Play

Ep 18: How To Implement The Power of Zero Strategy with David McKnight

March 6, 2019
The whole Power of Zero paradigm is predicated on tax rates being much higher in the future than they are today. If you don’t believe that, the Power of Zero paradigm is not one you’re likely to warm up to. Step one is to recognize that taxes will be higher in the future than they are today. The fis...

Episode Transcript - How To Implement The Power of Zero Strategy with David McKnight

0:00:05
A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
0:00:19
Hi there. This is David McKnight. Welcome to The Power of Zero show. Grateful that you're willing to spend a few minutes with us every week talking about the future of tax rates and how you can prepare your retirements accordingly. Of course, if you want to find out more about what we do here at davidmcknight.com, head on over there and you'll find a number of resources there. You can get copies of The Power of Zero or Look Before You LIRP. Of course, I've got my new book coming out which has been retitled The Volatility Shield—the working title is The Volatility Buffer, I have since changed it to The Volatility Shield—you can find out more about that soon at davidmcknight.com and I'll be doing a podcast on that as well.
0:01:03
Today, I would like to talk about the four-step process of adopting a Power of Zero paradigm, in other words, number one, how do you adopt a Power of Zero paradigm? What do you need to be convinced to adopt The Power of Zero paradigm? Then once you are convinced of that first step, what are the subsequent steps that you need to do to put your financial house in order? Starting off, the whole Power of Zero paradigm is predicated on this idea that tax rates in the future are going to be dramatically higher than they are today. If you don't believe that, if you don't believe that even 10 years from now, tax rates will be higher than they are today, then The Power of Zero paradigm is probably not a paradigm that you will easily embrace, the type of planning strategies that we espouse are not planning strategies that you're likely to warm up to.
0:02:00
The first step in this whole process is taking account of the fiscal landscape of our country, where are things headed? What is the fiscal gap? Larry Kotlikoff recently put that as high as $239 trillion. What is the actual publicly stated debt? How much worse than the $22 trillion is our fiscal situation? Remember what a fiscal gap is, a fiscal gap is the difference between what we've promised and what we can actually deliver, that's the present value of a future obligation, in other words, we would have to have $239 trillion sitting in a bank account today earning Treasury rates to be able to afford everything that we've promised to the American people. All of this dovetails into this notion that tax rates are going to be higher in the future than they are today. If you believe in your heart of hearts that's the case, The Power of Zero paradigm is for you, you are a perfect candidate for Power of Zero type planning.
0:03:06
Once you recognize that tax rates are going to be higher in the future than they are today, what's step number two? Step number two is to recognize that in a rising tax rate environment, there's a perfect amount of money to have in your taxable bucket and there's a perfect amount of money to have in your tax-deferred bucket. We know that the perfect amount of money to have in the taxable bucket is six months’ worth of daily living expenses. I talk about this all the time about the couple who lived through the depression, they come into my office and they say, “Dave, we've got 9 CDs for $100,000 each in 9 different banks. We think that we may be paying too much in tax,” and the answer, of course, is they are paying too much in tax, they’ve got way too much money. I tell people this all the time as well, “You can have more than six months worth of basic living expenses on your taxable bucket as long as you recognize that comes at a price. You are literally choosing to pay taxes in that account that you wouldn't otherwise have to pay. That's an optional tax.” We have six months worth of basic living expenses in that account because we like the liquidity, we like being able to take money out of there without penalties or taxes, or at least dramatic taxes, so it's a great place to have short-term savings for basic emergencies of life. Anything above and beyond that is costing you money. There is an economical price tag attached to having too much money in that bucket. We know that in the tax-deferred bucket, there is a maximum amount of money that you would want to have in there. If you don't have any pensions or other types of residual income like farm income, rental income, or things like that, then we want the balance into that bucket to be low enough that required minimum distributions at 70 1/2 are equal to or less than your standard deduction, which in today's dollars is $24,400, but also low enough that it doesn't cause your Social Security to be taxed. You can look at a calculator I have at davidmcknight.com that tells you the perfect balance to have in your tax-deferred bucket. If you have a pension, a substantial pension that exceeds your standard deduction and it is causing your Social Security to be taxed, so on and so forth, then you're going to want to have not really any money in your tax-deferred bucket. Step two in this whole process, after having recognized that tax rates in the future are going to be higher than they are today, step two is to recognize that there's a perfect amount of money to have in those first two buckets, perfect amount of money to have in your taxable bucket from a tax efficiency perspective, and a perfect amount of money to have in your tax-deferred bucket.
