INVESTMENT INSIGHTS RETIREMENT IN BRIEF. PORTFOLIO DISCUSSION Beware the retirement tax cliff. February 2015

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1 INVESTMENT PORTFOLIO DISCUSSION February 215 IN BRIEF More and more Americans are taking advantage of tax-deferred accounts for their retirement savings. Tax-deferred savings in 41(k) plans and individual retirement accounts (IRA) now represent a significant portion of the $27 trillion in total assets that Americans have saved for retirement. In the past, Americans planning for retirement widely assumed that their tax liability would decrease once they left the workforce. But today many retirees are surprised to discover how much they must pay in income taxes. The old rule of thumb tap taxable assets before tax-deferred accounts and wait until age 7½ to begin distributions may not always be the best choice. Income may increase at that time, causing taxes to suddenly spike, resulting in the retirement tax cliff. Other strategies may better diversify income sources, meet spending needs and manage taxes in retirement. Including a Roth IRA or a Roth 41(k) account as part of an individual s retirement income strategy may help reduce total taxes paid in retirement, diversify assets and provide estate planning benefits. In 215, the eldest baby boomers turn 69 years old. Born into post-war American prosperity, they came of age in the 196s. Today they stand as the first generation to have had 3-plus years to save in tax-deferred vehicles such as defined contribution plans and IRAs. AUTHOR Lena Rizkallah, J.D. Retirement Strategist J.P. Morgan Asset Management Legislation enacted in the 197s made tax-deferred saving more accessible. IRAs were first introduced in 1974 as part of ERISA (Employee Retirement Income Security Act), and after 41(k) legislation was signed into law in 1978, more employers began formalizing their supplemental savings plans. As more companies began restricting or eliminating their pension plans and encouraging workers to save using 41(k)-type plans, this prompted a shift in retirement savings, from defined benefit to defined contribution plans. Since that time, growing ranks of Americans have used taxdeferred accounts to build their retirement nest eggs. As the first wave of baby boomers (the generation of Americans born ) approaches age 7½, when they must begin required minimum distributions (RMD) from their tax-deferred accounts, they should closely evaluate their potential tax burden in retirement. In the past, Americans planning for retirement widely assumed that their taxes would decline once they left the workforce. But in recent years many retirees have been surprised to discover they owe more in taxes than they had originally anticipated. As they look to maximize their retirement income while minimizing their taxes, many Americans may consider converting some portion of their tax-deferred savings to a NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 PORTFOLIO DISCUSSION: Title Copy Here Roth IRA. Though some investors may dismiss Roth conversions because of the immediate tax consequences (pretax conversion amounts are includable in an individual s gross income in the year of conversion), they are more often considered to be an estate planning strategy. Roth conversions deserve a second look, however, as they may be an effective way for individuals to diversify assets and provide both taxfree income in retirement and legacy planning benefits. This paper presents a framework for evaluating income strategies and income tax management in retirement. In the following pages, we: analyze whether the old rule of thumb tap taxable assets before tax-deferred accounts, wait until 7½ to take distributions is the best choice for everyone explore strategies to diversify income sources, meet spending needs and manage taxes in retirement examine when and how to use Roth IRAs and Roth 41(k)s to diversify an individual s income tax picture use case studies to demonstrate the impact of different tax planning strategies The shift in retirement saving As more U.S. employers have eliminated defined benefit plans over the past few decades, more and more Americans are using tax-deferred accounts, including 41(k)s, traditional IRAs and annuities, to save for retirement. In 1979, 62% of workers who had access to a retirement plan participated only in a DB plan, but by 211 that percentage had fallen to 7%. In 1979, 16% of workers who had access to DC plans participated in those plans; by 211 that increased to 69%. 