This was originally published in the Tacoma News Tribune Sunday January 1, 2017.
You might be saving too much for retirement.
Counterintuitive? Yes. During this resolution time of year, you probably expected to read that you need to commit to saving more. You don’t have to search far to find indications that working Americans in general are unprepared to replace their income in retirement. Evidence from the largest 401(k) plan administrators makes it clear that the average account balance of people approaching retirement won’t enable long-term financial security for many of them.
But this headline-generating data is not true for a portion of the population. There are indeed people who end up with too much money in tax-deferred retirement accounts. It’s not widespread, but not uncommon either.
People who consistently save 10 percent or more of their income — and often earn at least a partial company match — can accumulate a retirement nest egg that may overfund their lifestyle desires and do so in a tax-inefficient way.
Rule of thumb guidance often suggests that most people can live on 80 percent of their pre-retirement income. The assumption is that your expenses will be reduced in several ways. You are more likely to be mortgage-free by this point. You no longer have the need to defer some of your income for retirement savings. The costs of working (transportation, attire, lunch out, etc.) also fade.
David Blanchett, head of retirement research for Morningstar, has evaluated the spending curve that turns downward in retirement. His conclusion: “While a replacement rate between 70 percent and 80 percent may be a reasonable starting place for many households, when we modeled actual spending patterns over a couple’s life expectancy, rather than a fixed 30-year period, the data shows that many retirees may need approximately 20 percent less in savings than the common assumptions would indicate.” Blanchett’s analysis shows retirees live on between 54 percent and 87 percent of pre-retirement income with the majority under 80 percent.
This creates an issue for some. You save to have more attractive options for how to spend your money in the future (after it has generated an investment return). But the savings may cause you to forgo experiences or conveniences today in exchange for protection against shortfall later.
Another conundrum is that every dollar withdrawn from pre-tax retirement accounts such as the 401(k), 403(b), or traditional IRA is subject to ordinary income tax, meaning that, for many people, the account balance on your statement should be viewed as effectively 25 percent less in spendable dollars.
One common assumption for saving as much as possible in the pre-tax retirement account is that you will have a lower effective tax rate in retirement than you do during the working years. This is not always the case, however, and may be less likely in the future.
After age 70½, owners of pre-tax accounts must withdraw at least a government-mandated minimum required amount each year. Often, this is more money than is needed to supplement Social Security and pensions or other retirement income. Realizing this fully taxable income even when it’s not actually needed occasionally causes further complications in that it can boost your income into higher tax brackets where Medicare costs are increased.
There is no reason to ever pass up free money of an employer match, but after that it may be worthwhile to give more thought to the character of your savings.
Since we don’t know what tax rates will be in the future, it may be helpful to practice tax diversification. If you’re eligible for a Roth IRA and its tax-free growth, that alleviates some tax-related issues in retirement. Converting a portion of existing pre-tax accounts to Roth may also be useful in some circumstances.
Saving in a nonretirement account subject to capital gains tax, rather than ordinary income, may also be beneficial. It would also come with more flexibility for when the funds are available to you without penalty as sometimes applies to retirement accounts.
Of course, you could also simply choose to increase your standard of living now. It may not be necessary to pass on valued life experiences now to defer until later when you can “afford it.”
Certainly, it is hard to judge exactly how much savings you’ll need. Retirement expenses are just one of several important variables that determine your financial security. Your required savings rate also depends on expected investment returns and longevity of life. A financial plan with sensitivity analysis to these influential factors may give you stronger confidence in your path forward.
Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Gig Harbor. Reach him at firstname.lastname@example.org.
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