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Ep 31: A Power of Zero Case Study (Pension Example) with David McKnight

June 5, 2019
The Power of Zero paradigm changes a bit when you have a pension. The best case scenario in terms of tax rates that you are going to experience is likely to be while you’re working. Let’s say we have two 60-year-olds that want to retire in 5 years. They have $500,000 in their IRA’s and 401(k)’s, and...

Episode Transcript - A Power of Zero Case Study (Pension Example) 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
Hello there. David McKnight. Welcome to The Power of Zero show. I'm glad to be your host, I'm glad you're with us, I'm glad you're taking time out of your busy schedule to learn more about The Power of Zero worldview. I am the best-selling author of The Power of Zero, Look Before You LIRP, and The Volatility Shield. You can find out more about me at davidmcknight.com.
0:00:42
Last week, we did a case study in which we talked about a fairly typical Power of Zero type case study that did not involve a pension. The landscape changes a little bit when you do have a pension. What we're going to do today is we're going to take a case study that involves a pension to see how, not only it contrasts with the typical non-pension approach, but also so that you can see that if you do have a pension, the types of opportunities that are going to be available to you given where tax rates are headed, given the best-case scenario that you'll likely experience in terms of tax rates is probably while you're working. Let's distill this into a single financial profile here.
0:01:35
Let's say that you got two 60-year-olds, they both want to retire in 5 years. They've got $500,000 of cumulative dollars in their IRAs and 401(k)s, it doesn't really matter which one for me, they're over age 60 so they can access both. Let's say one of the spouses has a pension of $5,000 per month. Let's say they're currently in the 22% tax bracket, let's say their line 10, which is their taxable income on their tax return, let's say that's $100,000, so that puts them in 22% tax bracket. Here's the opportunity here, if you have a $5,000 pension, that is construed as provisional income, that's the income the IRS keeps track of to determine if they're going to tax your Social Security because your pension is provisional income and it shoots you over the provisional income thresholds. In retirement, these two individuals, this married couple are looking at a scenario where the $5,000 per month pension—which is $60,000 per year—and up to 85% of their Social Security is taxable as well, that might be $25,000 or $30,000. When you couple those two together, even after a standard deduction, you are looking at filling up most of the 10% tax bracket, most of the 12% tax bracket, or the future equivalent thereof. Remember, starting 2026, it becomes, not the 10% and 12%, it becomes the 10% and 15%. Any dollar that Mr. and Mrs. Jones deign to take out of their IRAs and 401(k)s in retirement is going to flow into their graduated cylinder—remember, IRAs and 401(k)s in retirement is going to land right on top of all that other income at which point, they will pay taxes at 22% on whatever they take out of there or the future equivalent thereof, and of course, after 2025, starting January 1, 2026, the future equivalent of the 22% is going to be the 25%, future equivalent of the 24% is, of course, going to be the 28%. We have a situation here where they've got $500,000 in their IRA, and if they want to take money out, the best-case scenario for them is that they get to keep only 78% of that money. We're not even talking state tax, we're talking federal tax. Let's not talk state tax at all because they're going to have to pay state tax whether you have a pension or not. That's a common theme that's not going to change.
0:04:32
Where the opportunity lies with someone who has a pension is that if in retirement, the best they can do is keep 78% of their money, then all of a sudden, we have an opportunity, why? Because if they're currently in a 22% tax bracket—and we established that at the outset of the podcast—if they're currently in a 22%, they're going to be in a 22% as it relates to the 401(k)s and IRAs in retirement, can't we make the case that not a year should go by where they're not fully maxing out their 22% tax bracket between now and age 65, 5 years from now, can we make the case that they should at least be converting up to the top of that 22% tax bracket, which gives them over $60,000, almost $70,000 worth of space before they bump up into the 24% tax bracket?