1 Tax-deferred savings in 41(k)s and IRAs now represent the lion s share of U.S. retirement assets, which surpassed $27 trillion in 214 (Exhibit 1). The portion of U.S. retirement assets held in IRA accounts is expected to increase in the coming years. Rollovers from 41(k)s and other employer DC plans account for a substantial portion of IRA wealth, and as more people move assets from DC plans and retire, IRA assets will continue to grow. In 215, estimates project that IRA rollovers will reach $443 billion annually and the total value of IRA assets will increase by 9.4%. 1 Employee Benefit Research Institute: Private-Sector Workers Participating in an Employment-Based Retirement Plan, by Plan Type, Tax-deferred savings in 41(k)s, IRAs and rollover IRAs represent the lion s share of U.S. retirement assets EXHIBIT 1: GROWTH OF U.S. RETIREMENT ASSETS, The mix of retirement assets Not surprisingly, the mix of retirement assets varies depending on overall household wealth (Exhibit 2). Wealthier households have a more varied range of assets EXHIBIT 2: ESTIMATES OF TYPES OF RETIREMENT INCOME SOURCES FOR HOUSEHOLDS APPROACHING RETIREMENT Percent Private DB assets Public DB assets DC IRA assets Annuities outside retirement accounts Long-term mutual funds outside retirement accounts Social Security DB plans DC & IRA assets Other assets retirement assets: $27.4trn MF ex-retirement: $5.trn Annuities: $1.5trn IRA assets: $7.1trn DC assets: $6.1trn Public DB: $4.8trn Private DB: $2.9trn $ Source: J.P. Morgan Asset Management analysis, ICI, Cerulli. Long-term mutual funds excludes money market funds. Net housing wealth * Approximate average level of augmented wealth in 26 for augmented wealth quintile, which includes estimates of Social Security and DB benefits as assets Note: Households with the top and bottom 1% of wealth are excluded. Social Security wealth is estimated as the present discounted value (PDV) of the stream of Social Security benefits. Net housing wealth is the value of the home less mortgages. DB pension wealth is estimated as the PDV of the stream of DB benefits. Retirement assets include DC plan assets (41(k), 43(b), 457, thrift and other DC plans) and IRAs (traditional, Roth, SEP, SAR-SEP and SIMPLE). DB pension and retirement assets are derived from work in both the private and government sectors. Source: Investment Company Institute tabulation derived from Gustman, Steinmeier and Tabatabai (29) using Health and Retirement Study (HRS) data Bottom Second Third Fourth Top $93,5* $294,* $543,* $94,* $2,,* $4 $35 $3 $25 $2 $15 $1 $5 Trillion 64 2

3 Most people in retirement can draw income from several different sources, with the source mix typically varying according to wealth level EXHIBIT 3: SOURCES OF RETIREMENT INCOME Retirement Income Social Security Pension Plans Individual Savings Full benefits at Full Retirement (FRA) Benefits available earlier or later than FRA Up to 85% of benefit may be taxable subject to income thresholds Defined benefit Defined contribution (Traditional/Roth) Required Minimum Distributions (RMDs) at age 7½ IRA rollovers may be allowed Distributions are taxable unless qualified Roth withdrawal (tax free) IRAs & annuities Taxable savings Tax-free savings Withdrawals at any time IRAs and annuities are subject to 59½ and RMD rules Depending on type of asset, withdrawals may be subject to tax U.S. households in the lower wealth quintiles rely primarily on Social Security for retirement income and hold very little savings in retirement or taxable accounts; in fact, 5% of households have no savings in retirement accounts. Wealthier households rely much less on Social Security for retirement income and have a more varied mix of assets, including tax-deferred and taxable assets. While wealthier households can better afford to maximize savings in taxdeferred plans when compared with their less wealthy counterparts, eventually income thresholds and annual contribution maximums limit the amount they can hold in tax-deferred accounts. As a result, their savings beyond tax-deferred accounts tend to be more concentrated in taxable and tax-free opportunities than is the case for less affluent households. Whatever the mix of retirement income sources, it is important to consider how and when to draw on those sources as the timing, restrictions and tax consequences can be critical to maximizing income and minimizing taxes in retirement (Exhibit 3). Ideally, retirees should have a wide range of assets that they can tap for income. These assets may include Social Security benefits, defined benefit and defined contribution plans and other forms of savings, including