6 Hidden Downsides of an Oversized 401(k)
Experts frequently advise saving aggressively for retirement in tax-advantaged accounts such as 401(k)s for their tax perks and high growth potential. However, it is possible to save too much in these accounts.
For instance, the required age at which retirees must take required minimum withdrawals (RMDs) is 73 thanks to Secure 2.0 Act. This could mean some retirees end up with so much money it bumps them up to a higher tax bracket.
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Below, experts explain why you might want to spread your retirement dollars around into other retirement accounts.
1. Lack of Flexibility
Chad Kennedy, a partner at Lighthouse Financial, agreed the 401(k) does come with some limitations. "Traditional 401k's do not provide much flexibility," he said. "If you would like access to your cash prior to 59 1/2, you will have to pay a 10% penalty and income tax on your withdrawals," said Kennedy.
2. Tax Diversification Considerations
Concentrating all retirement savings in a 401(k) means withdrawals will be taxed as ordinary income, according to Kami Adams, a financial advisor and founder at Creative Legacy Group.
Abid Salahi, co-founder Of FinlyWealth shared an example from his practice in which a client had amassed over $4 million in his 401(k) by age 70.
"When RMDs kicked in, he was compelled to withdraw over $200,000 annually, catapulting him into the highest tax bracket and effectively reducing his retirement income by nearly 40%," he explained.
This scenario underscores the critical need for strategic retirement savings diversification.
3. Contribution Limits May Be Too Tight
Another concern is that annual contribution limits for 401(k) plans may not be sufficient for all retirement goals, Adams said. For 2024, the limit is $24,500 with an additional $8,000 for those 50 and older. That might not be enough.
"Utilizing other savings vehicles can help meet more ambitious retirement objectives," she said.
4. Limited Investment Options
Another mark against the 401(k) is that these plans often have limited investment choices compared to IRAs or taxable accounts, Adams explained.
"By spreading investments across different accounts, individuals can access a broader range of options, including individual stocks, bonds, ETFs, and mutual funds, potentially enhancing overall portfolio performance," she said.
5. Estate Planning Considerations
RMDs for 401(k) accounts can also complicate estate planning, Adams said. Roth IRAs, on the other hand, don't have RMDs during the account holder's lifetime, offering more flexibility for passing wealth to heirs, Adams said.
"Additionally, taxable accounts benefit from a step-up in basis at death, reducing the tax burden on beneficiaries," she said.
6. State Tax Implications
In addition to federal taxes on RMDs, retirees need to be aware of how state taxation on their retirement income varies, Adams said.
"Diversifying retirement savings across different account types can provide opportunities to minimize state taxes, depending on retirement location and financial situation," she said.
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal or tax advice.
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