Can your 401(k) account be too big?

Too much of a good thing can be wonderful, Mae West once said, but she definitely was not talking about tax-deferred savings accounts.

Why? For starters, workers under age 59 1/2 who have most of their savings locked up in a 401(k) or IRA generally will pay a hefty penalty, and extra taxes, in the event they need to withdraw funds for an emergency.

And for those already in retirement, too much saved in a traditional 401(k) can throw you into an unwanted higher tax bracket after age 70 1/2, when the government requires you to start taking money out and counts it as taxable income.

An overly large retirement account may seem like an issue only for the ultra-rich, but that is not the case, according to Larry Luxenberg, a principal at Lexington Avenue Capital Management.

"It's a problem for everybody," he said. "There are still people that have defined benefit pensions. They may also have Social Security. Once both spouses are claiming Social Security and if they have pensions, they are suddenly in a higher income bracket. They wouldn't consider themselves wealthy, but when they come into their 70s and take required minimum distributions, they would be paying taxes at a higher rate."

And that jump can be steep. One of the biggest increases in rates occurs when a married couple filing jointly has income over $74,900 (for 2015). At that point, their marginal tax rate goes from 15 percent to 25 percent. The next bracket applies to incomes over $151,200 for joint filers, but that increase is smaller, to 28 percent.

Younger savers who diligently put money away may also be vulnerable if they find themselves short on cash when they try to buy a home or face an emergency.

"For many people with nearly all their money in pretax accounts, it doesn't give them much flexibility if they have a sudden large need," said Stuart Armstrong, a certified financial planner with Centinel Financial Group.


There are ways, however, to mitigate the effects of too large a 401(k). One strategy is to use a qualified charitable distribution, which lets retirees donate as much as $100,000 of a required minimum distribution to charity. While you are not allowed to count it as a charitable deduction for tax purposes, it does not count as income, either.

Another option is to purchase a deferred annuity — often known as a longevity annuity. These start paying later in life, often at age 80 or 85, and protect you against running out of income. In addition, if you purchase the annuity with money from a 401(k), you generally can reduce your required minimum distribution. (Be careful, though: Fees on annuities can be high, and you need to be comfortable about waiting for the income to start. In addition, some experts warn that these annuities merely delay big required minimum distributions).

In addition to 401(k)s, you can build up savings in other types of accounts and draw on the one that makes the most tax sense at a given time.

Armstrong recommends a three-part retirement savings strategy: tax deferred accounts, like 401(k)s; after-tax accounts, like a Roth; and taxable investment accounts.

"The more those buckets are closer together in value, the more you are able to leverage tax brackets," he said. If, for example, the required minimum distribution from your 401(k) does not give you enough to live on, but taking more out of the account would bump you into a higher tax bracket, you could opt to use a different account.

A withdrawal from a taxable account does not count as income, though you would owe capital gains. And taking money out of a Roth account would be tax free.

Armstrong often advises clients to take advantage of years when their incomes are lower, like after they retire but before they reach age 70 1/2, to convert some tax-deferred retirement savings into a Roth account. You'll have to pay taxes on the converted amount, but after that, any gains and withdrawals will be tax free. Municipal bonds, which generally are free from federal taxes, are another way to build up savings that will not have a big effect on your tax bill.

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With more and more Americans relying on their own resources for retirement, there will be many who are financially unprepared, Armstrong said. Overfunding a 401(k) could become more common, he said, and the two issues are related.

Having most of a small amount of savings in a 401(k) "almost exacerbates the problem because they have to take the money out," he said.

The moral of the story: Save, but save carefully. It's not as simple as it seems.

— By Kelley Holland, special to CNBC