tax-deferred, taxable and tax-free accounts. Because tax treatment varies across account types and investments, withdrawals from each asset category should be carefully considered for tax diversification purposes. A more diversified mix of assets will offer greater opportunities to optimize income and wealth and to manage taxes. While tax-deferred assets often have income limitations or age restrictions on the timing of withdrawals, they also provide a benefit by sheltering income-producing investments from current income taxation. This could potentially result in greater long-term growth than if investments were held in taxable accounts. Generally, the longer the holding period, the more valuable and tax efficient is the tax deferral. That is one reason the traditional rule of retirement saving wait until age 7½ to begin distributions has become so well entrenched (Exhibit 4). Retirees typically wait until they are 7½ to access their tax-deferred savings accounts EXHIBIT 4: PERCENTAGE OF TRADITIONAL IRA-OWNING HOUSEHOLDS THAT DID NOT TAKE WITHDRAWALS IN TAX YEAR 212 Not likely at all 39% Source: ICI IRA owners survey. Not very likely 27% Very likely 16% Somewhat likely 18% J.P. Morgan Asset Management 3

4 PORTFOLIO DISCUSSION: Title Copy Here Diversifying retirement assets with Roth conversions Roth IRA conversions have become much more popular since the income limitations on their use were eliminated in 21. However, while most Americans appreciate the advantages of saving in taxdeferred accounts, many are wary of the immediate tax consequences that may result from the conversion of traditional IRA assets to a Roth IRA. In general, pre-tax amounts converted to a Roth IRA will be includable in the individual s gross income in the year of conversion. But by taking a pragmatic, methodical approach, a Roth conversion may help to diversify the various components of an individual s income tax and estate planning profiles. In addition, recent changes in legislation have made Roth 41(k)s more accessible to workers, and they can provide tax planning benefits in retirement. Although Roth IRAs and Roth 41(k)s share similar features for the most part, there are several key differences between the two saving vehicles. In 21, the income limits for converting a traditional IRA to a Roth IRA were eliminated, but income limits remain for individuals who wish to make contributions to a Roth IRA. For 215, married couples who wish to make contributions to a Roth IRA may do so if their modified adjusted gross income (MAGI) is less than $183, ($116, for single filers). Phase-outs on contribution amounts begin above that level. In contrast, Roth 41(k)s are not subject to any income limitation and anyone can contribute to a Roth 41(k) if it is offered by his/her employer. In addition, Roth 41(k)s are subject to RMDs, but Roth IRAs are not. That is a key reason it may make sense to roll over the balance of a Roth 41(k) into a Roth IRA before age 7½ it provides greater flexibility and may reduce income tax liability overall. More employers are offering Roth 41(k)s; in 212, 53% of employer plans offered a Roth 41(k) component and about one in five employees with a Roth 41(k) option contributed to a Roth 41(k). As more employers offer Roth 41(k) options and as workers recognize the benefits of Roth accounts, the number of Roth IRA accounts is expected to increase in the coming years, reflecting both IRA conversions and rollovers out of Roth 41(k)s. The retirement tax experience In the past, when individuals relied mainly on distributions from defined benefit plans for their retirement income, they could anticipate what their income tax liability would be and assume that it would remain fairly consistent throughout retirement. This can be seen in Exhibit 5A. Many pre-retirees assume that they will be in a lower tax bracket in retirement than they were in their working years but their tax bracket rises instead EXHIBIT 5: A COMPARISON OF RETIREMENT TAX EXPERIENCES 5A: TAX EXPERIENCE FOR DEFINED BENEFIT PARTICIPANTS Tax bracket Tax bracket Pension distributions Social Security benefits 7½ 7½ RMDs 5B: TAX EXPERIENCE FOR DEFINED CONTRIBUTION PARTICIPANTS Tax bracket 62 Withdrawals from taxable accounts Social Security benefits 7½ RMDs 5C: HYPOTHETICAL TAX EXPERIENCE INCORPORATING PRE-7½ RETIREMENT WITHDRAWALS Withdrawals from tax-deferred accounts Withdrawals from taxable accounts Social Security benefits RMDs J.P. Morgan research, presented in a paper titled The Importance of Being Earnest, found that people can control taxes early in retirement when