[As with anything tax-related, see my disclaimers.]
You’re following the advice to max out your pre-tax contributions to 401(k) and Traditional IRA accounts. You notice the balances creeping up and you start to wonder, is there a point when you’ve saved too much in those tax advantaged accounts? Or, as Jeremy over at GoCurryCracker poses the question: “Is Your 401k Too Big?”
But first, it helps to understand how tax-deferred accounts could be too big.
Paying Tax: Now versus Later
The decision to contribute to a pre-tax account (e.g. 401(k), Traditional Deductible IRA) verses an after-tax account (e.g. Roth 401(k) or Roth IRA) comes down to the question of whether you are going to have a higher tax bracket in retirement or not. Expecting a lower tax rate in the future when you start withdrawing funds? Then you’re better off deferring paying the tax until later by using a traditional 401(k) or IRA. Expecting higher tax during drawdown? Then pay your tax now and save using a Roth 401(k) or Roth IRA. Expecting your tax rate to be the same now as in retirement? Then either route is pretty much the same.
How about simply deferring tax until your circumstances made it favorable or how about shaping your withdrawals to prevent moving into a higher tax bracket? Enter the RMD, or Required Minimum Distribution. The RMD kicks in at 70 and requires you withdraw a minimum portion of your tax-deferred accounts until they are depleted, paying tax on the distributions.
My Previous Tax Brackets
Tax brackets change and what tax bracket you’re in can fluctuate over time. The following is a chart of my tax brackets since 2003:
During this 15-year period, my average tax bracket was 20%. If I withdraw money from my tax-deferred account at a tax rate higher than 21% then I’ve paid more tax than necessary and would have been better off putting more money into an after-tax account.
Scenario One: I Chose to Pay No Tax
What’s the maximum account balance I can have today to avoid paying any tax in retirement? To avoid paying any tax, I need to withdraw no more than the standard deduction in any year. The RMD tables tell me that I absolutely must have less than $668,560 by the time I’m 70 years old or I’ll be paying tax at some point. This is a simple calculation: the standard deduction multiplied by the RMD value at age 70, or $24,400 * 27.4 = $668,560.
The next step is making a guess at what my rate of return will be in retirement. Even when taking the RMD, if my rate of return is high enough, I’ll need to adjust to keep my balances low enough that they won’t trigger an RMD greater than the standard deduction.
The following chart compares some after-inflation rates of return and shows the impact on account balances avoid paying any tax. In all cases we withdraw the standard deduction each year to avoid paying any tax.
You’ll notice that each curve “kisses” the bottom side of the RMD curve. Tax would be due any time that a curve crosses above the RMD curve.
As an example data point, at age 80 and on the 4% return line (green-dashed), my balance would be $384,326. That year my balances would grow by $15,373, I would withdraw $24.4k, and my final balance would be $375,299.
Scenario 2: Start Withdrawals Earlier Than Age 70?
The next chart examines what happens if I start withdrawing funds earlier than age 70:
We have the same curves that “kiss” the RMD curve but this time their inflection point moves further to the left and our minimum balance is increased. To see what happens if we start withdrawals even earlier, just extrapolate the inflection point even more to the left.
Scenario 3: Paying Non-Zero Tax
With a 4% after-inflation growth rate, It doesn’t look like I can have very much in my tax-deferred accounts without paying some tax. What if I increased my tolerance for tax to 10%?
And here’s what happens if we start taking withdrawals at age 50:
So again our balances are pretty small for higher rates of return, but quite a bit bigger than the “no tax” scenario.
Scenario 4: Losing the Pre-Tax Gamble
The next chart shows what happens if I lose the gamble by paying a tax of 22% at withdrawal when I was paying only 20% tax during contribution. Again, in this scenario I would have been better off putting my money into a Roth account, or maybe even a taxable account.
Final Scenario: Comparing the Tax Brackets Together
The following summary graph makes some assumptions that are I feel are pretty true to my current plans. I expect to “retire” around my 55th birthday and I fully expect to make a 4% after-inflation return. So this graph shows the different 2019 tax brackets in relation to each other:
As I keep my tax-deferred accounts under $2 million by the time I retire at 55, I should be able to keep things in the 12% tax bracket. I’ll have come out ahead in making tax deferred contributions now and paying the tax later.
Other Sources of Income
In this post I’ve ignored other sources of income, such as Social Security or rental properties. Any additional income would reduce the amounts that could safely be withdrawn if your goal is to stay within a particular tax-bracket. The curves shown above are upper bounds, and if you skirt the curves too tightly then you’ll likely be bumped into the next boundary.
I hope you’ve found this analysis helpful in understanding the impact that the RMD can have on your tax-deferred account balances if you’re targeting particular tax brackets in retirement.