(This post is the 2nd in a series. Subsequent posts forthcoming… soon. See the first post: Is Your 401k Too Big?)

A Traditional 401k / IRA allows us to invest for the future in a tax advantaged way. However, in some cases these accounts can become tax **dis**advantageous due to sheer size.

When the IRS forces withdrawals after our 70 1/2 birthday (the RMD), large accounts may get hit with higher tax bills. Those taxes could even be greater than what we saved on contribution.

We already saw this in the first post in this series. Even account values at age 70 1/2 of $350k or more (Married Filing Jointly) would most likely fail to Never Pay Taxes Again. But this isn’t necessarily tax disadvantageous.

Due to tax savings on contributions, are there higher account values that can be reached before our 401k becomes too big? And if so, how do we evaluate additional contributions?

# Is Your 401k Too Big?

## Higher Account Thresholds

When making contributions to Traditional 401k/IRAs we get an immediate tax deduction at our current marginal tax rate. We come out ahead If withdrawals are taxed at a lower rate.

Using the same methodology that we used to determine account value thresholds that allow zero tax burden, we can find glide paths that coast under the RMD without crossing over the 10%, 12%, and 22% tax brackets.

Methodology reminder: we make regular annual withdrawals to the top of a tax bracket, assuming a range of forward CAGRs (cumulative annual growth rates.) State taxes and ACA subsidy reductions not included.

The following charts are for the 10%, 12%, and 22% tax brackets, with CAGRs from 4% – 9%. All 2018 numbers for Married Filing Jointly (Single filers divide by 2.) Scales are the same for easy comparison. For years after 2018, all numbers can be scaled; X = Current Year Standard Deduction / 2018 Standard Deduction.

From this chart we can see that account values of ~$650k at traditional retirement age could likely never pay more than 10% tax. This is about 2x the account values that allow paying no tax. With higher acceptable marginal tax rates the account values can be larger… as can be seen in the 12% and 22% charts that follow.

Using these charts we can find target 401k values to achieve our tax minimization goals. All raw data is here, in both chart and table format.

Example Scenario 1:

At age 60, if our 401k was heavy on stocks (assumed 7%+ real CAGR), and we had an arbitrary goal of never paying tax at a rate higher than 10%, we might struggle to meet that goal if our 401k value was greater than $600k. (Or $1400k at 12%, or $2600k at 22%.)

Example Scenario 2:

If throughout our accumulation phase we were earning at the 12% marginal rate, and now Traditional 401k/IRA values exceed $2 million at age 70, then will likely pay some tax at 22%+. Could be considered slightly tax disadvantageous.

## Other Income and Credits

What about other income? Many “early retirees” have some rental properties, a pension, non-qualified dividends, interest, or accidental blogging income (basically anything that isn’t qualified dividends or long term capital gains.) And most people will have some amount of Social Security income. How does that factor into this?

The math is straightforward… albeit a bit messy the first time through.

Example:

Ordinary income: $43,050. This completely fills up the 0% and 10% tax brackets ($24,000 standard deduction, $19,050 10% bracket – 2018 numbers, MFJ)

Goal: max 12% tax rate

Target retirement age: 50

Allocation: 50/50 stock/bond (assume 6% CAGR)

Target 401k value at age 50 = Tax 12% 401k value @ 50 – Tax 10% 401k value @ 50 = 1630k – 692k = $938k

(Data here.)

For credits, we can choose to increase the size of IRA conversion / withdrawal. For example, if we have a Foreign Tax Credit of $600 from ownership of International Stock funds, we can convert/withdraw an additional $6,000 at 10% tax rate, $5,000 at 12% rate, etc…. Our target IRA size can be increased by ratio of increased withdrawal/tax bracket, e.g. 6,000/19,050 = 30%, 5,000/58,350 = 8.5%, etc…

## Reevaluating Additional Contributions

This is all well and good, but how do we know if we are on trend to exceed certain disadvantageous levels?

It helps to look at a specific target return of return. I’ve chosen 7% real since that is the actual long term CAGR of the stock market since the beginning of time.

We saw in the first post in this series that any 401k/IRA values exceeding the Tax 0% Blue Line in the above chart will result in tax being paid.