they can match gains and losses, invest in tax-free securities such as municipal bonds and pay much lower capital gains taxes on qualifying dividends and long-term gains in their portfolio when harvested to meet lifestyle expenses. Once RMDs begin, they are often pushed into higher tax brackets and incur more tax liability than they anticipated. As more wealth is deferred, RMDs potentially become larger. This leads to what some call the retirement tax cliff, an unintended result of maximizing taxdeferred accounts, resulting in an abrupt increase in income and income taxes. The tax cliff is illustrated in Exhibit 5B. Following up on our initial research, we set out to analyze under what circumstances people can avoid the tax cliff and 4

5 Case studies: Same profiles, different approaches EXHIBIT 6: THREE APPROACHES TO RETIREMENT TAX PLANNING Couple A Couple B Couple C Married couple, same age, retire at age 6 $1 million portfolio, 5/5 split between taxable account and IRA/41(k) Invested 3/7 in equity/fixed income, 5.2% estimated annual return Begin claiming Social Security at age 66 (full retirement age) Social Security benefit based on one maximum wage earner plus spousal benefit Initial spending need: $75,, grown by 1.5% annually Draw from taxable assets first Wait until age 7½ when RMDs begin Withdraw amount from tax-deferred account within existing tax rate from age 6 69 N/A Reinvest excess withdrawal in taxable account Convert excess withdrawal into Roth IRA and taxable account have a smoother tax experience in retirement. What is the appropriate mix of assets, and what is the best strategy on the timing of distributions, to help retirees meet their spending needs, manage taxes and maximize the legacy left to their beneficiaries? This optimal retirement result is illustrated in Exhibit 5C, on the previous page. Case studies To answer these questions, we tested three approaches to retirement income tax planning, each of which was implemented by a different couple with similar profiles (Exhibit 6). Couple A took the traditional approach of waiting until age 7½, when mandatory distributions begin, to tap tax-deferred assets to meet spending needs. Couple B adopted the early withdrawals/taxable approach of taking early withdrawals and investing in a taxable account. Couple C adopted the early withdrawals/roth conversion approach by systematically converting a portion of their traditional IRA or employersponsored retirement plan into a Roth IRA every year. Couple A: Evaluating the traditional approach Like many baby boomers, Couple A diligently saved for retirement using tax-deferred accounts, following the common practice of tapping taxable assets in early retirement in order to allow tax-deferred assets to grow. At age 7½, their required minimum distributions began. The result? As Exhibit 7 illustrates, Couple A utilized a mix of retirement income sources. In early retirement they relied on income from taxable assets (in blue), and later, Social Security benefits (in gray), to satisfy their spending need (the bold black line). Mandatory distributions from tax-deferred Using the traditional approach, Social Security benefits and withdrawals from taxable accounts help meet Couple A s spending needs until age 69 EXHIBIT 7: A TRADITIONAL APPROACH: TAXABLE ASSETS TAPPED FIRST, RMDs BEGIN AT AGE 7½ Withdrawal amount (USD) 2, 18, 16, 14, 12, 1, 8, 6, 4, 2, Taxable withdrawal Social Security benefits RMD Total federal taxes Tax-deferred portfolio (end of year) Taxable portfolio (end of year) Spending need 1,6, 1,4, 1,2, 1,, 8, 6, 4, 2, Portfolio value (USD) J.P. Morgan Asset Management 5

6 PORTFOLIO DISCUSSION: Title Copy Here accounts began at age 7½ (in orange). Because the couple relied mainly on taxable assets early in retirement, their taxable account was depleted by age 69 (blue line). By age 78, their RMDs exceeded their annual spending needs and they were able to reinvest the excess RMDs into their taxable account, enabling it to grow. The tax implications of this traditional approach can be seen in Exhibit 8. Although Couple A experienced minimal tax consequences early in retirement, once they began RMDs at age 7½, the increase in 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 (as shown in gray). The approach taken by Couple A concentrating the bulk of retirement wealth in tax-deferred accounts and waiting until RMDs are required to withdraw money from those accounts tends to limit options for tax diversification. For many, this approach may lead to increased realized income in later years, high income taxes overall