Is it Possible to Save too Much for Retirement?

Is it Possible to Save too Much for Retirement?

We spend most of our working years worrying about saving enough for retirement and reducing our current income tax burden. In doing so, we often maximize contributions to our qualified/tax-deferred retirement accounts (401(k), IRA, deferred compensation plans, etc.) and build up sizeable nest eggs for our retirement years. But what happens if you’ve maximized those opportunities and as you approach retirement, you realize you saved more money in your tax deferred accounts than you could possibly spend in your lifetime? 

Having excess assets in your tax-deferred accounts is a good problem to have, but it can create tax implications during your lifetime, as well as for your beneficiaries at your passing. Depending on your unique situation and goals, there are several options for minimizing the tax burden.

How do I know if I have more than I need in my tax deferred retirement accounts?

A great way to determine if you have more than you need is to work with a financial planner. A financial planner can help you identify and project your various sources of income in retirement, expenses throughout various stages of retirement, and estimate IRS required minimum distributions (RMDs) from tax-deferred accounts. 

If your RMDs consistently exceed the annual cash flow deficit that exists between all other sources of retirement income and projected expenses and you are expected to have a large balance left in your tax-deferred accounts at the end of your life, you may have saved more money in your tax deferred retirement accounts than you needed. 

What problems can arise from having too much in tax-deferred accounts?

If RMDs exceed your cash flow needs, you may be paying taxes on money you didn’t need to withdraw for your income needs. Excess income from RMDs can push you into a higher income tax bracket.  A higher income tax bracket can also have ripple effect on other tax deductions and credits, as well as how much you pay for Medicare Part B and Medicare Part D premiums.

Keep in mind that at the passing of the first spouse, the surviving spouse typically inherits the tax-deferred accounts of the deceased spouse. As a result, RMDs may remain unchanged but after the initial year of death, the surviving spouse’s tax filing status will change to single – possibly resulting in a higher tax bracket for the same level of income.

After your lifetime, current tax laws may require certain non-spousal beneficiaries to withdraw the balances of inherited IRAs within 10 years and pay income taxes accordingly. This can create a significant tax liability for the beneficiaries, depending on the amount inherited and the beneficiaries’ tax bracket at the time, among other factors.  

How can I minimize my tax burden?

There are numerous methods to minimize your tax burden on tax-deferred assets. The options below are some of the more common methods; however, choosing and implementing the best solution for you can include utilizing and layering multiple methods.  These strategies can get complicated and coordinating with your financial planner, tax advisor and estate planning attorney is a great way to ensure the outcome you desire.

Desired Goal: Pay No Taxes

• One way to prevent paying income taxes on your tax-deferred accounts is to give the assets to qualified charities.
• During your lifetime, current IRS rules allow IRA owners to donate up to $100k per year from traditional IRAs to qualified charities. Known as a Qualified Charitable Distribution (QCD), these can be used to satisfy your RMD or in addition to your RMD. Because QCDs are not reported as income on your tax return, they do not have any ripple effect on other taxes or Medicare premiums. There are rules and restrictions associated with QCDs, so we encourage you to work with your financial planner.
• At death, you can designate charities as beneficiaries of your tax-deferred accounts.

Desired Goal: Reduce Taxes During My Lifetime

• If you retire early, you can begin taking distributions prior to age 72 when RMDs begin. This may spread the distributions out over more years, reduce the amount of annual distributions, and ultimately reduce the annual tax liability.
• Be tax efficient when allocating investments to your accounts. To the extent possible, less tax efficient investments (those that generate taxable income) should be held in your tax-deferred accounts. More tax efficient assets (those that generate long-term capital gains or qualified dividends) should be held in non-qualified taxable investments. Capital gains receive more tax preferential treatment if they are realized in non-qualified/taxable accounts.
• Roth conversions are another option. While Roth conversions get a lot of attention, they are not always beneficial. They generally make sense if you are entering several years with a very low marginal tax rate, have adequate cash assets to pay for increased income taxes generated by the conversion, and a long enough life expectancy for investment growth in the Roth IRA to make up for the loss of your overall portfolio value incurred with the prepayment of income taxes.  

Desired Goal: Reduce Taxes for My Non-Spousal Beneficiaries

• Although a Roth conversion may not be beneficial for you during your lifetime, it can be a solution if you are more concerned about your beneficiaries’ tax liability than your own, for example, if your children are in higher tax brackets than you. Like traditional IRAs, certain beneficiaries of your Roth IRA may have up to 10 years from inheritance to take distributions. The goal with this strategy is not necessarily to reduce your tax burden, but to reduce the total taxes paid over the duration of the account.

As mentioned, having more than you need for retirement is certainly a good problem to have but still requires some planning on your part. If you’ve reached the end of your working years and realize you may have more money saved for retirement than you’ll need in your lifetime, it’s a good idea work with your financial planner to discuss what options may be available for you and your individual goals. Learn how we can help.