Saving Too Much for Retirement

This essay is meant to refute the oft-stated advice that everyone should save as much for retirement as possible, meaning that we all should be making the maximum legal contribution to tax-deferred accounts. I realize that this may be reasonable for some average consumer, but I am certain that it isn't reasonable for me, and it might not be reasonable for you either. Clearly tax deferring as much as possible isn't a useful strategy at the low end of the income scale. If I earn $10K/year, and I somehow manage to make a $2K IRA contribution each year, I would then be saving too much. My contributions would defer only $200 worth of federal income tax, and my withdrawls are very likely to be taxed at a higher rate. Saving 20% of your income in tax-deferred accounts makes sense only if you do it for a small proportion of your working life, because it never makes sense to defer so much income that your required minimum distributions (RMDs) are larger than your income was. If you are going to consistently save for retirement from age 30 to 65, spending 80% of your pre-retirement income when retired, you only need to save about 12% of your income annually:

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If you save too much in tax-deferred retirement accounts, you may end up either paying early-withdrawl penalties, or working additional years in order to avoid them. Once you have saved enough to retire starting at age 65, additional retirement savings should not be tax deferred, so that you can use them for early retirement. If you plan to withdraw no more than $10K/year in retirement, starting at age 65, you can fully fund your retirement with $2K/year IRA contributions, (or fully fund $20K of retirement income for a couple with $4K annual IRA contributions). These amounts sound modest, but when you add $18K of Social Security, the total is $38K, quite close to the median annual income of American households. That means approximately half of the American public could fully fund their retirement with a traditional IRA.

What about 401k and 403b retirement plans? Many employers offer these, and they have contribution limits much larger than a traditional IRA. For example, faculty of the University of Colorado at Boulder make mandatory 5% employee and 10% employer contributions, tax deferring a total of 15% of their incomes. That means many CU employees are saving too much for retirement. Unless they work less than 35 years, CU employees would be well advised to avoid contributions to any other tax-deferred retirement plans, like IRAs or SRAs. Roth IRAs are the best savings vehicle for people who might retire early, since they permit investors to withdraw savings early, and they have no required minimum distributions. Taxable investments are also a reasonable alternative, and they have the advantage of being usable for non-retirement expenses. Of course, there isn't any point in worrying about this if you love your job, and are not looking forward to retirement. Mandatory contributions may force you to pay more in taxes, but they also mean more income, definately a net positive. It would be nice if CU benefits would recognize that it is forcing some employees to put too much money in tax-deferred accounts, and permit some alternative.

How can you tell if you're saving too much for retirement? It depends on how large your retirement accounts are, and how much you plan to withdraw from them when retired. If the ratio of the amount you'll be spending to the amount you will defer exceeds 20, you should stop making contributions to tax-deferred accounts, if possible. You could undo excess tax deferral by saving to non-deferred accounts, so that you can stop working early and convert some of your tax-deferred accounts to Roth IRAs. While your RMD could start out at 1/27th of the value of your tax-deferred accounts, it may be a good idea to withdraw more than that initially. Otherwise you may fail to offset the appreciation in the accounts, and could have ever-larger RMD withdrawls, with ever-larger tax bills as a result. Although you probably won't need to spend that money on yourself, the taxes will divert money that could have been given to charity or family to the government. The larger than necessary withdrawls can be reinvested into assets that do not have to be sold until you are ready to pay capital gains taxes on them.

There is another cost of tax deferral that is often ignored. Having taxable income above $10K/year (for a single person) makes Social Security benefits taxable. If you have an IRA with $270K in it, and your RMD is 1/27th of that amount, you'll have $10K of income from your RMD alone. For people in the middle to upper income brackets, this isn't very important. They won't be able to get below that threshold in any case, but for people in the 15% federal tax bracket, it's something to think about. It's perfectly possible to pay those income taxes up front, buy taxable investment assets for retirement, and only have capital gains taxes (now 10%) due on the appreciation. Then a $10K/year Social Security benefit would be tax free, worth $1500 more than it would have been if you'd maxed out the tax-deferred retirement accounts. This annual tax cut is 5 times as large as the tax bill that is deferred each year someone in the 15% tax bracket makes a $2K IRA contribution.