3 Ways More Money in Retirement Might Cost You
You might think that there is no such thing as too much money in retirement. After all, without a steady income from working, you need your retirement nest egg to last you throughout your golden years. So more money must be better, right?
Well, as The Notorious B.I.G. once said, the more money we come across, the more problems we see — even in retirement. While I would never discourage anyone from saving as much as they can for retirement, it is a good idea to recognize what kinds of additional problems a large retirement portfolio could cause you.
Here's what you need to know about the potential pitfalls of having more money in retirement:
1. You Will Owe Taxes on Tax-Deferred Retirement Accounts
According to the Bureau of Labor Statistics, as of December 2016, 44% of all workers were participating in a tax-deferred defined contribution plan, such as a 401K or an IRA. These types of retirement accounts allow workers to put pretax dollars aside for their retirement, where the money grows tax-free. Once you reach age 59½, you may withdraw money from such tax-deferred accounts without penalty.
The potential trouble comes from the fact that any distribution you take from your tax-deferred account is taxable as ordinary income. This means that you will be taxed on that income in the same way you would be taxed on the same amount of income from a job. Because of the taxes you will owe on your distributions, the money in your tax-deferred retirement account is worth less than the dollar amount.
Since many workers anticipate having a lower tax bracket in retirement than they do during their career — that is, they expect to have a much lower retirement income than career income — it makes sense to put off the taxes they will pay on the money in their 401K or IRA until after retirement. However, for anyone who manages to create a large retirement portfolio from a modest salary during their career, the tax burden in retirement will be much larger.
2. Required Minimum Distributions May Force You to Withdraw Money You Don't Want
If you put money aside into a tax-deferred account, the IRS will want to see its cut of the money eventually. For that reason, the IRS requires each account holder to begin withdrawing money during the year that he or she reaches age 70½. There is a minimum amount you must withdraw, and the IRS levies a stiff penalty for failing to do so — you will owe 50% of the amount that should have been withdrawn.
In addition, the required minimum distribution is calculated based on your date of birth, the balance of each tax-deferred account as of December 31 of the previous year, and one of three IRS distribution tables. That means your required minimum distribution must be recalculated each year using your new end-of-year balance from the previous year and your new distribution period according to the IRS distribution table. Getting the amount wrong can be potentially costly, and if you have a great deal of money in your tax-deferred accounts, you will be required to take more money than you necessarily want to access in one year.
Don't forget, this required minimum distribution is also taxed as regular income (as we discussed above), so in addition to potentially withdrawing money you don't want, you will also owe taxes on the amount that you are required to withdraw.
3. You Will Be Taxed on Your Social Security Benefits
Many people are unaware of the fact that up to 85% of their Social Security benefits may be subject to income tax in retirement. The higher a retiree's non-Social Security income, the more likely it is that they will owe taxes on their Social Security check.
The way the IRS determines whether your benefits are taxable is by calculating something known as provisional income. The formula for determining the provisional income is: One-half of your Social Security benefits, plus all your other income, including tax-exempt interest. (While tax-exempt interest is included in this calculation, tax-free distributions from a Roth IRA are not.)
Your provisional income is compared to an upper and lower base amount to determine how much of your Social Security benefits are taxed, if any. If you file as single, then your lower base amount is $25,000. If your provisional income is above that amount, then you owe taxes on 50% of your Social Security benefits. The upper base amount for single filers is $34,000. If your provisional income is above that amount, then you owe taxes on 85% of your Social Security benefits.
What this means is that the more money you take from your retirement accounts, the more of your Social Security benefits are considered taxable.
For instance, if you are single and you take $38,000 from your IRA in retirement each year, then you are in the 25% tax bracket and you owe taxes on 85% of your Social Security benefits since your income is above the upper base limit. If you decide to withdraw an additional $1,000 from your IRA one year, your additional $1,000 in income will cause $850 more of your Social Security income to be considered provisional income, making it subject to taxation at your marginal tax rate of 25%. You'll owe $462.50 on your $1,000 withdrawal ($1,850 x 25% = $462.50) between your IRA taxes and your Social Security benefit taxes.
More Money in Retirement Is a Good Problem to Have
Though having a large nest egg may cause some headaches after your retirement, it's important to remember that this is a better problem to have than facing retirement without enough savings. Just recognize that large amounts of money need to be properly managed and you need to stay on top of your financial life post-career. You can handle each of the financial problems that you may see with a larger retirement portfolio, as long as you are aware of them and prepared for them.
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