Big IRA's: When maxing out a 401(k)/403(b) doesn't always make sense
This week’s photo is of our irises at our front steps. They have just come out this week. While not the first (the daffodils were first), they have proudly announced that summer is here.
It’s a nice problem to have: You and your partner are making a healthy household income, you’re maxing out your contributions to your respective 401(k)’s/403(b)’s and you’re also putting aside funds for other goals. What could possibly be wrong with this picture?
Recently we analyzed a couple’s financial situation with these characteristics: High income, high tax bracket, modest spenders, and excellent savings habits for multiple goals including retirement. They are in their mid-40’s and have another 20 years or so to go before they plan to retire or shift careers. Currently they have the following saved for retirement in Traditional (pre-tax) 401(k), 403(b) and IRA accounts: $890,000. By age 72, if they continue maxing out, they’ll have approximately $5.6 million, using a 6% rate of return.
That sounds like a nice nest egg, right?
At age 72 they’ll need to start taking Required Minimum Distributions or RMDs. Because this money has never paid any tax, all distributions are taxable at ordinary income tax rates, e.g., the same rate you pay on earnings which is typically a higher tax rate than that applied to capital gains.
For an account of this size, at age 72, the first RMD must be for $218,000. If the couple is currently earning $450,000/year, that may not sound like a big deal. They’ll use all of that money, right? However, RMDs cannot be avoided.[1] In other words, you have to take the money out and pay taxes on the distribution each and every year, whether you need the money or not.
Keep in mind that currently this couple is in the 35% marginal federal tax bracket. With current tax rates scheduled to return to the higher, pre-2018 tax rates, this couple could be faced with paying higher tax rates when they have to begin taking RMDs.[2] Based on pre-2018 tax brackets, they would be in the 39.6% bracket. In addition to this tax rate, other additional taxes may apply.
What’s the solution?
There are several options which depend on specific circumstances including doing an “in plan” conversion of part of the 401(k)/403(b) [if the plan allows] over the next several years, switching to Roth contributions, reducing salary deferrals in favor of saving through other tax-deferred options or a combination of these.
If this sounds like you or you want to know more, give us a call. We’re here to help.
Lyman H. Jackson
617-653-3303
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. FPS provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client after entering into an advisory relationship. Information herein includes opinions and forward-looking statements that may not come to pass. Information is derived from sources believed to be reliable. Information is at a point in time and subject to change without notice. Such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.