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Published: Sep 28, 2017 8 min read
Photo illustration by Money; Getty Images (1)

It’s virtually impossible to save too much for retirement. While the 1% might worry about dying with too much cash on hand, the vast majority of folks are just trying to stash away some savings amid the daily grind.

But “is it possible to put too much money in a 401(k)? The answer is yes,” says Greg Geisler, professor of accounting at the University of Missouri-St. Louis.

If your entire nest egg winds up in a traditional 401(k) — or for that matter a traditional IRA — you could be setting yourself up for a higher tax bill in retirement.

That's because a fat 401(k) comes with a downside: In retirement, taxes are going to take a big bite out of any funds you withdraw to live on when you’re no longer earning a paycheck.

Say you're single and in the 15% federal income tax bracket in retirement, and you collect an average amount of Social Security benefits each month. If you withdraw an additional $10,000 from your traditional 401(k) or IRA, you’ll pocket only between $7,750 and $7,225, after paying between $2,250 and $2,775 in federal income tax, depending on how much of your Social Security benefits is subject to taxation, Geisler says. Subtract whatever you owe in state income tax on top of that, and you'll keep even less.

Money in a Roth IRA, by contrast, can be withdrawn tax-free in retirement. In other words, you pocket $10,000 of every $10,000 you withdraw from these accounts. That’s because in a Roth, you've already paid taxes on your contributions at the point of deposit.

Financial advisors generally recommend spreading your money around — diversifying not only the assets you own but also the types of accounts you hold those assets in.

Having a pot of tax-free funds in a Roth IRA or even a Roth 401(k) (if your employer offers one) can increase your financial flexibility in retirement.

Still, these vehicles remain relatively underused. Roth IRA assets represent just 8% of overall IRA assets, according to the most recent figures from the Internal Revenue Service. And 43% of firms that offer a traditional 401(k) don’t have a Roth option, according to Bank of America Merrill Lynch.

To figure out if a Roth is for you, here are some considerations to weigh at various stages of life.

When You’re Just Starting Out in Your Career

A Roth account makes sense for most young workers, says Matt Fellowes, founder and CEO of United Income, a money management firm focused on retirement. If you’re just out of college, you’re likely earning a starting salary in your profession. That mean you’re in a low income tax bracket—or at the least, a lower bracket than you’ll be as you get more established and your earnings grow.

In that case, it makes sense to pay taxes on some retirement savings now. You’ll pay them at a lower rate than you would later in your career, and you’ll enjoy decades of tax-free growth and tax-free withdrawals in retirement.

Of course, there are some exceptions. Professional athletes and start-up stars may see their earnings peak in their youth. But these high earners wouldn’t be eligible to contribute to a Roth in any case: the income threshold for contributing to a Roth (at any age) in 2017 is under $196,000 for married couples filing jointly and under $133,000 for singles or head of household filers.

If you have the option of a Roth 401(k), and your company offers matching contributions, then you may not need to open a Roth IRA, experts say. The annual contribution limits are higher for a 401(k) than an IRA, at $18,000 vs. $5,500 for both a traditional and a Roth IRA.

If you don’t have a Roth 401(k) option, a good rule of thumb is to put just enough money into your traditional 401(k) to get the company match, and then to put any additional savings into a Roth IRA.

At Mid-Career

The decision to contribute to a Roth gets a bit more complicated the further along you get in your career, Fellowes says.

For starters, mid-career workers may have serious expenses that increase the present value of the traditional 401(k) deduction. If your child’s college tuition bill is due, then you may want to pocket the tax savings now, rather than later.

Moreover, you’ll likely be nearing your career peak in terms of earnings, so your income tax bracket may be as high as it will ever be. You may want to take the deduction now on a traditional 401(k) contribution and then pay taxes in retirement, when you’re likely to be in a lower bracket.

Late in Your Career

In the late stages of your career, you might have a better idea of what your retirement tax bracket will look like. Do you expect to do some kind of paid work once you quit your main career? Do you plan to take Social Security at age 62, at 70, or at some point in between?

Advisors say it’s common for professionals when they stop working to drop from the 25% federal income tax bracket to the 15% bracket, whose upper limit is $37,950 for a single filer and $75,900 for couples filing jointly. But a drop is not a given: you might have some part-time work or rental income that could keep you up in that higher bracket.

And even if you do drop a bracket in early retirement, there’s a chance you’ll pop back up again when you reach your 70s, and the government requires you to begin withdrawing money from your traditional 401(k) or IRA. These are called required minimum distributions (RMDs), and they’re Uncle Sam’s way of finally getting a piece of money that’s grown tax-deferred for decades.

These RMDs increase every year and can push diligent savers (with large required minimum distributions) back up into the same tax bracket they were in before retirement.

Here’s where a Roth can really come in handy. If you’re able to dip into tax-free funds to cover necessary expenses, then you can remain in a lower bracket and save on your tax bill. These savings have a magnifying effect, Geisler notes, since extra taxable dollars can trigger higher income tax on Social Security benefits.

This story has been corrected to reflect the impact of increased taxation of Social Security benefits on the withdrawal of $10,000 from a traditional 401(k) or IRA in retirement.