Similarly, if values exceed the Tax 10% Orange Line, then taxes in excess of 10% will be paid at some point. Taxes in excess of 12% (Taxes 12% Gray Line) and 22% (Tax 22% Gold Line) will be required as values grow further.

We can use these thresholds to determine if additional contributions are warranted.

Example:

Age 50, 401k/IRA value = $1 million.

If Marginal rate on contribution is 22%, then there is definite value in more Traditional contributions.

If Marginal rate is 12%, then contributions to Roth or brokerage account would have better long term value.

## Summary and Next Steps

In this, the second post in this series, we evaluated higher thresholds where 401ks can become tax disadvantageous, and how to evaluated if there is benefit to additional contributions. We also explored how to make adjustments for other income and tax credits.

Whereas account values of more than $250k will potentially struggle to achieve a lifetime 0% tax rate, our 401k can reach into the millions while still being advantageous to higher income earners.

All of the raw data in chart and table format is located here.

So far we’ve looked at things purely from a marginal rate perspective, and the analysis has been orderly and predictable. It even seems like we have some semblance of choice or control in the matter. In the next post… I’ll dissuade that delusion.

(This post is the 2nd in a series. Subsequent posts forthcoming… soon.)

(See the 1st post here.)

#### Are you tracking your 401k / IRA values?

We monitor our 401k/IRA values using free tools from Personal Capital (affiliate link).

I always maxed out both my 401k and a Roth or post tax regular IRA depending on income limits and put another 15% of income in a brokerage account. I was in the 33% tax bracket most of the time and in retirement I’m in the 24% bracket with side gig income. I think maxing the 401k and not doing Roth conversions saved me money.

Most likely it did. It might not when you hit 70.5.

Won’t the standard deduction and the income tax brackets change over time? For example won’t the standard deduction become 20% greater in about 7 years? Wouldn’t this affect the charts you provided?

Kinda. Using real returns means everything is inflation adjusted. Just like the standard deduction.

This one was a bit confusing, but I think I got it by the end. Our combined traditional 401k/IRA are worth over a million and we’re 45. I’ll double check our tax marginal rate, but I’m pretty sure it’s more than 22%. Anyway, we’ll keep contributing for now.

Once Mrs. RB40 retires, then we’ll do some conversion at a lower tax rate.

Leave OR first.

Oregon is truly tax hell for early retirees, well most people, I guess. Funny how twenty years ago Portland was considered a place for younger people to escape California and retire early. I guess someone has to pay the piper for their huge social programs despite half the state having no economy.

While I can’t disagree with the maths, I think there’s still a considerable amount of control you have over this. There are extremes (a strategic year abroad) but also more quotidian methods – doing a Roth conversion during a market slump for example. What’s your opinion on timing conversions for market slumps? Am I ignoring something critical here or is that a reasonable idea?

It’s not unreasonable.

If you do a conversion at a “bottom” and you pay the tax 100% from existing cash then it could help, but that is assuming your 401k was big enough to warrant taking those steps.

Completely Greek to me! You are writing above our heads. Please do a “Baby” version of your exquisite article so that we ordinary folks can benefit also. Thanks for sharing your amazing insights (this one just did not translate for me)

Think of it like a text book. You only need to really read the intro to each chapter.

Intro.

What do you think about taking our more than the RMD requires early in the RMD timeline (but not spend it all) so that RMDs will be smaller later? Could that have the effect of smoothing the marginal tax rate?

The answer is the same as should you make additional contributions. Saving 12% now is better than paying 10% later but worse than paying 22% later.

It might also be interesting to add potentially higher taxes on social security or Medicare IRMAA that could occur with higher income later.

See the examples above where income fills the 0% or 10% bracket. SS is just a form of income. If you get taxed on 24k worth of SS every year, then that occupies your standard deduction / 0% tax bracket. This reduces target 401k values by ~$300k

I second the comment about including the impact of RMDs on the taxation of social security and the tax bracket one ends up in… Thanks. (I also share the experience of this post being over my head….)

Really interesting take on this, as from what I understand (I’m a UKer) its pretty much a given that everyone needs a 401K! I guess our equivalent is an ISA? please someone correct me if I’#m wrong!

