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A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
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Hi there. It's David McKnight. Welcome to The Power of Zero show. I'm the author of the number one best-selling book, The Power of Zero, as well as Look Before You LIRP, as well as The Volatility Shield, all of which can be found at my website at powerofzero.com. They can be bought in bulk as well if you just follow the links on that site, all are now available on Audible as well.
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Today, I would like to share with you a case study. We're almost up to 30 episodes here, I think it's time that we give some real-life application to all of the concepts that we've been discussing so far. I'm going to layout the profile for the couple we're talking about, then we're going to sort of walkthrough step-by-step what I might do in their situation. Of course, if you want any advice on how to handle your particular situation, talk to the advisor that gave you The Power of Zero book or if you got our book off Amazon or some other outlet, feel free to reach out to us at davidmcknight.com and we are happy to give you a hand.
0:01:27
Let's say we've got two 60-year-olds, they want to retire at 65. They've got $300,000 sitting in their taxable bucket, they've got $700,000 sitting in their tax-deferred bucket between IRAs and 401(k)s. Like I said, they want to retire at age 65, they've got nothing happening in their tax-free bucket, they've got no life insurance, they've got no long-term care insurance. This is really just a basic case that I want to use to try to drive home some fairly simple points.
0:02:01
If you think back to some of our earlier podcasts, there's been this recurring theme about some steps we need to take to be able to embrace The Power of Zero world view. The very first step that we have to do is we have to be convinced that tax rates in the future, even 10 years from now, are going to be dramatically higher than they are today. If you're not totally convinced of that, might I suggest that you reread Chapter One of The Power of Zero or that you go to Amazon, Google Play, reelhouse.org, or to any of the other outlets where you can find The Power of Zero: The Tax Train is Coming. If you watch that movie, that documentary, we interview all of the most important experts across the country that have knowledge of the fiscal path of our country, that understand why tax rates in the future are going to be dramatically higher than they're today. If you're not convinced after watching that movie, I don't think anything is going to convince you.
0:03:08
The first step is you have to be convinced the tax rates in the future are going to be higher than they are today. The second step is given that tax rates in the future are going to be higher than they are today, there is actually a perfect amount of money to have in the first two buckets—the taxable, tax-deferred bucket—In the case of this particular couple, whereas they have $300,000 sitting in their taxable bucket, let's say their lifestyle requires $100,000 per year, they currently have way more than they really need to have in that bucket. They've got $300,000 on that bucket, they should really have closer to $50,000. We know that they should, over the course of the next 7 to 10 years—I really like to get all my heavy lifting done before tax rates go up for good—we've got seven years before that happens, so long as we can do that shifting in a way that we don't bump up into a tax bracket that gives us heartburn, it's perfectly appropriate to do it over seven years. They've got way too much money in their taxable bucket, $300,000, they need to get it down to $50,000, they should be systematically repositioning dollars from taxable to tax-free.
0:04:18
There's a couple of ways that we can do that, we know that we can do that through the Roth IRA, they can do that through the LIRP, and they can also do that through paying taxes on any shifts that take place between tax-deferred and tax-free, that really is the ideal way to do Roth conversions and do other shifts from tax-deferred to tax-free, pay the tax out of the taxable bucket if you have too much money in there. We're going to leave the taxable bucket for now. Remember we've got $300,000, let's say it's growing at 6% per year, so we've got to take care of the growth in that bucket, we've also got to take care of some of the principal. We've got to get that spent down to $50,000 by 7 years from now.
0:05:00
Now they have $700,000 in their tax-deferred bucket, we're going to assume they don't have any 401(k)s, we're going to keep this nice and simple, they don't have 401(k)s, they're going to retire in five years but we've got seven years to do the shift. What we need to do is we need to first establish what the ideal balance is in that bucket seven years from now, so we know that we want the balance in this bucket to be low enough that when they start taking money out, they can take an amount out equal to or less than their standard deduction or also low enough that it doesn't cause their Social Security to be taxed. We know that seven years from now, they will be taking Social Security so we'd really like to get all the heavy lifting done by seven years from now. But ultimately, we want that IRA balanced, that tax-deferred balanced to be low enough that by 70 1/2, when the IRS forces them to start taking money out, we want that balance to be low enough that RMDs are equal to or less than their standard deduction, but we also want that balance to be low enough that it produces an RMD that doesn't also cause their Social Security to be taxed. If they don't have a pension—in this case study, we're assuming they don't have any recurring streams of income like farm income, rental income, or pension income—if that's the case, then we know that the ideal balance in their tax-deferred bucket, depending on their Social Security amounts is probably going to be in the area of $300,000.
0:06:33
Remember, it's okay to leave some money in your tax-deferred bucket. Why? Because if you get all of the money out of your tax-deferred bucket, pay tax on it, everything is in tax-free by the time you retire, you have to remember you still have a standard deduction that will go on use. By the time these folks retire, by the time we hit 2026, remember that it's going to be the standard deduction and personal exemption. Standard deduction is going to go down, personal exemption is going to come back, but grouped together, added together, it'll be about equal to whatever the standard deduction would have been, so not a big game-changer there, but we do want our balance to be low enough that we don't cause Social Security taxation and we stay off the IRS’ radar, we stay in the 0% tax bracket. That means we need to keep that balance at about $300,000.
