Maxing Out Retirement = Saving Too Much?

I came across an interesting online discussion the other day, about how maxing out both a 401k and an IRA was simply a lot of over-saving. The discussion was based on some article about a single adult male who maxed out his 401ks and IRAs every year, and had another $1200/month to invest. His income was not known, but it was assumed that he could make no more than $95k. The general consensus was that anyone with that income and that savings is not having any fun in life. I almost choked when I read the discussion as I have had plenty of fun on far less money when I was single and living in the most expensive area in the country. But mostly what is missed is the brilliant tax strategy in this plan. When figuring a true savings percentage, the 25% – 50% figures people were postulating as an effective savings rate were way off. If this guy did indeed make closer to six figures, he was only saving 15% of his gross income to retirement; not exactly a stretch for a single adult whom I assume does not have a lot of commitments. Let me explain how.

The reason that it was assumed in this individual’s case that he made no more than $95k was because that is the income limit for ROTHs (if you are single). Make more than that and you lose your ability to make a full ROTH contribution. This is error number one. The $95,000 limit is based on your modified adjusted gross income. This means for most of us it is your salary, plus interest and dividends and other sources of income, minus some adjustments, and minus any 401k contributions. So in this case, you can have $110,000 in income and max out both retirement vehicles. ($110,000 income minus 401k contribution of $15,000 = $95,000 modified adjusted gross income). You probably don’t even run the risk of your investment income pushing you over the ROTH income limit if you are diverting most of your investments into tax-deferred retirement vehicles. But basically, a full $15,000 401k contribution would then be 13.6% of this guy’s income. & that is all he would have to contribute. 13.6%. Because his income tax rate is probably in the 25% range, if not more with state taxes. So his $15,000 401k contribution will save him on average $4,000 in income taxes. ($15,000 x 25% = $3,750 tax saved). He doesn’t even have to change his withholdings or do anything fancy. When you contribute to a 401k it adjusts your taxable income downward at the paycheck level so automatically less taxes will be withheld. There is the $4k contribution for his ROTH, plain and simple. It just took some tax planning rather than a lot of scrimping and saving, to come up with the ROTH portion.

Another way to look at it is that if he chose to only contribute to his 401k, he would save $4,000 in taxes. So though $15,000 is getting diverted to his 401k plan, only the $11,000 ($15,000 contributed netted against the $4,000 in taxes saved) is really coming out of his gross pay. This is in comparison to if you simply put aside $15k of your after-tax pay. That would be a much bigger stretch.

Say your income is $75,000, and you are an aggressive saver. Put 20% in your 401k (or $15,000), and you will still have the same end result. You will save about $4k in taxes that you can then deposit into a ROTH. In this case it may be more of a stretch, but I wouldn’t find it impossible or view it as an overly aggressive savings strategy either.

I also think it is great this individual is hedging his bet with two completely different retirement vehicles. He is definitely taking advantage of the tax savings now in a higher tax bracket (with his 401k). But he also has some money in a ROTH which will be tax-free when he draws it in retirement. This hedges the bet for now that his income tax rate will be lower in retirement, because really nobody knows for sure.

I think it is important for people to understand their options. With all of the different employer type plans and different IRAs it can get very complex. Overall though, if you make a high wage and are offered a 401k or a 403b or such, consider diverting most of your savings into such a plan. If nothing else, you will shelter some of your income from taxes. If you are a heavy saver, you really should use retirement vehicles to your advantage. At the end of the day it means you get to keep more of your money, particularly if you are in a higher tax bracket. More to your own retirement, and less to Uncle Sam.

FYI, the maximum you can contribute to a 401k in 2007 is $15,500. The maximum traditional or ROTH IRA contributions for both 2006 and 2007 are $4,000 if you are under 50 and $5,000 if you are 50 or over. Subject to many limitations of course, depending on your individual situation.

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14 Responses to Maxing Out Retirement = Saving Too Much?