0:05:43
Once we've recognized that, the third step is to recognize that anything that is above and beyond those ideal balances in the taxable and tax-deferred bucket should be systematically repositioned to tax-free. We have to engage in what we call asset shifting. If you have too much money from a tax efficiency perspective in those first two buckets, you should reposition that money to tax-free. How quickly should you do it? You should do it quickly enough that you get all the heavy lifting done before tax rates go up for good which is in 2026, but you want to do it slowly enough that you don't rise too rapidly in your tax cylinder such that you pay so much tax that you get heartburn. There's a perfect amount of money to be shifting each and every year. If you want to figure out what that is at least from your tax-deferred bucket perspective, you can also go to davidmcknight.com, there's a calculator there and it will explain to you what your magic number is. Also Chapter Six of my updated and revised version of The Power of Zero will also tell you about that magical number, that number which is the perfect amount of money to shift each and every year between now and when tax rates go up for good such that you're at the perfect balance at retirement. Step two is identifying that there's an ideal amount of money to have in those buckets. Step three is to identify that if there are too much of those first two buckets, we need to systematically shift those dollars to tax-free. Remember, we want to stretch that tax liability out over as long as we possibly can and then preferably getting all that heavy lifting done before tax rates go up for good.
0:07:33
Let's say that having done steps one, two, and three, you have recognized that your magic number is, say, $100,000. If your magic number is $100,000, then we need to recognize that $100,000 is probably going to go to 3 different places. Number one, we know that you got to pay the piper, you have to pay the IRS before you do anything else. Of that $100,000, you may be giving up, let's call it 25% for state tax, maybe we've got some 22% federal marginal tax bracket, maybe you got 3% effective tax rate, just to make our numbers easy, for state tax, you're giving 25% or $25,000 of that $100,000 to the IRS. I give you permission to not enjoy it, but I also give you permission to recognize that paying it today versus paying it 10 years from now, we will look back on 2019 and say that 25% of effective tax rate is a good deal of historic proportions. Remember, all tax rates have to do, in the future, is to go up by 1% for the math year to make sense, really, it comes down to asking yourself, “Do you think that tax rates down the road are going to be higher than they are today?” If they do, if you do think that, then the rest of it becomes pretty, pretty easy.
0:08:54
So $25,000 of that $100,000 is going to go towards tax which leaves us with $75,000 to be able to reposition to tax-free. Now, where should that $75,000 go? Certainly, some of it should go towards the Roth conversion. Remember, the Roth conversion allows you to lock in today's tax rates, you’re basically prepaying your tax, you're paying your taxes preemptively on your terms so that you're not required or forced to pay taxes on the IRS’ terms whatever those terms happen to be somewhere down the road. The Roth conversion is great. Last week's podcast we talked about the Roth conversion. We want to make sure that we're, whenever possible, staying within those 22% or 24% tax brackets. There's a lot of space in the 22% and 24% tax bracket. Make sure that you're maxing out, at the very least, the 22%. The 24% is only 2% worse, why not take advantage of that as well? You're going to take a portion of that $75,000 sticking into your Roth conversion, but in some instances, you may want to consider taking a portion of that $75,000 and also putting it into the LIRP, the life insurance retirement plan. If you are between 50 and 65, there's a good chance that you've been thinking about long-term care recently and this is likely because your mom or your dad on either side is dealing with long-term care issues. You're asking yourself, “How are we going to deal with long-term care issues? We don't want to burn through all of our assets. We don't want to end up in a Medicaid-funded nursing facility. How do we protect ourselves against this bogey?” Like I've said all too many times before, people aren't opposed to having long-term care insurance, they're just opposed to paying for it. What the LIRP does is it gives you the ability to grow money safely and productively in a tax-free environment just like you might in a Roth IRA or Roth conversion, it allows you to grow money safely and productively, it guarantees that you'll never lose money. If you can get 6% or 6.5% net of fees without taking any more risk than what