth accounts. If I take $1000 and invest in a Roth @ 10% it’s worth $1,100 in a year and I pay no further taxes however that same $1000 is only worth about 1,075 in a taxable account when taxes are considered. A taxable account is the worst possible choice since the Roth is available.

    1. Hi Mike,

      Good points, but you assume everyone has access or qualify for a Roth IRA, or Roth 401(k). In my case my income is too great to qualify for a Roth IRA and I’m not aware of a Solo 401(k) option out there. But yes they are not bad vehicles and if available to you should diversify into them if possible. I would not put all my eggs into Roth accounts as you don’t know what the future holds for taxes, or could the rules for Roth accounts change mid-stream.

  2. In addition to the deduction/exemption/lower brackets issue other commenters have mentioned, this article doesn’t seem to be taking into account that it’s a net gain to put a dollar into a tax deferred account even if you take it out in the same tax bracket later.

    For simplicity let’s assume you want to invest $1, and it will double by the time you spend it; also that you’re in the 25% bracket now and in the future, that the taxable investment stays invested the whole time and the gains are all in the forms of a single capital gain at the end of the period. If you put it in a tax-deferred account you invest the whole dollar, and then withdraw it and pay 25% taxes on the whole amount, giving you $1 to spend. If you put it in a taxable account you pay 25% taxes now, leaving you only 75 cents to invest. It doubles to the same $1.50, but then you have to pay 15% (now 20% in 2016, but it was 15% when this article was written) on half of those gains, which is 11.25 cents. You are 7.5% worse off than if you had used the tax deferred account.

    That said, depending on specifics, due to various effects like the taxability of social security payments, what state you retire to, etc. you may very well be in a higher tax bracket in retirement than you were during your working years. Like Harry @ PF Pro I recommend tax diversification – put the majority of your retirement savings in deferred accounts but a good portion into Roth and maybe taxable accounts.

    1. All good points. I created this article primarily because most assume the standard advice. There are situations whereas you aren’t best to stuff everything into tax differed accounts. As you stated tax diversification should taken into consideration.

  3. My personal opinion is that it depends on the financial situation of the individual. My wife and I reach the highest marginal tax bracket. We were putting some money into Roth 403b and backdoor Roth IRA accounts to diversify, but I recently changed our retirement allocation into tax deferred accounts. My rationale is that we are putting in “above the line” money that would be taxed at 45% plus between federal and state income taxes. When we withdraw the money, assuming it would be the sole source of retirement income, and starting out, every dollar up to the highest marginal rate would be taxed at a lower marginal rate than what we would have been taxed at now. This is of course assuming that tax rates don’t dramatically increase across the board.

    I have contemplated decreasing my yearly retirement contributions and putting more money into taxable accounts so it is liquid. I mean, how much money do you really need in retirement? They say 75% of your pre-retirement income, but I think that is not realistic or necessary when you reach a certain AGI.

  4. I guess I really never stopped to think if you could save too much for retirement, and have it hurt you. Just as you said though, I really don’t see myself being able to retire with the job I have right now. I can’t say that I completely trust retirement accounts either. This is a great article. Thank you for opening my eyes to something new.

  5. I think Roth would solve a lot of the problems you mention here. I always recommend about a 2:1 or 3:1 ratio of 401:roth contributions for the very reasons you mention above. I’d also like to bring up the point that should you ever have a period of reduced income(going back to school, laid off, etc) that is a great time to live off savings and rollover part of your 401k to a roth ira.

    1. Hi Harry that is if you qualify for a Roth IRA (meaning under income requirements), or can do the Roth IRA rollover option for high income earners. Otherwise yes without question on both statements you made.

  6. @Larry. You note some very important points regarding some of our desires to meticulous save for retirement and how it could become counter-productive. However, I would like to offer a counter point to your statement that “Tax deferred accounts, does NOT mean tax avoidance.” Theoretically speaking, there is a small chance for an individual to legally avoid Federal Income tax on a portion of their contributions made to tax-deferred accounts in the year they take a distribution. Assuming an individual has no additional income streams besides SS and tax-deferred savings, the amount of funds received as a distribution would be tax-exempt up to the sum of their Standard Deduction and Personal Exemption – assuming our tax code still allows for these deductions in the future.

    1. Hi Ronald, that is a great point, and like you say assumes the tax code stays the same. 🙂 The other issue is I think long term we are in for a VAT, which even then things like a Roth accounts it means you still have to pay tax, just on consumption.

  7. I think that it is possible to save too much for retirement. Individuals also shouldn’t risk missing out on important life opportunities because they are saving for retirement.

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