NEW YORK (TheStreet) -- Prevailing wisdom holds that American workers will generally land in a lower tax bracket once in retirement. But many retirees find just the opposite and are surprised that a long-recommended asset-tapping strategy may actually nudge them into a higher tax rate. So much for prevailing wisdom.
Advisers have perennially suggested clients use taxable assets first for retirement income needs and draw from tax-deferred accounts such as IRAs and 401(k) plans last, in order to delay taxes on those plans as long as possible.
But according to Lena Rizkallah, a retirement strategist at J.P. Morgan Asset Management, many clients have been surprised just how much in taxes they end up paying, especially when required minimum distributions (RMDs) of tax-deferred accounts kick in at 70.5.
"That's when they see all of a sudden their tax rate goes up,” Rizkallah said. "And also a lot of their Social Security benefit is subject to tax because their income went up."
The leading edge of baby boomers is now approaching this "retirement tax cliff." For purposes of finding tax-efficient distribution alternatives, Rizkallah considered a married couple, with spouses of the same age who retire at age 60. Requiring a spending draw of $75,000 from a 30%/70% stocks/fixed-income portfolio of $1 million, the couple holds half of its assets in a taxable account and half in a tax-deferred account.
The study examined three scenarios:
A) Using the standard withdrawal strategy -- taxable withdrawals first, then RMDs from the tax-deferred account -- the couple remained in a 10% tax bracket until age 70.5. At that point "they kind of slithered into the 15% tax rate," Rizkallah says.
B) Using the same assumptions -- tapping the taxable account first, but also taking additional distributions from the tax-deferred account -- the couple takes only as much as possible from the tax-deferred account without getting bumped into the higher tax rate. The withdrawals exceeding the couple’s $75,000 spending level are reinvested in the taxable account.
C) Applying the same rules, except that the couple takes the extra tax-deferred withdrawals and converts them into a Roth IRA instead of reinvesting them in the taxable account.
In scenario B, by making early tax-deferred account withdrawals, the couple took less in RMDs later and saved $52,000 in taxes. With the Roth conversions used in strategy C, the couple saved $240,000 in taxes and ended up with more than $330,000 in additional wealth.
The hypothetical couple drew the same $75,000 income in all three instances but saw a drastically different impact to its remaining wealth, especially when utilizing the annual Roth IRA conversions.
"They were able to substantially minimize their taxes overall in retirement," Rizkallah noted. "And very importantly, their ending wealth was really key. At the end of the day they got [the same income], paid the least amount of taxes and ended up with the most amount of wealth."
It’s an elegant alternative to the traditional asset withdrawal strategy. But retirees seeking the most efficient distribution of their assets will also want to consider wealth-transfer issues, including the tax impact to a surviving spouse and other beneficiaries.
And tax-planning strategies are rarely a set-it-and-forget-it exercise. Future changes to the tax code are always possible and certainly unpredictable.