0:05:37
Here's the problem, folks, we really want to drain those IRAs and 401(k)s by the time they reach retirement, we want all that money coming out tax-free. Remember, we worry about the things we can control, we don't worry about the things that we can't control. We can't control the fact that their pension, their Social Security can be taxable, we can control the rate at which they get taxed on all these other assets. We've established the case that not a year should go by where they're not maxing out their 22% tax bracket, guess what, if they only convert that $70,000 per year to max out the 22%, they will not get all of the money shifted out of there before tax rates go up for good. If they don't get it all done by five years from now, then they're going to have to pay higher taxes on the balance, they would need to get it out of there by January 1, 2026. They've got seven years. They really need to get the money out of there before tax rates go up for good. If they only do $75,000 per year, that's not even going to cut it because of growth on the $500,000, let's say it's growing at 6 1/2%, that's $30,000 plus that is growing. Only converting up to the top of the 22% is not really going to get the job done.
0:06:54
The question is what's the next tax bracket? The next tax bracket, of course, is the 24%. For only 2% more, we get an extra $150,000 of conversion space. Why would they not want to take advantage of all of the 24% tax bracket? It's only 2% more, but they can protect, they can insulate from the impact of higher taxes an extra $150,000 per year between now and when they retire, but ultimately they want to get all the heavy lifting done before tax rates go up for good on January 1, 2026. The question becomes, “Would you be willing to pay an extra 2%?” Even if you paid that extra 2%, you would still be lower than the 25% tax bracket that the 22% is eventually going to become starting January 1, 2026.
0:07:57
When you have a pension, here's the real distinction, if you are already in a 22% tax bracket—and there's a good case that you are—I would say that at least 2/3 to 3/4 of the people we see on a daily basis are either in the 22% or 24%, if you have a pension, it's all provisional income, it's likely to cost your Social Security be taxed which will fill up the first and second tax bracket—that's the 10% and 12%—so you can really make the case that if you find yourself in that situation that really not a year should go by where you're not maxing out the 22% tax bracket, and probably maxing out the 24% as well. We're in a normal scenario, we might say, let's be a little bit more thoughtful in terms of, “Hey, if you're in a higher tax bracket today than you are in your retirement, then we want to really feel convinced the tax rates at that point in time are going to be higher today.” The difference here is that we've got real urgency because every year that goes by where you fail to take advantage of that 22% tax bracket is potentially a year beyond 2026 where you will be forced to pay taxes at the equivalent of the 22%, which will be the 25%,—but I'm not even really concerned about taxes being at 25%—what I'm concerned about is what happens when we start to have a sovereign debt crisis, when countries like China, Saudi Arabia, and Japan don't want to loan us any more money because they're afraid we won't be able to pay the money back. Of course, we can't print money to get our way out of our Social Security and Medicare crisis because Social Security and Medicare are pinned and pegged to inflation. As inflation goes up as we print more dollars, then the cost of those programs increases commensurately. You start to really run out of options other than increasing taxes. If taxes are to rise dramatically in 2026, 2028, 2030, and beyond, then we will look back on these 22% tax brackets, especially if you have a pension. By the way, I'm saying if you have a pension, this could be rental income, it could be farm income, it could be any sort of residual income that is taxable to you on your tax return that feels like a pension. It all gets taxed the same way. If you have a rental or farm income, there may be some amortization that comes into play. But the point is whatever ends up showing on your tax return is going to be accounted as provisional income, it's going to cause a portion of your Social Security, either 50% up to 85% of your Social Security would be taxable, and you will literally you'll look back on the 22% tax bracket and say, “Why in the world were we dragging our feet? Why in the world did we not take advantage of those tax rates? They were good deals of historic proportions.”
0:11:07
The bottom line, the message I have to those of you who have pensions, or for those of you financial advisors who have clients that have pensions, is to simply take a look at what their tax bracket is today, take a look at what the best-case scenario is going to be once their pension and the taxable portion of their Social Security fills up those first two tax brackets, what's the tax rate going to be on all of those 401(k) and IRA dollars when they attempt to take those dollars out of those accounts? I think what you'll find is that when you recognize that 22% is better than 25%, 24% is better than 28%, then you'll see that really not a year should go by where you're not taking advantage of these historically low tax rates.