and a greater share of Social Security benefits subject to taxation. Couple B: Evaluating the early withdrawals/ taxable approach Couple B, hoping to avoid a sudden increase in taxation at age 7½, first meet with their tax advisor to determine their top marginal tax bracket (the top tax rate they would pay for an extra dollar of income). This enables them to estimate how much additional income they can receive before they are bumped into a higher tax bracket. They then determine how much to withdraw from their tax-deferred account, money that they will reinvest in a taxable account. As Exhibit 9 (next page) shows, while Couple B continues to use taxable accounts to meet spending needs early in retirement, they also strategically tap tax-deferred assets and reinvest the proceeds into a taxable account (in lavender). They draw on their taxable portfolio throughout the year for spending needs. At the end of the year, they determine how much room they have within their existing tax bracket in order to make a withdrawal from their tax-deferred accounts. That amount is then invested in the taxable portfolio, allowing for continued growth of the account. Beginning RMDs at age 7½ leads to a higher tax rate and causes more Social Security benefits to become subject to taxation EXHIBIT 8: TAX IMPLICATIONS OF A TRADITIONAL APPROACH: MARGINAL TAX RATE JUMPS TO 15% AT AGE 7½ Ordinary investment income Tax-deferred withdrawal Taxable Social Security benefits Tax rate 2, Adjusted gross income (USD) 15, 1, 5, Source: J.P. Morgan Asset Management. Note: Does not include capital gains income since it is taxed differently. For illustrative purposes only. 15% 1% Standard Deduction 6

7 When RMDs begin at age 7½, the value of Couple B s tax-deferred holdings is lower than it would have been had they not made earlier withdrawals from tax-deferred accounts, and this helps to reduce their total tax liability EXHIBIT 9: EARLY WITHDRAWALS/TAXABLE APPROACH: EARLY WITHDRAWALS FROM TAX-DEFERRED ACCOUNTS, EXCESS OVER SPENDING NEEDS INVESTED IN TAXABLE ACCOUNTS Withdrawal amount (USD) 2, 18, 16, 14, 12, 1, 8, 6, 4, 2, Taxable withdrawal Tax-deferred withdrawal Social Security benefits RMD Total federal taxes Tax-deferred portfolio (end of year) Taxable portfolio (end of year) Spending need ,6, 1,4, 1,2, 1,, 8, 6, 4, 2, Portfolio value (USD) When RMDs begin, their mandatory distributions are smaller than they would have been had the couple not made earlier withdrawals from tax-deferred accounts. They are able to meet their spending needs with Social Security benefits, taxable assets and RMDs, and still maintain a taxable account that can serve as a savings cushion throughout retirement. What are the tax implications of this approach? Couple B s tax experience remains relatively consistent throughout retirement (Exhibit 1). They begin retirement in the 1% tax bracket, moving into the 15% bracket in their early 7s. Because they diversified their retirement asset mix, they are in a better position to reduce overall lifetime income taxes. Retirees who strategically tap tax-deferred accounts early in retirement and reinvest the assets in a taxable account appear to be better able to avoid the sudden increase in income at age 7½. Over the course of their retirement they may more effectively control their level of income and manage their tax liability. Because Couple B is able to diversify their retirement asset mix, their lifetime taxes are minimized EXHIBIT 1: TAX IMPLICATIONS OF EARLY WITHDRAWALS/TAXABLE APPROACH: A CONSISTENT TAX EXPERIENCE THROUGHOUT RETIREMENT Ordinary investment income Tax-deferred withdrawal Taxable Social Security benefits Tax rate 2, Adjusted gross income (USD) 15, 1, 5, % 1% Standard Deduction J.P. Morgan Asset Management 7

8 PORTFOLIO DISCUSSION: Title Copy Here Through retirement, Couple C maintains a Roth account that grows and from which they can eventually make tax-free withdrawals EXHIBIT 11: PROACTIVE APPROACH WITH ROTH CONVERSION: EARLY WITHDRAWALS FROM TAXABLE AND TAX-DEFERRED ACCOUNTS ARE USED TO PAY TAXES, REMAINDER CONVERTED TO ROTH IRA Withdrawal amount (USD) 2, 18, 16, 14, 12, 1, 8, 6, 4, 2, Taxable withdrawal Tax-deferred withdrawal Social Security benefits RMD Total federal taxes Tax-deferred portfolio (end of year) Taxable portfolio (end of year) Spending need Roth portfolio (end of year) ,6, 1,4, 1,2, 1,, 8, 6, 4, 2, Portfolio value (USD) Couple C: Evaluating the early withdrawals/ Roth conversion approach Like Couple B, Couple C aims to avoid the tax cliff, the sudden spike in taxes at age 7½. Like Couple B, they