If you’re a typical retirement saver, you look forward to the day you receive that treasured gold watch and retirement. Gone will be the days waking up to a demanding alarm clock, wrestling with the morning (and afternoon) traffic, and seeing a huge chunk of your paycheck go to the government.

Wait a minute. Rewind that.

Unfortunately, much to the surprise of new retirees, the part about paying the government, that stays (see “Retirement Savers’ Most Taxing Misconceptions,” FiduciaryNews.com, April 25, 2017). For a number of years now, smart financial advisers have been recommending a complimentary mix of both tax-deferred savings (e.g., IRAs and 401(k) plans) and tax-free savings (e.g., Roths).

Such a strategy offers greater flexibility in retirement years regarding the source of funding. (I use the term “funding” here rather than “income” because not all funding is income.) Using some portion of the tax-free savings to pay retirement expenses can lower – or even delay – certain taxes.

But let’s digress for a second and talk about the heart of the matter – psychological framing. A recent mass media article (albeit in a financial publication) spoke of how people moving from employment to retirement are often flummoxed. For their entire career (if they do things correctly) they’ve been living a lifestyle geared towards saving. All of the sudden, when they get that gold watch, now they’ve got to quit thinking about saving and start thinking about spending. (After all, you can’t take it with you.) Such a transition can wreak havoc on the mental conditioning of the newly minted retiree.

Similarly, retirement savers are conditioned to make tax-deferral strategies the primary priority. Once they retire, the primary vehicle for tax deferral – shifting earned income into retirement plans – instantly evaporates. They must therefore transition from avoiding taxes to paying taxes (hopefully at a lower rate).

Note: This is not saying retirees shouldn’t consider tax reduction strategies (we’ll get to that in a moment). What I am saying is that the retiree’s mindset regarding taxes must necessarily be different than the retirement saver’s mindset regarding taxes.

Many retirees will need the deft hand of a human coach to guide them through this changeover. Guess which humans are most likely to possess such deftness of hand-ness?

We can liken paying taxes in retirement to squeezing a tube of toothpaste. At any moment in time, while you can sometimes delay a certain taxable event, the culmination of all inevitable taxable events will result in the same net tax in the end. It’s like squeezing a tube of toothpaste. You can rearrange the toothpaste any way you want, but no matter how you squeeze the tube, there’s still the same amount of toothpaste in the tube.

Now, here’s the difference between taxes and toothpaste. While at any moment in time the net tax is the same no matter how you squeeze the taxable events, over time the order in which you choose to squeeze can change that net tax.

It’s like saying when you squeeze the toothpaste one way, it causes a reaction within the tube that dissolves some of the toothpaste, while when you squeeze the toothpaste another way, it causes a reaction within the tube that causes the toothpaste to grow.

Here’s a very simple example of how this applies to the order of squeezing the taxes. Some people choose to take Social Security at 62 in order to allow their IRA to grow tax free for another nine years. This results in a much higher required minimum distribution (RMD) at age 70½.

Since Social Security is means tested, the higher RMD makes it more likely their Social Security will be subject to a higher tax. The combination of Social Security and the RMD might even push the total tax rate into a higher tax bracket.

If you’re following my convoluted tax math, you’re concluding this is a “not good” situation.

Let’s squeeze that tax tube a little differently. Let’s say, instead of taking Social Security out at 62, we defer until age 70 and fund the retirement with the IRA.

Yes we’ll have to pay an income tax on the IRA withdrawal, but the net effect will be a smaller IRA at age 70½ and a smaller RMD.

If the RMD is small enough, the greater Social Security payout at age 70 will not suffer from a means-test. The retiree, though paying more in taxes in the early retirement years, now pays less in taxes in the later retirement years.

This is a necessarily over simplistic example. When you start layering on Roth plans, taxable savings, and other funding sources, the tax savings scenarios broaden considerably.

Retirees may be surprised to discover they’re still on the hook for paying taxes, but they may also be surprised to learn that, just because they’re out of their tax-deferred retirement savings ammo, there’s still a few tricks up their sleeve they can use.

And the money they save on these post-retirement tax savings strategies can buy an awful lot of toothpaste.

Instant Insights /

Surprise -- you still need to pay taxes when you retire

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