Updated for 2019. With regular headlines reporting on the retirement savings shortfall facing many Americans, it may seem odd to consider whether it’s possible to save too much for retirement. Although this particular affliction is far less common, it is possible to save too much for retirement. For most individuals, retirement isn’t the only financial goal, requiring investors to balance cash flow needs with retirement contributions in some years. While saving for retirement is essential to secure your financial future, it is also important for individuals to live their life in the present.
Ways investors can over-save for retirement
There are three common ways individuals can accidentally save too much for retirement:
- Failing to balance retirement contributions with cash needs for other goals
- Concentrating retirement savings too heavily in certain areas (e.g. tax-deferred accounts or a business)
- Being overly frugal during working years and saving your whole "bucket list" for retirement
Balancing retirement with other financial goals
Investing isn’t only about the long game. If buying a home, paying for college, or maintaining a healthy annual travel budget fuels your late nights at the office, you may be wondering the best way to find a balance. Depending on your income and other expenses, it may not be possible – or advisable – to max out all of the retirement-savings vehicles available to you, particularly if your company offers a deferred compensation plan (commonly called a Supplemental Executive Retirement Plan or SERP) in addition to your 401(k).
High cost of not having enough cash on hand
One of the benefits of saving in a retirement plan is that the funds are difficult to access (and therefore spend) before retirement. Unfortunately, without proper planning, this can actually hurt individuals who have been saving diligently for retirement and didn’t anticipate their cash flow needs.
Although it may be possible to dip into your 401(k) or IRA without an additional 10% penalty depending on what you need the funds for, it may be best to simply plan for known expenses and set funds aside in an appropriate vehicle (e.g. a savings account or a 529 plan).
Not having enough cash on hand can make certain financial goals out of reach, or at least much more costly. For example, most individuals seek to purchase a home where they can cover their expected monthly mortgage payment with ease. But in most situations, the challenge is coming up with the down payment. A smaller down payment could mean private mortgage insurance (PMI), a higher interest rate, and a greater overall interest expense over the life of the loan. In some situations, if the debt-to-income ratio is too high, a buyer may not even qualify.
At least having a mortgage is considered ‘good debt’, as it may be advantageous from a tax perspective (assuming you can still itemize your deductions after the near-doubling of the standard deduction starting in 2018 and scheduled to sunset in 2025). Taking on debt for other goals, like paying for college or lifestyle expenses such as a wedding, travel, or car, may offer no tax benefit at all.
Depending on your goals and life stage, it may be advantageous to increase your financial flexibility by over-weighting to cash during certain periods. If you need to reduce your retirement contributions for a time, set a date to restore or increase your contributions so the extra cash isn't inadvertently spent on lifestyle expenses once your goal is met.
Over-concentrating your retirement savings
Exclusively using pre-tax retirement accounts
Some investors may not be over-saving in dollar terms, but from a diversification standpoint, they may be over-exposed in certain areas. Using a tax-deferred account such as a 401(k), 403(b), SEP IRA, and traditional IRA are popular ways to save for retirement. While the benefits are clear - reducing your taxable income in the current year plus tax-deferred growth until withdrawals are made in retirement - for high-income savers, large balances in tax-deferred accounts can create a 'tax bomb' in retirement when required minimum distributions begin at age 70 1/2.
This is particularly the case for individuals with a pension plan, or those with access to a deferred compensation plan which allows pre-tax deferrals in excess of the IRS contribution limits.
When considering how best to allocate and invest your retirement dollars, diversification should once again be top of mind. In addition to asset allocation, diversification is important for tax planning.
Three main types of investment accounts investors can utilize to save for retirement:
- Tax-deferred (e.g. 401(k), 403(b), traditional IRA)
- Tax-free (e.g. Roth IRA or Roth 401(k))
- Taxable (e.g. brokerage account)
Depending on your situation, it can be advantageous redirect a portion of your savings from a tax-deferred account to a taxable or tax-free account to help avoid all of your income in retirement being taxed at ordinary income rates.
Regardless of income, any taxpayer can make one Roth IRA conversion per year. If you're in the middle of a job transition, consider whether a full or partial Roth conversion makes sense for your old 401(k) plan. If you have an old 401(k) or 403(b) you've already rolled over to an IRA, consider utilizing that account for a Roth conversion.
If you have a Roth option as part of your employer's qualified retirement plan, you may be able to split your retirement contributions with ease. With a Roth 401(k), investors at any income level are able to make aggregate pre-tax and after-tax contributions up to the IRS annual limit, $19,000 in 2019 (if under age 50).
A brokerage account is the most flexible type of investment account. There are no limits on how much you can contribute or rules about when you can withdraw the funds. However, a brokerage account is taxable annually, so any dividends you receive will be taxed and you may also incur capital gains (or losses) throughout the year if you sell a portion of your portfolio or are holding a mutual fund (capital gains distributions).
Investing too heavily in a business or company stock
If you're a business owner, a partner in a business, or hold a significant amount of your net worth in your employer's stock, you may be underestimating the concentration risk that strategy can pose to your retirement plan. It is common for individuals who are very close to a particular company to develop a biased view about the future prospects of the company.
If you're a partner or owner in a closely held company, develop a plan to boost your investments outside of the company. Also, don't delay planning for an exit, sale, or a succession strategy until you're ready to retire. You'll want to work with a valuation expert years before you may be ready to retire to get an objective opinion about what the business may be worth.
Some publicly traded companies require executives to hold a certain amount of the company's stock to have skin in the game. To the extent that you're able to diversify, consider developing a plan to systematically liquidate and reinvest the proceeds from stock options or restricted stock units into other investments. Of course, there are tax considerations, particularly with stock options, which should be evaluated prior to exercising your options. Overall, try to remain objective about the future trajectory of the stock price and balance the desire to defer taxable gains with the need to diversify.
Saving for retirement vs being the richest person in the graveyard
As with anything, being frugal is best when done in moderation. Saving for later is important, but so is living a full life today. Remember, planning for the future is different than controlling it, and unfortunately, life doesn't always go according to plan.
For example, if you or you and your partner have been dreaming of a bucket list trip after you retire, consider whether it's feasible to work it into your budget beforehand, especially if retirement is still a ways off. Changes to your health, your family's health, or other unforeseen circumstances could prevent you from living the exact life you expected in retirement.
It is also worth doing some planning and projections to better understand your income needs in retirement. If you've already amassed (or are projected to) a retirement portfolio well in excess of what you might reasonably be able to spend during your life, take some time to consider your goals. Are you interested in leaving a legacy to your heirs? Charitably inclined? Involved with a particular college or university? There may be a lot of opportunities for planned giving, but some strategies do take some time, so it's worth reflecting on your wishes in advance.
While over-saving for retirement can be one of those "good problems" in certain cases, in other situations it can be rather costly if you're hit with penalties or unable to access funds when you need them. At Darrow Wealth Management, we take a deliberate and disciplined approach to proactive planning with clients to help ensure short-term goals are properly funded without derailing the end goal. To discuss your situation or to learn more about our comprehensive wealth management program, please contact us to schedule an introductory consultation.