No idea about comparison to UK. But not everyone needs a 401k. A married couple making median income could save 20% of income in IRAs alone

I love this series can’t wait for part 3. I think I’ve read each part 5 times, slower each time to digest it.

I have long had the fear that there is a point where you have too much in a tax deferred. I don’t think the charts do it justice since SS isn’t calculated in. I think as higher income earners (especially if you have 2 high income earners), when they start taking SSN and then have RMD’s they could potentially be forced into higher brackets. I’m not too worried about being 100+ and RMD’s accelerating, heck if I make it over 100 I will say that is a good problem to have. I am personally trying to decide this year if I want to max out pre-tax since if I don’t I could potentially use more of a 199A deduction now. So that 22% may only be 17.4 (22% x .20 = 4.4, 22-4.4=17.4).

SS income (and all other income) is different for everybody, but you can calculate it yourself for your specific situation.

Thanks for an excellent, clear presentation of some complex math. I would like to add one point to the conversation.

I would prefer to optimize around the 4% or so assumed return. If a retiree achieves 7% real CAGR for 20-30 years, they are not going to have any problems. In that case paying a little extra tax is not a big deal.

On the other hand, if they experience 4% CAGR, then they may struggle with their 4% withdrawal rate and will regret paying some taxes upfront, having optimized around the 7% return case.

If you optimize for 4 and get 7, no big deal. If you optimize for 7 and get 4, you have cost yourself a difference-making amount as you struggle with your 4% withdrawal rate.

Also note Bogle predicts 4% stock returns over the next decade or so: https://goo.gl/qj5N5D

We do have to make a choice/prediction, and your guess is as good as mine (or Bogle’s.)

One thing I’ll critique about Mr. Bogle’s method is you have to look at combined buybacks and dividend yield, not dividend yield alone.

Am I reading this correctly? I am single with a little more than $500K in Traditional IRA value as of today (market correction included). Looks like I really need to max my ROTH conversion if my goal is to minimize RMDs. I have $100K in 457b and $1M in after-tax account. Am currently retired. Thanks

I dunno, it depends on what you mean by minimize RMDs and how old you are.

An RMD by itself is no big deal unless it forces you to pay more taxes than you wanted, and is mostly a consequence of being financially successful. (Also, about RMDs – they ramp up slowly and half of all tax paid is after age 90 or so. Most people are dead by then, so isn’t necessarily something to worry about.)

But, if you never want to pay tax at a rate greater than 10% then that might be difficult, but if 12% is ok then you are probably fine. ymmv

Ugh – help me out here:

I’m 50 will retire in 5-10 years

my tax deferred total is 660k

my tax free total is 98k

I am 22% married filing jointly

I could stop contributing to tax deferred 401k and make all 401k contribs as ROTH 401k 19k + 6k (25k/yr with catch up contrib)

plus I still contribute max to roth ira for both my wife and myself (additional 12k/yr)

total roth contributions: 37k per year for the next 10 years to beef up my tax free total

simple math tells me my tax deferred total will grow to about 1M give or take a hundred k or so… when I retire I can convert the 24k annually into roth and continue that growth so I don’t have to deal with complex taxes as I age….

I can’t tell, should I? or should I NOT continue tax deferred contributions?

Thanks in advance!

Hey Steve,

The following is a lengthy walk through of the data in this post with your numbers, to show how I would explore the decision:

Looking at the source data, it says if your Traditional accounts at age 60 are greater in value than $1.8 million w/ 5% forward growth or $1.4 million with 7% forward growth, then you will probably pay some tax at a rate higher than 12%.

If we assume that you have $24k in taxable social security income, then this reduces the target Traditional account values by $300k – $400k since it consumes the standard deduction. These are the values from the 0% table in the source data / never pay taxes again example from part 1. Subtracting this, we get target values of $1.4 million @ 5% or $1.1 million at 7%. If you have other regular income, you’ll need to make additional adjustments.

By my math, $660k in tax deferred accounts today would grow to $1.1 million at age 60 with 5% real growth or $1.3 million with 7%, even without additional contributions. With an additional $25k/year for 10 more years these numbers become $1.3 million and $1.6 million respectively. In other words, your past contributions are doing most of the heavy lifting at this point (ain’t compound interest a beautiful thing?)