  1. Zachary says:

    I agree. I don’t think it’s possible to save too much for retirement. Since when did living frugally mean having no fun??!!??

  2. Amy F. says:

    Like Zachary said, most of us don’t have to spend a lot of money to have fun–so why not save all we can and give ourselves lots of future options? The critics of this man’s savings habits are probably just jealous that he will be able to retire early and they won’t.

  3. dong says:

    I’m not sure where this discussion was, but I know I was part of a discussion on this at some other blog. (This guy was featured in Walter Updegrave’s column on CNNMoney). I know the discussion I was more centered around what he was saving after his 401k and Roth. Saving as much as you can is all great and good, but it really does need to have a purpose. As Amy F. say if it’s future options that’s great, but it’s improtant to think about those Future options. There isn’t a point in forgoing current pleasures if you don’t knwhat future options you want. There wasn’t enough information in Walter’s column to really know anything one way or the other.

  4. Stan says:

    For some people, saving is a form of having fun. I’ve seen it with some of my friends that I tease, but I’m sure it will be them who will be teasing me later in life.

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  7. Dus10 says:

    Well, I certainly think that someone can over save for retirement… but, I think it is rather difficult to do. Even at this savings rate, there are plenty of things to consider that can show how this is just proper planning.

    If he is young (which is our perspective, here), then he is getting in as much money now, while he is young, as possible. This is the best time to make large contributions. If it is done for the first ten years of a career, it will be able to have huge gains over the long run. Then, one can scale back a bit later for things like homes and saving for the education of any offspring.

    If he is old (which is not the perspective here), then perhaps it is just “catch up” time. This would actually mean that it may be too low.

  8. broknowrchlatr says:

    I definately agree. I am in roughly the same income range but have a stay at home wife and 2 kids. I max out a 401k, 2 IRAs, and an HSA. I can still afford a $1500 a month house payment and we are taking 4 total vacations this year.

    Now, if this was someone making $40 a year, that would be differnt.

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  11. j says:

    75,000 incomes, 95,000 incomes – so sick of reading about rich people all the time. The median income isn’t that high and yet everything in the world seems to assume everyone is rich.

  12. Fern says:

    I would never discourage anyone from saving as much as possible for retirement, as there are so many unknowns (the cost of healthcare and long-term care among them), HOWEVER, as i was cleaning up an fat file of old personal finance articles in a file i’ve got i came across one from 1998 that i found worth re-reading.

    It said that for many years now, tax-deferred savings has been the mantra for all of us but that for some folks, especially for those in low to moderate income levels, tax-deferred savings may come back to haunt you when you’re in retirement. That’s becus it is not entirely a given that you will be in a lower tax bracket when you retire.

    Over the long term, taxes always seem to be inexorably increasing, so in a sense, you might say that chances are you’ll be paying more in taxes 20 or 30 years down the road regardless of what tax bracket you’re in. So according to this article, you might be in for a nasty surprise.

    I think that at least when it comes to a 401k plan with an employer match, the benefits of contributing far outweigh the risk of having accumulated so much for retirement that it bumps you into a higher bracket.

    However, I have been slow to convert most of my traditional IRAs to Roths as i’m now in the 25% tax bracket ($54K income) and am not convinced that my bracket will change when i get into my 60s since the 25% bracket goes from something like $30k up to $75K.

  13. Henry @ Binary Dollar says:

    I think it’s possible to be saving too much if your money could go elsewhere and be more effective. For example, if you have tons of credit card debt, you should probably pay that off first.

  14. needtaxbreak says:

    Hi all,

    Both my husband and I are making low 90s(x2), we dont have a house (we are putting it off because we THINK housing market will go down more next year, meanwhile we will have more money saved for downpayment), I max my 401k; he doesnt have any 401k plan as of yet; in few months he will have a 401K. How can we get a tax break? any advice will be greatly appriciated!! thanks all!

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