0:11:59
By the way, we can do a whole nother podcast on this, but your tax rates are going to double no matter what when you have a spouse that dies. Remember, the tax brackets get cut in half when you have a spouse that dies, in other words, it only takes half as much money to get to the top of the 10% tax bracket, it only takes half as much money to get to the top of the 12%, same with the 22%, same with the 24%, that's how you get to those upper tax brackets where it really starts to equalize a little bit, but in those lower tax brackets, the married couple version of these tax brackets is basically double. If you become a single, then all of a sudden, the cost of unlocking those dollars from those highly taxable accounts literally doubles even if, for some reason, somehow, someway, taxes in our country did not double, your taxes personally will double once your spouse dies. I know it really feels like kicking you while you're down, it doesn't seem fair at all, but that's how the tax system works.
0:12:59.2
Recognize that not everybody dies at the same time, couples don't always die at the same time. By the way, if you're saying to yourself, “I'll just leave off my pension and my Social Security, leave everything in my IRA,” guess what, there's legislation happening right now in Congress where they're looking to eliminate the ability to spread out the reception of IRAs to the next generation. They're talking about eliminating the ability to take those RMDs over one's life expectancy, and instead potentially, have to realize it as income all at once, of course, this could happen at your peak earning years, if you're the one receiving the inheritance, when tax rates are dramatically higher than they are today. If you are the person with this IRA, why not get those dollars shifted over to tax-free whether it be through a Roth conversion or peeling off a portion of that and put it into the safe and productive environment within an LIRP, get some death benefit, get some long-term care while you're at it and really just take advantage of these low rates while they're around? Low rates are not going to last. Remember, when we cut taxes, we did the exact opposite of what all the economists said, they said, “We need to be increasing revenue and lowering expenses.” What did we do? We did just the opposite, we lowered revenue and we increased expenses by a trillion and a half dollars over the next 10 years to pull it off. We can't keep kicking the can down the road, the national debt is growing bigger and bigger. I've been trying to get the word out on this for years and years and years. When you're starting to finally see some mainstream media outlets acknowledge that the tax, the debt is spinning out of control every year that goes by where we fail to make some earnest attempt to liquidate this debt, the problem becomes bigger and more unsolvable. Think about this as you're letting every year go by where you're not taking advantage of these historically low tax rates. If you have a pension, it really is a no-brainer. Make sure that you are assessing what your tax bracket is today, the tax that you might pay on a conversion or some other distribution out of there to tax-free, and recognize that if it's lower today, then it will be in retirement, and for many pensioners that is the case, then you should really, really take advantage of these tax rates while they're still around.
0:15:19
Remember, the highest marginal tax bracket in 1960 was 89%. The poorest among us at that point we're paying 23%, 24%. We haven't seen these tax rates in a long time, but we hear them talked about in our documentary, The Power of Zero: The Tax Train is Coming—which is available now, of course, on Google Play, Amazon, iTunes, and reelhouse.org—we see evidence of experts all across the country who are making the case that we are at unsustainable levels of debt. Tom McClintock talks about how eight years from now, we’ll be Venezuela. George Shultz calls this an absolute crisis, we are at the crisis point, it's spinning out of control, make sure that you are taking stock of where we are as a country fiscally. Make sure you're taking advantage, you got to either pay taxes now, you got to pay them later. If you weigh in all the evidence, decide the tax rates for you down the road are going to be dramatically higher than they are today, figure out what tax bracket you're comfortable with, convert up to the top of that 22% tax bracket. Remember, my second favorite tax bracket beyond zero is the 24% tax bracket, not a year should go by where you're not maxing out that 24% if you have that much money in your tax-deferred bucket.
0:16:44
Again, these are important things so I hope that you act on them because every year that goes by where you fail to act on them is potentially a year beyond 2026 where you could be forced to pay the highest tax rates you're likely to see in your lifetime.
0:16:59
All right, folks, that's the show for today. I hope you enjoyed it. Again, if you want to learn more about me, go to davidmcknight.com. You can get all my books on Amazon. If you want to get my books in bulk, you can go to powerofzero.com, click on the books link, and find all of our books are available with bulk discounts. Follow me on YouTube, you can subscribe on YouTube, if you follow me on iTunes, subscribe on iTunes, same with Spotify, same with Pandora. Thank you so much for being part of the show. Again, davidmcknight.com, if you have any questions about your personal situation, we're happy to help you out. We will talk to you next week.

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