You’ve been saving aggressively in an IRA or 401(k) plan for your whole career and you’re set up well for retirement. Or are you? If you’ve built up a large nest egg only or mostly in tax-deferred accounts, you may give up too much of your hard-earned savings to taxes when you begin withdrawing from your IRA.

Saving in tax-deferred vehicles offers the advantage of sheltering some of your income during peak earning years. Most savers assume that their income will be lower and they’ll face the same or a lower tax rate when they must pay taxes on the withdrawals in retirement.

But if you save too much, you can lose the advantage of tax deferral when you start taking money out. Tax-deferred accounts like traditional IRAs and 401(k)s require you to take required minimum distributions (RMDs) after age 72. With a large IRA, the RMDs are also large, and the IRA tax is at regular income tax rates—not the lower rate for capital gains and qualified dividends. 

Given the long-term economic forecast and fiscal policy trends, it’s likely that future income taxes will be higher. A lopsided portfolio with too much money in tax-deferred accounts could mean that you end up paying higher taxes on a higher income.  

Added to any other source of income, RMDs can bump you into a higher tax bracket. Distributions can also raise your income over the threshold where you will pay taxes on up to 85 percent of your Social Security benefits, rather than half. 

Over-investing in tax-deferred accounts also costs you some flexibility. Before age 59 ½, you can’t get that money out to take advantage of other investment opportunities or take care of emergencies without paying regular income tax, plus a 10 percent early withdrawal penalty.

In contrast, after-tax contributions to a Roth IRA can be withdrawn tax-free and penalty-free at any time. Earnings or funds converted to a Roth IRA may face penalties if withdrawn before age 59 ½ or in less than five years, but there are exceptions. Withdrawing from a Roth IRA early is penalty-free under special circumstances: for example, if the funds are used to help a child or a grandchild purchase their first home or cover adoption costs or large medical expenses. 

To preserve access to your money when you need it and minimize the tax bite in retirement, it’s better to balance your assets between tax-deferred and after-tax investments that grow tax-free or at the lower capital gains tax rate. 

If you are concerned that you have saved too much in your IRA and are overexposed to future taxes, your options may include the following:

  • First, switch your savings to make after-tax contributions to a Roth IRA or another investment that provides tax-free income. 
  • If you are of retirement age and in a comfortable tax bracket, take required distributions sooner than required and reinvest the money in assets that will earn long-term capital gains and qualified dividends taxed at a lower rate.
  • Calculate whether it is advantageous to roll some of your savings from a traditional IRA to a Roth IRA, a Health Savings Account, or a Section 529 or Coverdell education savings plan. You will pay taxes on the converted funds but they will grow tax-free, and with a long enough horizon until you need the money, the earnings may outweigh the up-front tax bill. This is most effective if you expect higher future taxes and can time the conversion to avoid penalties and a higher tax bracket.

The calculation of how much tax-deferred savings is too much depends on your current income and tax rates, expectations about future taxes, and the amount and type of income you expect in retirement. Contact us for help calculating your needs and balancing your retirement portfolio so that you can keep the most of every dollar. 

-Toni Shears