So, if you have 5% growth you are all good and if you get 7% growth you might pay some tax at a rate greater than 12%, someday.

Higher than 12% is just the next tax bracket up (22%), and paying 22% now is exactly the same as paying 22% on future withdrawals. Same same.

Someday is whenever larger withdrawals happen, probably from the RMD. RMD withdrawals don’t really get that big until age 85, and half of all taxes paid is after age 90. So you might never see the 22% rates, and if you do it is 40 or more years from now, after you have had some wonderful growth.

So personally, I would continue to make deductible tax deferred contributions, and invest the current year tax savings in a taxable brokerage account. (If you contribute $25k, that saves $5500 in taxes today.)

In the years between retirement and RMD, you’ll want to make large withdrawals up to the top of the 12% tax bracket. That is about $100k/year minus SS. Post-retirement / pre-Medicare, this will impact ACA subsidies.

Hopefully this helps. Let me know if you have any Qs.

This is great! Thank you. I have read this once over, i will do so again so i am confident i inderstand. I was going to switch to all roth to beef it up, but another 5-10 years contributions to tax deferred seem safe for now and i agree i can keep pumping funds into my taxable accout..

Sure do wish i had the roth significantly higher, but – i will continue those contributions as well.

Btw – i worked in building 42 back in the late 90’s on the operating system teams – fun times. Maybe we can share a beer sometime when you are around the NW again

Best Regards,

Steve (NWOutlier)

Just realized – if I feel uncomfortable with 25k tax deferred, I can do my “catch up contributions” as ROTH and normal contributions (19k) as tax deferred. hhmmm

Yessir, you can dial it anywhere from 0% to 100%.

re: I wish I had the Roth significantly higher – we are all really just playing a tax now vs tax later game. It can be nice to have the simplicity of the Roth, but too often people pay way more tax today than they would pay later if they chose Traditional. I’d rather have a little complexity and be a whole lot richer.

Have I mentioned how much you ROCK!?!?! :) — I’ve read this many times over and gone back to my spreadsheets, dividends, savings rates… etc.. the suggestions you make are laser focused and will benefit me huge! Thank you! Sure wish I had this clarity when I was younger, I fall into the “if you save early you only need a few hundred a month, but if you wait, it will cost thousands a month”… past 3 years I’ve saved between 50-70k/yr each year not because I know what’s right – but because I have to to catch up…. I hope others see the benefits of your work… and save early, save often.

I wish I did not have to save so much now, because I’m in the stage of life for (unfortunately) family passing, kids going to college… and I would like some time to enjoy some of the money…. but it’s not possible yet…

anyway – thank you for all your work, while retired. :)

Don’t forget to enjoy the ride!

Love your posts, they are always super insightful. This one in particular is my favorite, and I noticed you left us hanging indicating that there will be a follow up post dissuading the delusion that we have some semblance of choice or control in the matter. Hope to see that one soon! I appreciate all that you do and love all your content.

Hi Shane. I hope to see that one soon too, sorry. I see I posted this one over 6 months ago… I’ll try to bump it up my to do list.

Hello, thank you for this post. I think I understand it to a degree, but not enough to definitively apply it to my situation and get an answer. With that, can I ask you: with minimal 401k contribution to trigger employer match leading to approx 1.7 mil at my likely retire age of 63 (6% CAGR), and assuming social security annual income at 26K and a pension of about 80K, is it safe to say that increasing my 401k contribution at this point won’t help me in terms of minimizing taxes?

Hard to say with just what you shared here, but with only pension and SS you’ll be in the 22% tax bracket (MFJ) or 24% tax bracket (single.)

(See tax bracket info here.)

If you aggressively Roth convert post-retirement you’ll probably pay 22%+ on <=100% of 401k withdrawals. Maybe some at 24-32%. Compare that to your current top marginal rate.

Thank you, I’m currently MFJ, 39 years old, and paying 22% marginal. I think that means I don’t have to increase my contributions beyond employer match.

A lot can happen in 25-30 years… but yeah, no sense in saving 22% now to pay 24% later.

