Think this is a rich man’s problem? It’s not. Shoven and Wise say ordinary savers could find themselves caught in a 401(k) trap. Consider a schoolteacher who starts working at the age of 25 with a $25,000 salary and invests 10 percent of her income each year in growth stocks with a 10 percent real rate of return. At 64, according to the study, she would have an account so large that she’d be penalized with an extra tax. An MBA who started with a salary of $50,000 but earned only an 8 percent real return would cross the threshold at the age of 62. ““Rather than taxes on the rich, these are much more widespread penalties placed on lifetime savers,’’ says Wise. Here are the lessons to be drawn from the report:
Don’t Stuff Your 401(k) Too Full If you think your retirement account will hold $1.6 million by the age of 50, or $1.4 million at 60, you’ll be better off sinking further savings into a non-tax-deferred account. Why? If the 401(k) gets bigger, your distributions are likely to be subject to a 15 percent excise tax once it’s reinstated in 2000. That doesn’t sound so bad. But when it’s levied on top of high federal and state income taxes, it’s a big bite. The total marginal rate for a Californian, for example, comes to 61.5 percent. If, instead, you save the excess in a tax-efficient investment, such as municipal bonds, a growth stock that doesn’t pay dividends or an index fund, you’ll be better off, even without the 401(k)’s tax-deferring advantage.
Escape While You Can Let’s say you’re already retired and will be a victim of the excise tax. Should you haul out a big lump of money between now and the year 2000, while the tax is suspended? Shoven and Wise say yes. They looked at two strategies for a 65-year-old with more than $2 million in a retirement account. One involved beginning withdrawals between the ages 65 and 69, to shrink the account beyond the excise tax’s reach, and reinvesting the proceeds in municipal bonds yielding 5.76 percent. The other called for keeping the account intact, in corporate bonds yielding 8 percent, until age 70^. At that point forced withdrawals would begin and be hit by the excise tax. By age 88, the early withdrawer has $88,156 more than the investor who waited. Escaping the excise tax, says Wise, ““significantly enhances the advantage of taking a large distribution.''
Don’t Die With Money in a Retirement Account If you’re a widow or single and have a net worth of more than $600,000, the effect of the excise tax on withdrawals is a mere mosquito bite compared with another levy: the ““excess accumulations’’ tax of 15 percent. Once again, it isn’t just the extra tax that hurts. It’s the battery of estate, income and excise taxes that a retirement account faces if it’s left in an estate. Here’s the shocking bottom line: your heirs might collect only 10 or 15 cents of the last dollars you stowed away. Shoven and Wise found marginal rates that ranged as high as 92 percent to 96.5 percent. ““Many people in this position don’t have a clue about what’s going on,’’ reports Stephen Corrick, a tax partner at Arthur Anderson in Washington. How much is too much? Right now, anything more than $1.2 million at age 65 or $955,358 at age 75. The penalty for dying with too much money in a retirement account is so high that it almost always makes sense to downsize the account. And now’s the time to do it.
