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Can you save too much, pre-tax?
By this, I mean can you find that you've saved so much in your 401(k) and/or pre-taxed IRA that you are in a higher tax bracket when you are making withdrawals than when you made the deposits? To analyze this, we have to choose a starting point. First, we will state that the withdrawals at retirement represents 4% of our pre-taxed retirement savings. See my article, Retirement for further discussion on how this is determined. Next, as many have pointed out to me, we cannot know what tax rates will be in two years, let alone twenty, so we will look at numbers for a couple retiring this year, 2008. For this couple, their standard deduction is $10,900, and two exemptions ($3500 each) all total $17900. It would take an account balance of $447,500 to support this level of withdrawal.
So, a couple can accumulate $447.5K and the withdrawals (at 4%/yr) will be at a zero tax rate. Even if they were in the 15% bracket while working, at withdrawal, it's zero. It would take a remarkable overhaul of our tax system to impact this, unless 401(k) and IRA withdrawals are targeted to be taxed worse than ordinary income which is pretty far fetched. Next, let us look at the marginal rates for this couple:
Taxable income over But not over The tax is Plus Of the amount over
0 16,050 0 10% 0
16,050 65,100 1,605.00 15% 16,050
65,100 131,450 8962.50 25% 65,100
131,450 200,300 25,550.00 28% 131,450
From this chart, we see the next $16,050 is taxed at 10%. It would take another $401,250 to support this additional annual withdrawal. We now total $848,750 in pre-tax savings, an annual withdrawal totaling $33,950 and still remain in the 10% bracket. The 15% bracket covers the next $49050 which is the annual withdrawal supported by an additional $1,226,250 worth of assets. I'll stop at this point, having shown that $2M in pretax savings is not a large enough sum to put you over the 15% bracket. You may feel that the current long term capital gain rate, and dividend rate is 15%, so this may be the break even point, where you may choose to use a post tax account. I would suggest that one's life frequently is not a smooth path, there may be periods of unemployment for one reason or another. Using those times to convert from the 401(k) or IRA to a Roth IRA can help to minimize your tax burden and reduce the risk of saving your way to a higher tax bracket.
(Note: This brief analysis does not address the Social Security Tax Trap. An upcoming article will discuss how to balance that against the information shared here)