adopt a proactive approach, taking early withdrawals from their taxdeferred accounts up to the level that would push them into a higher tax bracket. But instead of investing those tax-deferred assets in a taxable account as Couple B did, they convert the assets to a Roth IRA. The result can be seen in Exhibit 11. By establishing a Roth IRA, Couple C is able to optimize and vary their retirement assets. Early in retirement, they use their taxable assets and Social Security benefits to meet their spending needs. At the same time, they take early withdrawals from tax-deferred accounts and convert those amounts to a Roth IRA, building up their Roth IRA account over time (lime green line). If they have an unexpected need for income during retirement, they can draw from a range of assets, including taking qualified tax-free distributions from their Roth IRA. The tax implications of this approach are compelling (Exhibit 12). Retirees who use early withdrawals to convert to a Roth IRA may have a greater opportunity to limit their overall income tax liability EXHIBIT 12: PROACTIVE APPROACH WITH ROTH CONVERSION: A STEADY TAX RATE THROUGH RETIREMENT 2, Ordinary investment income Tax-deferred withdrawal Taxable Social Security benefits Tax rate Adjusted gross income (USD) 15, 1, 5, % 1% Standard Deduction 8

9 By converting early withdrawals to a Roth IRA, Couple C is able to remain in the 1% tax bracket throughout retirement, even into their 9s. As their experience illustrates, retirees who use early withdrawals to convert to a Roth IRA will have a greater opportunity to diversify assets, minimize lifetime RMDs and limit their overall income tax liability. Putting it all together: Case study lessons Exhibit 13 presents an overview of the three couples we have profiled, highlighting the income tax, wealth and lifetime RMD implications of their different strategies. EXHIBIT 13: THREE COUPLES COMPARED: TAX, WEALTH AND LIFETIME RMD IMPLICATIONS OF THEIR DIFFERENT STRATEGIES Total income taxes paid in retirement Couple A Couple B Couple C $293k $241k $53k Because Couple A waited until age 7½ to begin withdrawals from their tax-deferred accounts, they received the most RMDs of the three couples, paid the most in taxes and experienced a notable increase in tax liability when they started RMDs. Couple B avoided the tax cliff by taking early withdrawals and reinvesting the funds in their taxable account at the beginning of retirement. Compared with Couple A, they received almost half the total RMDs, paid $5, less in taxes overall and had a slightly higher taxable account at the end of retirement. By proactively converting tax-deferred accounts to a Roth IRA on an annual basis, Couple C did the best job of diversifying retirement assets from an income tax perspective. This allowed them to realize significant tax savings. They paid a total tax bill of $53,, which is one-fifth of what Couple B paid and one-sixth of what Couple A paid. Couple C also received the least amount of lifetime RMDs. Finally, they were able to maximize their estate, the bulk of which was in a Roth IRA account. Portfolio Ending value ($) Ending value ($) Ending value ($) Taxable 1,79,944 1,311,15 157,192 Tax deferred 493, , ,162 Roth N/A N/A 1,553,719 Total ending wealth 1,573,387 1,589,777 1,97,73 Total RMDs 1,335,49 743,734 52,255 Like the three couples in our case studies, many baby boomers have done an excellent job of maximizing retirement savings in tax-deferred accounts. The ongoing tax deferral during the accumulation phase allows assets to grow more quickly and provides a healthy nest egg in retirement. But because there is an embedded tax bill owed on these accounts the tax is deferred, not eliminated the manner in which IRA withdrawals are made can have a significant effect on the size of that cumulative tax bill. In short, disciplined saving in tax-deferred accounts may result in limited income distribution options and an increase in income taxes in retirement. Legacy considerations Legacy considerations often play a role in retirement tax planning. Keeping the bulk of wealth in a mix of tax-free and taxable accounts may be more advantageous for beneficiaries from a tax and flexibility perspective. With a taxable account, a beneficiary may receive a step-up in basis (the market value of an asset at the owner s death) and no RMDs are required. These factors provide the beneficiary with more flexibility and potentially lower tax liability. A Roth IRA allows a beneficiary to receive tax-free RMDs after the owner s death, a considerable tax benefit. For tax-deferred accounts, distribution options are limited for non-spousal beneficiaries. A non-spousal beneficiary can withdraw the entire balance immediately in a lump sum; he can withdraw it within five years; or he can stretch out the withdrawals over the course of his lifetime. Distributions are taxable at the beneficiary s ordinary income tax rate. J.P. Morgan Asset Management 9

