Participants Must Manage Tax Diversification

The J.P. Morgan Guide to Retirement is a major annual project for the retirement strategy and investing team at J.P. Morgan Asset Management.

This year the guide includes an extensive analysis of the Roth 401(k) retirement savings vehicle. Readers will surely know the basics about Roth retirement savings—that the accounts are populated with post-tax dollars in the interest of allowing tax-free withdraws once the saver has entered retirement. Generally, they make sense for lower-income workers (who expect to remain lower-income) or those just starting out their career, who are likely to be at their lowest level of annual earnings anticipated over their lifetime.  

But the guide lays out just how complex the task of actually analyzing an individual workers’ long-term tax picture can be. As an example, the guide points to an investor who has entered their peak earning years with a good health/longevity outlook. In the case that the individual has not generated significant retirement savings, it probably makes sense to take the traditional 401(k) route, because this will lower the person’s tax burden today while also taking advantage of the fact that, given their lower lifetime savings projection due to the late start, they will most likely be drawing less income annually in retirement.

Take the same individual and assume she has been a diligent saver up to this point and already has generated significant tax-deferred savings in a traditional 401(k)—for this person the better route may just be to make Roth contributions. The strategy won’t lower the current income tax burden, but it will start to generate crucial tax diversification for the individual, which can prove to be extremely valuable by the time retirement rolls around. 

Important to note alongside such considerations is that, however carefully considered one’s forward-looking tax plan may be today, there is real likelihood that Congress could move in the near- or mid-term future to reform the tax treatment of retirement savings. Against this backdrop, the J.P. Morgan analysis urges investors to take a deep dive into the interplay of pre- and post-tax retirement savings in a wide variety of scenarios. It might not hurt to have a Plan B or even a Plan C in mind should big changes to the Roth vs. traditional 401(k) structure make it into law.

The J.P. Morgan analysis points out one relatively unknown strategy that may help investors respond to big changes in the tax treatment of their savings: Proactive traditional-to-Roth conversions during lower income retirement years. The idea is that those folks already at retirement age with their assets concentrated in a traditional 401(k) or IRA can take advantage of proactive Roth conversions during lower income retirement years—especially in the case that required minimum distributions are likely to push the saver into a higher tax bracket in the near future.

Readers should note that multiple Roth accounts are treated as one Roth account for withdrawal purposes and distributions must be drawn in a specific order deemed by the IRS that applies regardless of which Roth IRA is used to take that distribution. Furthermore, taxes are due upon conversion of account balances not yet taxed.

The full 2017 Guide to Retirement, which also includes extensive analysis of retirement spending patterns, state taxes, and other topics, is available for download here.