Financial Planners Can Help Clients from Falling Off the Tax Cliff

Lena Rizkallah, J.D, a retirement strategist at J.P. Morgan Asset Management recently published results of a test to determine how financial planners can best advise clients on retirement accounts. The test was compiled as a way to address the tax cliff that many Americans face once they begin receiving payments from tax-deferred accounts.

The tax-cliff is experienced when the retiree’s income suddenly increases considerably once payments from retirement accounts begin, which in turn causes income tax to increase. Financial advisors have long been advocates for tax-deferred retirement accounts, as those Americans that have saved have continued to build tax-deferred assets.

The experts are now questioning if tax-deferred is the best way to go for retirement savings because of the tax implications later in life, so they created three hypothetical test couples.

  • Couple A waited until the mandatory distribution age of 70½ to withdraw from their tax-deferred accounts, receiving income from Social Security and taxable accounts before that time.
  • Couple B used a combination of taxable and tax-deferred accounts and withdrew from tax-deferred accounts early in retirement as their tax-bracket allowed.
  • Couple C transferred portions of a standard IRA and rolled it into a Roth IRA on an annual basis.

The results were that Couple A had the highest overall tax consequences based on their savings strategy. Their taxes were nominal in the beginning of retirement but as their distributions increased, so did their taxes.

Couple B took a diversifying approach and had the most consistent taxes during retirement. Their mandatory tax-deferred distributions remained smaller by making withdrawals only as needed in combination with regular taxable accounts.

Couple C was able to minimize tax fluctuations by distributing funds between a traditional account and a tax-deferred account.

Overall results conclude that financial planners need to be more proactive in recommending the diversification of retirement savings accounts to ensure clients are able to avoid the tax cliff that is plaguing so many.