Many Americans are shocked to see their taxes in retirement are considerably higher than anticipated. The culprit is often called the retirement "tax cliff" -- an unintended result of maximizing tax-deferred accounts that may lead to an abrupt increase later in both income and income taxes.

Since the late 1970s, clients have used tax-deferred plans like 401(k)s and IRAs to save a substantial amount of their wealth for retirement. Early in retirement, many retirees tap taxable accounts for income, allowing their tax-deferred assets to continue to grow.

Yet as more wealth is deferred, required minimum distributions may become larger. Now, as baby boomers approach age 70½, they must begin taking RMDs from their tax-deferred accounts. But they should closely evaluate their potential tax burden as they begin to withdraw their retirement savings.

To help financial advisors address the tax cliff with clients, the J.P. Morgan Individual Retirement team wanted to consider three questions:

  • Is the old rule of thumb -- withdraw from taxable assets first and then from tax-deferred accounts -- the best way to access retirement income?
  • Are there advantages to tapping retirement assets sooner than age 70½?
  • Could a Roth conversion help clients minimize taxes in retirement?

3 COUPLES, 3 APPROACHES

To answer these questions, we tested three approaches to retirement income tax planning by creating three different hypothetical couples; we assumed they were middle class and had the same portfolios.

  • Couple A took the traditional approach, waiting until age 70½ (when mandatory distributions begin) to tap tax-deferred assets. In the earlier part of retirement, they relied on income from taxable assets and later, Social Security benefits, to satisfy their spending need.
  • Couple B used their taxable portfolio to meet spending needs early in retirement, but they also strategically tapped tax-deferred assets. At the end of each year, they determined how much room they had within their existing tax bracket; based on that, they made a withdrawal from their tax-deferred accounts and invested it in the taxable portfolio, allowing for continued growth.
  • Couple C systematically converted a portion of their traditional IRA or employer-sponsored retirement plan into a Roth IRA every year.

Here's how it worked out:
While Couple A experienced minimal tax consequences early in retirement, once they began RMDs at age 70½, the increased income from the required distributions automatically pushed them into a higher tax bracket. In addition, more of their Social Security benefits became subject to taxation.

When RMDs began for Couple B, their mandatory distributions were smaller than they would have been had the couple not made earlier withdrawals from their tax-deferred accounts. They were able to meet their spending needs with Social Security benefits, taxable assets and RMDs, and still maintain a taxable account that could serve as a savings cushion throughout retirement. Diversifying their retirement asset mix put Couple B in a better position to reduce overall lifetime income taxes. Their tax experience remained relatively consistent throughout retirement.

Couple C also used taxable assets and Social Security benefits to meet their spending needs early in retirement. But they also took strategic, earlier withdrawals from tax-deferred accounts -- and unlike Couple B, they moved those funds into a Roth IRA, building up that account over time. If they had an unexpected need for income retirement, they could draw from a range of assets, including taking qualified tax-free distributions from their Roth IRA, provided the assets had been in the account for at least five years.

The tax implications of this third approach are compelling. By carefully controlling their withdrawals and moving early withdrawals to a Roth IRA, Couple C was able to meet their spending needs while minimizing their tax income liability throughout retirement. Retirees who use early withdrawals to contribute to a Roth IRA may have a greater opportunity to diversify asset location, minimize lifetime RMDs and limit their overall income tax liability.

Individuals need careful, comprehensive tax planning as they approach retirement. The traditional approach -- tap taxable assets before tax-deferred accounts and wait until age 70½ to take distributions -- may not be the most effective strategy for everyone. More proactive approaches may better diversify income sources, meet spending needs and manage taxes in retirement.

As our research shows, by taking early withdrawals from tax-deferred accounts and reinvesting in a taxable account, or converting to a Roth IRA, individuals may optimize their retirement outcome and avoid the pain of the retirement tax cliff by reducing tax liability, diversifying retirement assets and expanding legacy planning benefits.

Lena Rizkallah, J.D. is a retirement strategist at J.P. Morgan Asset Management specializing in tax policies and the author of the Beware the Retirement Tax Cliff research study.

Read more: