(This post is the 1st in a series. Subsequent posts forthcoming… soon.)

The stock market has had a pretty good run over the last 10 years or so.

If you’ve been following financial best practices by contributing to Traditional 401ks and IRAs, the odds are good that those retirement accounts are reaching lofty heights.

Is it possible that those accounts have grown too large? Is your 401k TOO BIG?

Is Your 401k Too Big?

Assuming I didn’t have to work any longer or harder for it, I’d much rather have $1 billion than $1 million. Having too much money isn’t high on most people’s list of problems.

So how could a 401k be too big?

These accounts allow us to invest for the future in a tax advantaged way. However, in some cases a 401k can become tax disadvantageous due to sheer size.

To determine if our 401k has (or will) become too large for its own good requires a bit of tax law and investment return foresight, but in this and subsequent posts I attempt this feat nonetheless. (All numbers in this post are for a Married Couple Filing Jointly. Single Filers can divide by 2.)

Beating the RMD

Maybe you read on the Internet somewhere about how you can Never Pay Taxes Again? Using that as a goalpost, a Married Couple Filing Jointly could make completely tax free annual Roth conversions equal to the Standard Deduction ($24,000 in 2018.)

Repeat for 10, 20… 50 years. An example: I previously shared our own efforts to build the world’s longest Roth IRA Conversion Pipeline.

At what level / size does the 401k become too big, such that this task become Mission Impossible? When the minimum distribution amount exceeds the Standard Deduction. See chart. (All #s in 2018 $.)

401k Too Big

At first it appears an IRA value at age 70 1/2 of ~$650k would be a good target; those early RMD withdrawals won’t result in tax due.

Alas, RMDs are based on life expectancy, which is a nice way of saying they are designed to drive IRA value to zero before you die. This is done by requiring increasing large distributions, which are inherently tax inefficient. The IRS wants their money.

As such, if we are even close to this “IRA value” threshold, subsequent years will definitely result in a tax burden.

To avoid this, we need to determine a glide path that will coast under the RMD. This is the opposite of a large lump sum withdrawal – regular annual withdrawals of a size designed to minimize lifetime taxes.

Since this is dependent on future investment return, I implemented a series of Standard Deduction sized Roth conversions at multiple CAGRs such that total tax on all conversions is zero even as the RMD takes effect.

401k Too Big

Here we see that an IRA value of more than ~$350k at Age 70.5 is “too big” except for low expected real return, either by design (low equity allocation) or a series of unfortunate market events.

And here it is in Table format – All numbers are real / inflation adjusted. For future use, scale all numbers: Today’s Standard Deduction / 2018 Standard Deduction.

Tax: 0%
ROI = real
4%5%6%7%8%9%
30569k468k396k341k299k266k
40554k461k392k340k299k266k
50532k449k386k336k297k265k
60499k430k375k330k293k263k
70450k399k355k317k285k258k
80378k348k319k292k268k246k
90272k264k255k243k230k218k
100114k129k141k145k149k151k

Deeper Analysis

Let’s look at the case where IRA value is $650k at Age 70 1/2, the minimum IRA value that will result in the RMD exceeding the Standard Deduction in that year. What does the future tax burden look like, assuming a 7% real return going forward?

401k Too Big

We can see that the 401k / IRA value continues to balloon (Purple line), even as withdrawals grow (Teal line), peaking at ~$865k at age 85. We can also see that RMDs cause annual tax burden to climb (Light Blue line.)

Imagine that you are 40 years of age in the 22% tax bracket, and evaluating whether to make 401k contributions for the year. “On the one hand, I want to not pay taxes in retirement. That sounds cool. On the other hand, I don’t want to pay taxes today and I get a tax deduction for contributing.”

Contributing the max ($18,500 in 2018) will save $4,070 in tax today. The NPV at Age 40 of the entire series of tax payments in the chart above is…. wait for it… $4,070. The peak tax burden starts in the late 90s, and half of total burden comes after age 97.

If we live long enough both options have equal value, but one is more predictable and immediate. Given the enormous delta in IRA values, I’d err on the side of contributing too much.

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 deliciously simple in this regard, and we can just reference the Standard Deduction. Earn income equal to 1/4 of the Standard Deduction? ($500 per month.) Reduce the target IRA sizes by 1/4.

If the income is Social Security, first determine what percentage of the income is taxable (max 85%.)

For credits, we can choose to increase the size of IRA conversion / withdrawal into the 10% tax bracket. For example, if we have a Foreign Tax Credit of $600 from ownership of International Stock funds, we can convert an additional $6,000 or 1/4 of the standard deduction. Our target IRA size is also therefore increased by 1/4.

Summary and Next Steps

For extremely early retirees or late savers, no tax burden in retirement may be a natural and predictable outcome. But the IRA values that allow it are not large.

Instead, we can focus on lifetime tax minimization. Mathematically speaking, it is better to have an extra dollar and pay tax on it than to have no dollar at all. Furthermore, it would make little sense to pay more tax now (by not making additional 401k or IRA contributions) just to not pay tax later. Don’t let the tax tail wag the dog.

Are there other higher thresholds where 401ks can become tax disadvantageous?

Is there a point where it makes sense to reevaluate additional contributions?

Can we take steps to minimize the peak tax rates?

These questions and more will be explored in the rest of this series.

(This post is the 1st in a series. Subsequent posts forthcoming… soon.)

Is Your 401k Too Big?