0:07:29
We got a problem here, if they've got $700,000 in their IRA or cumulative IRAs and it's growing at 6% per year, net after fees, they are not spending it, by the time they reach 65, when they retire, they're going to have a lot more in there than $700,000 if we don't do some shifting—by the way, there's a calculator at davidmcknight.com that tells you your magic number, you can punch in there how much money you want to shift over what period of time, it will actually tell you how much money you should shift and get all the heavy lifting done before your investment horizon comes to an end—if we want to get the shifting done over 7 years, and it's $700,000 and it's growing at 6%, we know that just to keep it even, it's going to be $42,000 of shifting per year. We also want to not just keep it flat but we want to shrink it down from $700,000 to $300,000. I'm not looking at my calculator right now, but I think what you would find is that over that 7-year period, you're going to have to shift probably another $50,000 per year. We're talking 6% of $700,000, that's $42,000 plus another $50,000, this might be a $92,000 shift.
0:08:46
Remember, you want to stay in a tax bracket that doesn't give you heartburn. For most people, that means staying in the 22% or 24% tax bracket. Remember 24% is my second-favorite tax bracket, it's only 2% more than the 22%, but it allows you to shift an extra $150,000 to tax-free. You're telling me that for an extra 2%, I can shift an extra $150,000? That's the deal of the century if you ask me. I think that's a great, great deal. From tax-deferred to tax-free, we're probably going to be shifting on the order of $90,000 per year, that's just a ballpark—for those of you out there listening to me, you can always go to davidmcknight.com and see how close I am—but we got to shift $90,000 per year, I would probably recommend paying the tax on that out of the taxable bucket. What's that tax going to be? On $90,000, it's probably going to be in the 24% tax bracket, assuming this couple is already in the 22%, we're probably going to bump into 24%, 24%, throw in another 6%, we're talking $30,000 for taxes. Of that $90,000, $27,000 is going to come out of the taxable bucket and that allows all $90,000 to go to the tax-free bucket.
0:10:13
We pay the $27,000 out over the course of the next 7 years and that $27,000 per year over 7 years, that's almost $200,000 that's going to come out of the $300,000. That's going to go a long way towards spending down that taxable bucket. Remember, we have $300,000 in there, if we can keep our balance down to $50,000, that's going to go a long way towards protecting or insulating ourselves from tax-rate risk in the taxable bucket.
0:10:57
What have we done so far? We've said we need to shift $90,000 per year from tax-deferred to tax-free, we're going to use the taxable bucket to help pay that tax and to help catalyze the transfer from tax-deferred to tax-free. We now have $90,000 that's going towards tax-free. Remember the idea with the LIRP for two 60-year-olds is one of the single greatest threats to their portfolio in retirement is long-term care, they can completely burn through all of their retirement assets if they don't have a plan for long-term care. The LIRP becomes a very efficient, reasonable, and useful way, an effective way to pay for their long-term care. What we want to do is we want to get them enough death benefit where it's impactful. I think, for most people, that's $400,000 to $500,000 worth of death benefit. We have $400,000 to $500,000 of death benefit over 7-year funding of an LIRP, that's going to take probably $35,000. Of that $90,000, we want to take $35,000 and stuff that into two fully-funded LIRPs. If we have $35,000, it's going to be a tiny bit more premium into his to get the exact same amount of death benefit as hers, so it's probably going to be a split that looks a little bit like maybe $19,000 on him and $16,000 on her to get to the $35,000, that's probably what it's going to look like. If we have $35,000 going towards the LIRP, that means we've got $55,000 going towards their Roth conversions.
0:13:04
By the way, if they have any money left over in their taxable bucket, I would probably recommend putting that into their Roth IRAs, let's fully fund the Roth IRAs—each and every year, between now and when they retire, we're assuming that they're under $200,000 or $300,000 of modified adjusted gross income—let's put that money into they're Roth IRAs because we want to have as many different streams of tax-free income as possible by the time they retire.
0:13:36
What are our different streams of tax-free income? We have Roth IRAs, LIRPs, Roth conversions—by doing the Roth conversion, we can get their balance in their IRAs down to the ideal balance which is about $300,000 in their tax-deferred bucket—and if we have all of those streams of tax-free income, we can now get to the 0% tax bracket and also get their Social Security tax-free.
0:14:07
This was just an easy case, it doesn't involve pensions, it doesn't involve any real tricky scenarios. I didn't want to keep you too long today. I just wanted to do a basic, basic case study where we have too much in the taxable bucket, too much in the tax-deferred bucket, we need to systematically reposition those dollars to tax-free. If we do so, over the course of the next seven years, we can get to the 0% tax bracket without rising up into a tax bracket that gives us heartburn and really be in a very, very good place by the time tax rates go up for good.
0:14:39
That's it. Once again, subscribe if you haven't done so yet to be able to get your favorite medium to email you, letting you know every time we have a new episode. Again, if you are looking for help on getting yourself to the 0% tax bracket and you don't have an advisor that can help you do so, feel free to go to davidmcknight.com and we're happy to guide you and give you some assistance. Thanks for being on the call today and we will talk to you next week.
