People are presented with many different strategies to minimize taxes in retirement, Lena Rizkallah, a retirement strategist at J.P. Morgan Asset Management, said in a recent webcast, “The retirement Tax Cliff: Maximize Retirement Income While Managing Taxes.” For example, the Roth individual retirement account (IRA) has become an important tool to balance the need to use assets and limit taxes to whatever extent possible, she contends, pointing out that tax rates are likely to fluctuate depending on the source and total amount of income retirees draw in a given year.
The use of Roth accounts, structured as IRAs or 401(k)s, is gaining steam, Rizkallah says. “The rules have changed, making it easier for employers to implement them,” she says. Deferrals average around 4% to 5%. Similar to Roth IRAs, Roth 401(k)s accept after-tax contributions, but these accounts have no required minimum distributions (RMDs).
Leveraging tax deferral strategies has changed retirement planning, Rizkallah feels, and the old rule of thumb, in which the retiree withdraws first from taxable assets and then from tax-deferred accounts may not be the best strategy. In fact, there may be advantages to tapping retirement assets earlier than age 70½, using a Roth conversion to help minimize taxes in retirement.
To clearly illustrate how the traditional approach of taking withdrawals at the required minimum age of 70½ compares with a more proactive one—in which the investor takes early withdrawals from tax-qualified accounts, and invests some of the assets into a Roth IRA—Rizkallah describes three hypothetical married couples.
All three couples are the same age, all retiring at age 60, with a $1 million portfolio, split equally between a taxable account and an IRA or 401(k). Their holdings were allocated identically—30/70 in equities to fixed income—and they received an identical 5.2% estimated annual return.
All began to claim Social Security benefits at age 66 as maximum wage earners; all had an initial spending need of $75,000 and all drew from their taxable assets first. All died at exactly age 95, giving them all 30 years of retirement (and taxation) to plan for.
The variables came at the withdrawal stage of the retirement accounts. First, imagine a couple named Diana and Hector Gomez. The Gomezes tapped their taxable assets first, then waited until they were 70½ to begin taking the required minimum distributions. Using the traditional approach, according to Rizkallah, the marginal tax rate jumps to 15% at age 70½.
The next case study is a couple named Henrietta and Henry Henrickson. Between the ages of 60 and 69, they withdraw from the tax-deferred account within the existing tax rate, and make contributions to a taxable account, an approach that allows their tax rate to stay consistent throughout retirement.
Last, Gabriella and Giancarlo Zarelli tap their retirement assets and make Roth IRA conversions with the excess withdrawals, a strategy that keeps their tax rate at 10% throughout most of retirement.
At the end, the Zarellis wound up paying the lowest taxes ($53,000) and the Gomezes the highest ($293,000). The Henricksons didn’t do much better for taxes ($241,000). The Gomezes also wound up with the lowest ending wealth in their portfolio, at $1,573,387, and the Zarellis had the highest dollar figure ($1,907,073). The Henricksons ended up with $1,589,777.
Key conclusions of the JP Morgan Asset Management’s analysis are:
- Clients will continue using tax deferral as a main source of retirement saving;
- Tax planning is key as retirees navigate the complex tax codes;
- Even median-income retirees may face a marginal tax rate jump when they begin RMDs at age 70½;
- A Roth conversion can help significantly reduce taxes and provide estate planning benefits; and
- A proactive approach to retirement income can help clients to better diversify assets and provide a smooth tax experience in retirement.