Is it possible to put too much money into your 401k account?

[An earlier version if this post incorrectly stated that Roth IRA contributions could only be withdraw after 5 years time. Once I dug deeper into the proper IRS documents for another post I realized that was untrue. I have amended the post below as required. -wsg]

I like to talk to people about money, a lot. It sometimes gets to the point that my wife needs to tell me to relax and stop trying to calculate the gross savings rates of my friends  in my head. I’ve definitely been in internet arguments about the future effect of inflation rates on the real return of consumer investment growth. As a result though, I have a lot of friends that also enjoy discussing the finer points of personal finance and financial optimization with me.

Recently I was asked about the optimal savings strategy for someone that thinks they might be able to retire early. The problem my friend recognized was that the traditional retirement savings schema that exists today is largely structured in such a way that all your “retirement” money is unavailable until you reach a certain age. Most all private and government pension plans do not offer payouts until the recipient is in their early to mid 60’s. 401k and IRAs do not allow one to access the funds within them until age 59 1/2 without paying a significant penalty (10%). So if you’re lucky to retire at, say, 42, where do you get your money for the next 17 1/2 years?

Before going any further though, a bit of review and explanation about where this question arises from:

  • An IRA, or Individual Retirement Account Arrangement [again, a clarification as a result of research for another post, Early Withdrawal from Roth IRA Contributions, a Closer Look], is an account that anyone can (and should) open. It provides several tax advantages for retirement savings. In 2013, the individual contribution limit for an IRA is $5,500. Once in the account, with a few exceptions, the money cannot be removed without paying the above mentioned penalty until the account owner is 59 1/2 years old.
  • A 401k is another tax advantaged retirement savings account that is usually associated with a workplace savings plan. These plans are set up by employers for employees. If you are really lucky, your employer might even go so far as to contribute money into your 401k, separate from your salary, on your behalf. This is extremely beneficial. In 2013, the individual contribution limit for a 401k is $17,500 (not including any employers contributions, if present).
  • The tax advantages of both 401k and IRAs can be simply summarized like this: the money you put into the accounts is pre-tax money. Meaning that the government doesn’t count the money you make and put into these account as income. This is advantageous because it a) lowers the amount of income tax you pay the year(s) you contribute and b) the money that you would have paid in taxes is invested instead.
  • You will pay income tax on the money in 401k and IRA accounts when you withdraw it. Usually though you are in a much lower tax bracket in retirement and therefore have a lower effective tax rate at withdrawal that you did when you originally deposited the money earlier in life.

So back to the question at hand, is it possible to put too much money into your 401k account? If you’re 42 and have a ton of cash sitting in 401k accounts and you think that it’s enough to support you for the rest of your life, can you retire and get at that money without paying the 10% early withdrawal tax? If you can’t get to it, then it seems like maybe you did put too much money into your 401k account! That isn’t the case though, here are the roundly accepted options/strategies you have:

  1. You can avoid the issue altogether and use distributions of principle from a Roth IRA for the period of time between retirement and age 59 1/2. Roth IRAs are similar to IRAs except that you contribute to a Roth IRA in post-tax dollars (instead of the pre-tax dollars you put into a regular IRA). But Roth IRAs also differ in another very important way, you can withdraw your contributions to a Roth IRA at any time and for any reason as long as they were made more than 5 years prior. For example, if I put $2,000 into a Roth IRA in 2010 and it grows at 5% a year for 5 years, I will have in the account. I would then be allowed to withdraw my original $2,000 contribution, penalty and tax free. The remaining $552.56 worth of investment gains would need to remain in the account until I was 59 1/2. BINGO! I’ve now withdrawn money to use between retirement and 59 1/2.

This clearly sidesteps the original question about having placed too much money into your 401k account though. But, I included it because it forms the basis for strategy #2. If you are willing to get a little bit craftier you can further expand on the basic idea outlined in #1 to free up some of your 401k funds as well. This is especially helpful if you think you might already have too much in your 401k. You see, you are allowed to perform a rollover of your 401k to a Roth IRA. Very simply, this means that you transform your 401k into a Roth IRA. (This is something that is done by your brokerage or employer retirement plan administrator. Ask them for details if you are considering this.)

Basically, the government will see this rollover as you taking some money from your 401k, converting it to taxable income, and then contributing it immediately to a Roth IRA. This action will trigger a tax on the money from the 401k as income, but it will avoid a penalty tax usually associated with early withdrawals since you are putting it right into the Roth IRA. Since the rollover money from the 401k is now a contribution in your IRA, it is accessible and available for withdrawal from the Roth IRA in 5 years. BINGO! You just took money from your 401k (let it marinate for a minimum of 5 years in your Roth IRA) and now it’s in your checking account, available to spend as needed.</br></br>

Ideally, you would only roll over a year’s worth of expenses at a time, each year. That way you have a pipeline of income ready for withdrawal from the Roth IRA. Clearly this strategy requires a little bit of planning to execute successfully since the money from the 401k must sit in the Roth IRA for 5 years. But let’s be honest, if you’re encountering this problem in the first place you’re clearly a planner. People don’t retire at 42 by accident.

Perhaps the most confusing option you have if you think you’ve put too much into your 401k account earlier is called “Substantially Equal Periodic Payments, or SEPP (also referred to simply as Section 72(t) withdrawals because that’s the section of the IRS code where these withdrawals are defined).

I’ll avoid too much detail but, simply, the IRS prescribes an interest rate that is based on something called the Applicable Federal Mid Term rate which is then combined with your life expectancy, amortization rates, and mortality rates to arrive at the amount you are allowed to withdraw each year without penalty. A widely referenced calculator on the subject is here: http://www.dinkytown.net/java/Retire72T.html. It shows that you’ll get about $1,650 per year for each $50,000 you have in your 401k. BINGO! Clearly this isn’t a ton of money, but it could help to offset some of the regular expenses in early retirement.

And maybe the simplest idea, consider the money in your 401k account(s) to only be your “regular retirement money.” The simplest answer to “Is it possible to put too much money into your 401k account?” is simply, do the math and check. If you have enough to last you from 59 1/2 until you don’t need it anymore, then you have enough. You can figure out what you think you’re going to need to live on after the age of 59 1/2 and stop contributing to the 401k once you reach that amount. If we assume that you can live on $33,000 a year and will live until you are 93, using a 4% withdrawal rate, you’ll need:.

Continuing the exercise, we assume you are 28 now and already have $147,000 in your 401k account. If we assume a 4.5% inflation adjusted (it’s important to use an inflation adjusted number here) rate of return on that money for the next 32 years, will it be enough?

A quick and easy calculation:

\$147,000 \ast 1.045^{32} = \$601,227

shows that you will have around $601,227 in the 401k at the age of 60, not quite enough. Contributing the maximum to that 401k for another 4 years or so will get you to that $825,500, at which point you could begin to maximize your other investment vehicles.

Really though, I think the answer to “Is it possible to put too much into your 401k?” is “Nope!” This is especially true considering the ease with which you can access the money in a 401k early with #2 above. Besides, if there is an opportunity for a company matching contribution to your 401k, there is no reason you shouldn’t be contributing in order to capture that match.

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