The question then becomes what you do with your savings. If you can do Roth 401k contributions and/or backdoor Roth (mega or normal) then you can at least get the growth to be tax free.

I’m on the fence about it at the moment…should I pound the brokerage account and try to retire earlier, say around 55, and fill in the gap between 55 and 63 (or 65) with tax free gains and Roth conversion, or focus more on just putting it in a Roth for tax free growth, or just split it 50/50 between the two? Then again, I can always take the principal out of the Roth without penalty during those years, so just focus on the Roth and when I hit 55 , start taking out as much as possible from the 401K up to 12% marginal and do the Roth conversion…yeah this is just too damn hard.

Seems like you have a pretty good handle on it though.

But here is something to keep in perspective. Even if you make the absolutely worst possible choices in every case, what happens… you are super rich and you pay 24% tax instead of 22%.

Yes, that’s true. Thanks again.

Thanks for your hard work! Loving this series and patiently waiting for the next one to drop.

So, looking at the charts: I am 33, MFJ, 22% marginal with 325k in 401ks. That means that continuing to contribute to 401k will likely put me over 22% upon withdrawal, correct?

Potentially. 30 years of 7% real cagr on $325k would put you at ~$2.5 million, in which case the marginal dollar might be taxed at 22%+.

This is one of my favorite articles I have probably read it 10 times both part 1 and part 2. I also read the comments and I think what people fail to think of is, you don’t have to wait until RMD’s to start withdrawing at lower tax rates. You can fill up the 10 and 12% brackets before RMD’s which have been changed from 70.5 to 72 since this article was originally published. Maybe CA will inspire you to write the part 3 cliff hanger to the series. I keep leaning towards traditional since, if I’m completely wrong I will likely be in the 22% bracket, otherwise I win with the 10 or 12. Kids are getting older (1 or 3 out on her own, 2nd close behind) and its actually quite shocking how quickly expenses are dropping. Focus on expenses and fill up those lower 2 brackets each year and it seems very controllable to me.

The recent Secure act affects these calculations in 2 significant ways. The first and beneficial change is the delay of RMD’s to age 72. The other and detrimental change is the requirement that inherited tax deferred accounts be drained in 10 years. This can force you into a higher tax bracket and interfere with Roth laddering plans. It also adds a lot of uncertainty as is not something you can precisely plan for in advance. For those that do not retire early it can mean taking IRA withdrawals at the same time as your peak earning and tax rate years. You also cannot do Roth conversions from inherited IRA withdrawals. I have not found any clever strategies to mitigate this.

Multigenerational tax planning is more complex (if you or your elders care about tax rates after death.)

See:

Multi-Generational Tax Minimization

The SECURE Act – Compression of the Stretch IRA

very useful ideas – was there a part 3 in this series?

I never did get around to writing part 3. fwiw it says it is entirely out of your control anyway… just continue contributing

Interesting indeed and thank you for sharing. I think I’ve absorbed this at a surface level and I will continue to study it. We have nearly $4M in tax-advantaged accounts. If we contribute to taxable instead of tax-advantaged now, our marginal rate rises to 45% (inc state tax). We will have some rental income in retirement and will be retiring after 59 1/2. Does this make us not early retirees. We havent’ been putting much in taxable so we aren’t well-positioned to do the 401k-ROTH conversions when our income drops unless we reduce tax advantaged savings for the next 5 years when we may retire. Looking at the RMD schedule, I don’t see us having such high marginal tax rates until one of us inherits, if then. Unless taxes go up significantly (possible), then all bets are off. Does this sound like I’m following? Thank you

Given that the highest (federal) tax bracket is 37% the likelihood of paying more than 45% in retirement is low unless you remain in a high-tax state. Then it might just be a wash.

With $4KK in tax-advantaged accounts, it may not matter what you do at this point. Adding another $60k/year is peanuts compared to normal market activity.

At age 59.5, you have unrestricted access to all retirement accounts -> You don’t need funds in taxable accounts to fund daily expenses. You could do Roth conversions, locking in tax rates of 24-35% or so, depending on your target annual budget. This could result in some small tax savings vs just letting it all ride.