you're accustomed to taking in your savings account, that's a pretty safe and productive way to grow at least a portion of your money. You will be paying expenses, I tell people over and over again, with the LIRP, the average per year over the life of the program is about 1.5% per year, you aren't going to be paying them, that’s similar to what you might pay overtime in a 401(k), but the difference here is you're getting something very useful in exchange for that 1.5% on average per year, you're getting a death benefit that doubles as long-term care. Like I said, people aren't opposed to having long-term care insurance, they're just opposed to paying for it. If you can get it with dollars that would have maybe otherwise been earmarked for IRAs or 401(k)s, where you are also paying 1.5%, now all of a sudden, you're taking dollars where you had agreed to pay that 1.5%, you're putting it into a bucket, the cost of which is 1.5% and now you're getting something eminently useful in exchange for that 1.5% which is a death benefit which doubles as long-term care.
0:12:00
Now, keep in mind that if you die peacefully in your sleep 30 years from now never having used the long-term care, then your kids, a charity, or what-have-you are still going to get a death benefit. There isn’t that sensation of how you paid for something you hope you never have to use. It is potentially a good idea, depending on your situation, to earmark a portion of that remaining $75,000 towards your LIRP so you can get the safe and productive growth, you can give the death benefit, you get the ability to take money out tax-free if you need to just like you would in your Roth IRA, but you also get a death benefit that doubles as long-term care. That really, in essence, covers that risk that 70% of Americans are going to be confronted with at some point in their retirement.
0:12:52
In summary, we got the three steps which is (1) recognize that tax rates are going to go up, (2) recognize that in a rising tax rate environment, there's a mathematically perfect amount of money to have in taxable bucket and the tax-deferred bucket, (3) is anything above and beyond those ideal balances should be, year-by-year, systematically over a period of time, repositioned to tax-free, and (4) really make sure that you're getting some good diversity within your tax-free streams of income, you have to pay the tax but with what's leftover after-tax, you're going to want to fund your Roth conversion, you're also going to potentially, depending on your situation, peel off a portion of that and fund your LIRP. How much death benefit should you have in your LIRP? I tell a lot of people, “Look, you want a meaningful and impactful amount of long-term care insurance, that means, you're going to get a death benefit anywhere from $400,000 to $500,000 for the husband, $400,000 to $500,000 for the wife, worst-case scenario, let’s say you only got $100,000 of death benefit, that's not very impactful, that's like rearranging deck chairs on the Titanic, that's going to give you about $25,000 per year for 4 years to earmark towards the cost of long-term care, that's just not going to cover that bogey with today's long-term care rate. You probably need $400,000 to $500,000, at $500,000, that's going to give you about $125,000 of long-term care coverage per year every year for 4 years to be able to use for the purpose of paying for long-term care.”
0:14:34
In summary, let me repeat those four steps, if you're looking to engage The Power of Zero process, (1) recognize that tax rates in the future are going to be higher than they are today, (2) recognize that in a rising tax rate environment, there's a mathematically perfect amount of money to have in your taxable and tax-deferred buckets, (3) once you recognize that there's that perfect balance of those first two buckets, reposition any surplus balances from those two buckets, by the way, it's not just the balance, it’s the contributions. If you're putting money in there and forcing that balance higher, especially if that's a 401(k) above and beyond the match, look at repositioning those dollars to tax-free. (4) make sure that once you decide what is the ideal amount of money to be shifted to tax-free that it gets funneled into a couple of different places, Roth conversion, possibly Roth IRA, certainly make sure you're funding your Roth 401(k)s if those are available, but also take a look at whether an LIRP is realistic and appropriate for your situation. It's going to grow safely and productively, but it's also going to give you a long-term care benefit that you might not otherwise have had, and should you die peacefully in your sleep 30 years from now never using it, someone is still getting a death benefit so it doesn't feel like you wasted those dollars along the way.
0:15:53
All right, folks, appreciate you being on the show today. I look forward to talking to you next week. Of course, don't forget to subscribe. If you subscribe to the podcast, every time we do a new podcast, you're going to get an email with a link to the podcast in your email inbox. Make sure you subscribe and go to davidmcknight.com if you're interested in learning more. Thanks for being on the show, we'll talk to you next week.

Subscribe to Our Podcast Updates

Get the latest updates and news right in your inbox.