Is It Possible to Save Too Much for Retirement?
While some employees aren’t saving enough for retirement, some save too much in their plans and pay the price in penalties.
Current State of Saving
More than one-third of the U.S. population is unprepared for retirement, according to a poll by TechnoMetrica Institute of Policy and Politics. Thirty-six percent of Americans do not have savings earmarked for retirement, while 38 percent plan to work beyond age 65 to build their retirement portfolio. In addition, the number of 401(k) participants has not increased from an estimated 60 million Americans since 2017.
This is particularly poignant in that stock market gains have made many employees millionaires. According to Fidelity Investments, the number of 401(k) accounts with balances of at least $1 million or more has recently grown 74.5 percent. Plus, the average 401(k) held $129,300 at the end of the second quarter of 2021, up 24 percent from 2020; the average IRA was $139,000, a 21 percent gain.
These gains are in large part attributed to the run-up in the stock market: The S&P 500 rose 38.6 percent, while the Nasdaq Composite jumped 44.2 percent.
Too Much of a Good Thing
While many employees understand the power of a 401(k) and compound interest, ignoring Internal Revenue Service (IRS) tax law limits can kill gains that 401(k)s provide.
Encourage your employees to save as much as possible, but also to be aware of IRS annual limits:
- 401(k): In 2021, employees are allowed to save $19,500 annually in their workplace retirement plan. Employees who are 50 or older can take advantage of catch-up contributions of $6,500.
- Penalty: There is a 6 percent penalty for excess contributions and the penalty continues for each year that the excess contribution remains in the account. Also, an excess 401(k) contribution can trigger double taxation: The excess contribution and earnings are taxed when they’re withdrawn, but the contribution also is added to taxable income for the year the contribution was made.
- All retirement plans: An employee who is 49 or younger can contribute a maximum of $58,000 to all of their retirement plans in 2021. For those 50 and older, the limit is $64,500. No employee can contribute more than they earned.
If an employee or their spouse is covered by a retirement plan at work, the deduction may be reduced or phased out. This reduction goes until the deduction is eliminated. The amount of the deduction depends on the taxpayer’s filing status and their income. If neither the taxpayer nor their spouse is covered by a retirement plan at work, the phase-outs don’t apply.
These are the traditional IRA phase-out ranges for 2021 (allowable contributions are phased out from 100% to 0% in these ranges):
- $66,000 to $76,000 — Single taxpayers covered by a workplace retirement plan.
- $105,000 to $125,000 — Married couples filing jointly. This applies when the spouse making the IRA contribution is covered by a workplace retirement plan.
- $198,000 to $208,000 — A taxpayer not covered by a workplace retirement plan married to someone who’s covered.
Income phase-out ranges for taxpayers making contributions to a Roth IRA:
- $125,000 to $140,000 — Single taxpayers and heads of household.
- $198,000 to $208,000 — Married, filing jointly.
Not withdrawing funds: Employees must start to withdraw funds from their retirement accounts by April 1 of the year following the year they turn 72. Each year thereafter, distributions must be made by Dec. 31. If they’re still working at age 72 and their plan allows it, they can put off required minimum distributions from their 401(k), 403(b) or other defined-contribution plan until they retire (unless they own 5 percent or more of the business). However, these employees must start minimum withdrawals from previous employers’ plans as well as IRAs and self-employed retirement plans including SEPs and SIMPLEs.
- The IRS penalty is 50 percent of the amount that should have been withdrawn.
Employees who realize they made an excess contribution can withdraw the excess and any earnings associated with it to avoid the penalty as long as they do it before they file income taxes. However, the withdrawal will be taxed as income. If the money came from an IRA, the employee may owe a 10 percent early withdrawal penalty on earnings if they’re under 59 ½.
How Employers Can Help
To get a clear picture of how important saving for retirement is to your employees, look at your company’s 401(k) participation and savings rates. If they are low, you can help your employees take steps to make saving easier.
Education is key. Many employees are not saving because they are living paycheck to paycheck — not because they don’t make enough — but because they don’t have a budget or plan. Employees should encourage and hear success stories from people who have improved their financial situation by focusing on new and healthy habits like budgeting, saving for emergencies and eliminating debt.
Also talk to them about compound interest. For instance, if an employee starts saving $2,000 of their salary annually starting at age 22 — even if they stopped saving at age 30 — they’d have $1.6 million by age 65 (assuming future economic conditions resemble historical trends). That same employee would only have a little more than $1 million at retirement if they didn’t start saving until age 30, even if they kept saving $2,000 annually until the day they retired.
Many companies automatically enroll new employees in a 401(k) plan. The typical savings amount is 3 percent of each employee’s pay. Automatic enrollment has been successful in getting more employees to save in 401(k) plans, but employees should be encouraged to increase the amount of their savings annually.