10 PORTFOLIO DISCUSSION: Title Copy Here Conclusion: People nearing or in retirement should consider multifaceted, dynamic tax planning Individuals will need careful, comprehensive tax planning as they approach retirement. The traditional approach tap taxable assets before tax-deferred accounts and wait until age 7½ to take distributions may not be the most effective strategy for everyone. Other options 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, an individual may optimize his/her retirement outcome by reducing tax rates, diversifying assets and expanding estate planning benefits. As our case studies have underscored, individuals across the income spectrum should take a multifaceted, dynamic approach to retirement tax planning. CASE STUDY ANALYSIS: TAX ASSUMPTIONS AND MODELING While Congress is debating various proposals to overhaul or simplify the tax code, our case study scenarios assume that no drastic change in the code will be made in the near future. Our model applies the prevailing tax code to retirement cash flows with a 2.5% inflation rate for an increase in tax rates and in the Social Security annual cost of living adjustments. Each analysis incorporates a Social Security benefit at full retirement age (FRA). The benefit is based on one maximum wage earner plus the spousal benefit, which is 5% of the working spouse s FRA. In the taxable account, we assume that 8% of equity gains in after-tax savings accounts are realized each year. The effective federal tax rate in retirement is always less than 5%. In all three scenarios, we used the standard deduction (married), personal exemption (x2) and elderly deduction (x2). No other deductions were taken. In addition, these scenarios did not incorporate the alternative minimum tax (AMT) or Medicare surtax. The households in each scenario do not have any sources of earned income in retirement, although many median income families over age 65 will have additional cash flow in the form of earned income. For Couples B and C, we assumed the maximum time horizon for taking proactive distributions from tax-deferred accounts without penalty (i.e., ages 6-7). Both couples retired earlier than the median U.S. retirement age (age 65). We note that most individuals will have less than a decade between actual retirement and the age to begin taking mandatory distributions (age 7½), during which time it may make sense to take proactive distributions. In addition, if there is earned household income during the period, proactive strategies may not be as effective as they are in our case studies. 1

11 TRIGGERING THE 3.8% MEDICARE SURTAX Although Roth distributions do not affect an individual s modified adjusted gross income (MAGI), and Roth and retirement distributions are not considered net investment income that would be subject to the 3.8% Medicare surtax, certain strategies may trigger the surtax (see diagram below). Individuals should be aware that excess withdrawals or Roth conversions from taxdeferred plans could bump income past the income thresholds. To the extent an individual has net investment income and her MAGI for that year exceeds income thresholds, the surtax may be applicable (see the middle column below, MAGI, single ). Note that these triggers could also cause Medicare premiums to increase should total income exceed Medicare thresholds. The MAGI thresholds for individuals to pay the standard premium amount for Medicare are $85, (single filers) and $17, (married filing jointly) or below. Income thresholds Single: $2, Married: $25, MAGI, single: $17, $2, income threshold Net investment income Capital gains Interest Royalties and rents Annuity distributions Current MAGI: Includes $3, investment income $4k $3k Roth conversion MAGI (capital gains) Trigger: Roth IRA conversion of $4, $14k MAGI How surtax applies The lesser of net investment income or amount above threshold New MAGI: $21, Subject to Medicare surtax: $1, J.P. Morgan Asset Management 11

12 PORTFOLIO DISCUSSION: Title Copy Here We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. JPMorgan Distribution Services, Inc., member FINRA/SIPC. 215 JPMorgan Chase & Co. RI-ARTICLE-TAXCLIFF NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE