A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
Hi there. David Knight. Welcome to The Power of Zero show. Grateful you took a little time out of your schedule today to join me. In today’s podcast episode, we are going to have part two of my interview with Living a Richer Life by Design. In today's interview, I'm going to recap the three different types of buckets—taxable, tax-deferred, tax-free—I'm going to talk about why the vast majority of Americans have the lion's share of their assets in tax-deferred versus tax-free, and we're going to talk about what vehicles qualify tax-free and why it's so important to have more than one tax-free vehicle, you got to have multiple streams of tax-free vehicles, none of which show up on the IRS’ radar, but all of which contribute to you being in the 0% tax bracket. We're going to dig into the LIRP, we'll talk about how the LIRP works, what are the benefits of the LIRP, what are the things that the LIRP can do that none of the other tax-free vehicles can do. Then at the very end, I'll make some recommendations on how to get started with your tax-free retirement plan and how to start shifting dollars from those first two buckets into the tax-free bucket. I hope you enjoy the episode.
Mark: Welcome to Living a Richer Life by Design with host Jonathan Krueger, and I'm you're contributing host, Mark Ralfs. Join us as we dive into a variety of subjects including fulfilling relationships, vibrant health, community engagement, social impact, and of course, the stewardship of your finances.
Jonathan: Welcome to Living a Richer Life by Design. This is Jonathan Krueger and co-host Mark Ralfs. On today's show, we'll continue our discussion with David McKnight, the author of The Power of Zero and who also wrote the book Look Before You LIRP, and most recently, The Volatility Shield. The Power of Zero has sold 185,000 copies and was recently made into a full-length documentary film. As a president of David McKnight & Company, he mentors hundreds of financial advisors around the country who specialize in The Power of Zero retirement approach. David has been featured in scores of national publications and radio programs including the New York Times, Fox Business Network, Bloomberg Radio, and MarketWatch just to name a few. If you missed the first podcast of this topic, we invite you to go back and access it through our website.
David: A pleasure to be back, thanks for having me.
Jonathan: Thank you for joining us again on the show. We cover a lot of ground in our first episode, and for those who haven't yet listened to it, could you provide a quick recap of what you call The Gathering Storm and where this country is headed?
David: Yeah, in short we feel like that the math demonstrates that our elected officials have made promises that they can't possibly afford to deliver on in the form of Social Security, Medicare, Medicaid, and to avoid getting voted out of office, they're likely going to raise taxes dramatically over the course of the next 10 to 15 years and the people who stand to lose the most are people who have the lion's share of their retirement savings in 401(k)s and IRAs because they haven't paid the taxes yet. The gist of the message of our last podcast is, “Hey, if tax rates are likely to be dramatically higher in the future—and most economists and financial experts agree with that—then we should really take a thoughtful look at repositioning assets from highly taxable tax-deferred accounts like 401(k)s and IRAs, pay the tax on those things preemptively, get them shifted to tax-free in an effort to really insulate ourselves from the impact of higher taxes.
Mark: David, we left off in our first episode talking about the three buckets that Americans tend to collect their assets in, and those are the taxable, the tax-deferred, and the tax-free. You gave us some insights into the taxable bucket and how much is reasonable to have in that kind of asset. Give us just a short recap of that again if you would, please.
David: Yeah, the taxable bucket, these are going to be your savings accounts, money markets, brokerage, stocks, bonds, mutual funds. You pay tax on these each and every year so they're the least efficient of all the places that you can save money for retirement because you give up a little bit of your growth every year and that really takes a toll over a long period of time. Given that reality, we should really only have so much money in that bucket, and most experts agree, this is the one thing they agree upon, the right amount is about six months worth of basic living expenses, anything above and beyond that amount should be systematically repositioned to a tax-free account.
Mark: Okay, now let's go to a bucket number two, which we call, and you call, the tax-deferred bucket. Remind us again what kind of assets generally make up that bucket?
David: These are the—among the most popular retirement accounts that most Americans have saved money in, $22 trillion of the cumulative retirement accounts of Americans are in that bucket, which is about 95% of all retirement dollars are in that bucket—these are things like 401(k)s and IRAs. We put money into these types of investments because it's easy, we can typically do it from our workplace, it's out of mind, it's out of sight. We've been doing it for so long, our parents did it, it's just second nature to go to your human resource person and say, “Hey, look, I want to do my 401(k), and so because of how easy it is and because of force of habit, this is where we save most of our money, and as we'll discuss in the rest of the podcast, there's a good reason to believe that this is not a great approach to retirement.
Mark: It sounds like many working Americans have the majority of their assets in the tax-deferred bucket. A couple of questions along that line, first, why has that happened? Then secondly, what are your recommendations for the optimum amount that should be included in this bucket?
David: Yeah. Like I said, I think that there's so much money in there because people, number one, is easy, force of habit, financial experts 20 years ago told us that it was a good idea, there are still a few outliers today that say it's a good idea. But one of the major reasons we do it is because we're addicted to the tax deduction, we love saving money today, and when I say saving money today, saving money due to the tax savings that we experience because we put money into our 401(k) today. In that regard, we're a little bit like the federal government in that way because we get instant gratification, the federal government loves to make promises because they get instant gratification, they get reelected or they get elected to office because they made a promise. They love to do things that make their constituents happy today without any thought for the long-term outlook, the long-term repercussions, or the unintended consequences. I think in that regard, a lot of CPAs these days love to get you a tax deduction today, it makes them look good. We like to get a tax deduction today because we don't want to pay taxes prior to when we absolutely have to. Like I said in the last podcast, we got to remember that the true purpose of a retirement account is not to give us a tax deduction, it's to maximize cash flow at a period in our lives when we can least afford to pay the tax.
Mark: In the book, you talk about maybe the optimum amount that should be included in this bucket or a strategy for having a certain amount included and not to exceed, could you tell us what that is?
David: Yeah, some people say, “Hey, taxes are going up, I should get every last dollar out of my tax-deferred bucket into the tax-free bucket,” and that's actually not the case. The reason I say that is because in retirement, most of the time, we've run out of our deductions—the house has paid off, the kids moved out, we're no longer contributing to a 401(k), when it comes to charity we're donating time, not money—so we don't have a lot of deductions left in retirement but we do have a deduction, it’s what we call a standard deduction. If you were to retire today as a married couple, you would have $24,400 worth of deductions, what does that mean? That means that you can experience income from any number of sources up to $24,400 and not pay any income tax at all. Guess what, if you shift all of your money from tax-deferred to tax-free and you don't have any taxable income in retirement, guess what, that standard deduction will sit there languishing and won't do you any good. We like to leave some money in the tax-deferred bucket, and for most married couples that don't have pensions, that's going to be $300,000 or $350,000, something like that. What we're really looking for is we want your required minimum distributions, which start off at age 70 1/2, as being about 3.65% of your income, we want those required minimum distributions to be equal to or less than your standard deduction, but we also want them to be low enough that they don't cause your Social Security to be taxed—that’s maybe a different discussion for a different day—but what we found is that for most typical American retirees, the ideal amount of money in there is about $300,000 to $350,000.
Jonathan: David, with that being said, I know that in a recent bill that's being proposed that would go before the House and Senate this summer, they're suggesting that inherited IRAs would have to have an accelerated withdrawal rate of 10% per year. Do you foresee that may also be something that they could change the RMDs and requirements during the later years?
David: This is a pretty major thing because right now, you can do a stretch IRA, you can stretch the tax liability out over time. If you're forced to take all of that money 10% at a time, over 5 years, or even as a lump sum, what does that do? It doesn't allow you to take that inherited IRA on your own terms, it forces you to take it on the IRS’ terms. What does that mean? If you think of the American tax system as a graduated cylinder from chemistry class, your money goes in, flows all the way down to the bottom, some of your money gets taxed at 10%, some at 12%, some at 22%, some at 24%, some at 32%, some at 35%, some at 37%. Let's say my mom left me an IRA for $1 million and let's say that I'm in the 35% tax bracket, if the IRS is going to force me to take all of that money all in 1 year, guess what, that $1 million is going to flow into my tax cylinder, land right on top of all my other income, and be taxed at my highest marginal tax bracket which is going to be 35%, quickly moving up to 37%, I'll pay state tax on that at the highest marginal tax bracket, if I were living in Wisconsin, that would be 7%, and you have an Obamacare surcharge, there are all sorts of different things that could pile on top of that. I could very easily, depending on the state that I live in, lose 50% of that IRA simply because I can't take that money out at my leisure, I'm taking it out on the IRS’ terms. That could be pretty devastating for a lot of Americans. I see this as a way, it's a cash grab on the part of the IRS, they get it, they realize that if people that are in the lower tax brackets can realize this income at a low tax rate over a long period of time, they're not ever going to have to give up a lot of that money into tax, and by forcing them to take it all at once or over just a few years, they're going to get a lot more tax revenue out of it. That's one of those steeper provisions in the tax [scale 0:12:32] that they try to slip in there, people don't understand the implications but it has massive huge implications, all the more reason why people should be accumulating dollars in tax-free, because if it's tax-free it goes to the heirs tax-free, they can take it at their leisure, they don't have to worry about the taxable implications, and they've really insulated themselves from those types of policies.
Mark: David, let's delve now into this tax-free bucket a little bit more. It sounds like that's the place to be given this Gathering Storm that you reference in the book, Roth IRAs fall into that category for sure, but what are some of the other vehicles that would be classified in this category?
David: Yeah, and by the way, when we say Roth IRAs, we mean Roth 401(k)s, Roth conversions, those are all great, and I identify a true tax-free investment, it’s got to satisfy two different tests, number one, it's got to be really tax-free, when I say tax-free, free from federal tax, free from state tax, and free from capital gains tax, but it's also got to not count as provisional income, and provisional income is the income the IRS tracks to figure out if they're going to tax your Social Security. Most people don't realize this, but most retirees will run out of money five to seven years faster because their Social Security gets taxed, and to try to compensate for that Social Security taxation, they will spend down all of their other assets that much faster. Roth IRAs, Roth 401(k)s, Roth conversions all qualify as true tax-free investments.
In Chapter five of my book The Power of Zero, I talk about another truly tax-free investments, what we call a life insurance retirement plan. What most people do when it comes to life insurance is they get as much death benefit as they possibly can for as little money as possible, we call that term insurance. Here we're doing just the opposite, we're getting as little death benefit as the IRS requires of us, we're stuffing as much money into it as the IRS allows in an attempt to mimic all of the tax-free benefits of the Roth IRA without any of the constraints or the prohibitions of the Roth IRA. Just to give you a quick profile on the LIRP, you can take money out of an LIRP pre 59 1/2 without penalty, no problem. As your money grows, you receive no 1099, so you're not going to get taxed as your money grows. When you take the money out, if you take it out the right way, you're going to take it out tax-free. There are no contribution limits. Whereas with a traditional Roth IRA, you can only put in, if you're over age 50, $7,000 per year, for a total of $14,000 if you're a married couple. You know what, the LIRP, I have clients that do $50 a month, I've got clients that do $200,000 per year, and everywhere in between. There are no income limitations, whereas with a Roth IRA if you make more than $203,000 of modified adjusted gross income, you can no longer do a Roth IRA. Bill Gates can't do a Roth IRA. Conversely, anyone can do an LIRP, a life insurance retirement plan, simply because there are no income limitations. My children, the oldest of whom is 17, can do Roth IRA.
Then one of the things that I really like about the LIRP is at least, historically, if history serves as a model, there may be no legislative risk when it comes to the LIRP, meaning that historically—and they changed the rules rather dramatically on these programs in ‘82, ‘84, and ‘88, and every single time they changed the rule, they simply said, “Whoever has the bucket before the rule changes gets to keep it and continue to put money into it under the old rule for the rest of their lives,” we call that a grandfather clause, so it may be immune from future legislative changes that may affect things like Roth IRAs, Roth 401(k)s, and Roth conversions, historically has been immuned from all those things. The IRS says, “Hey, if we're going to give you a big bucket of tax-free dollars, we're going to require that there be a cost of admission, we're going to require that there be a spigot attached to the side of that bucket of money through which flows on a monthly basis on expenses,” where do those expenses go towards? They go towards some administrative fees, but they primarily go towards the cost of term life insurance.
A lot of people that are rapidly approaching retirement, the house has paid off, the kids have moved out, retirement’s very, very close, they start dumping their term life insurance, and it's not exactly high on their wish list, and the companies that sponsor these programs recognize that, so they've done something to sweeten the pot, they say, “In the event that somewhere down the road you should need long-term care, they will give you your death benefit while you're alive for the purpose of paying for it.” It's not a silver bullet, it's not a panacea, it's great when used as a complement with all of these other tax-free streams of income that we've talked about, but it does do some things that none of these other tax-free streams of income can do, it can give you safe and productive growth, unlimited contributions, no income limitations. I think that people underestimate how important it is to have long-term care, the idea that you can get your death benefit while you're alive for the purpose of paying for long-term care is a very, very attractive alternative to the traditional use it or lose it long-term care where you pay for 30 years, died peacefully in your sleep never having used it, and nobody gets the money at the end. It's a very, very dynamic tool, it's not perfect, it's not a silver bullet, it's not a panacea, but when used in concert with all of these other tax-free things that we've talked about can be a very, very good way to round out your tax-free portfolio.
Jonathan: David, that makes a lot of sense, in fact, my own family is experiencing that now for my mom, being able to receive that benefit for some extended care that she has. She battles cancer. But one of the things that I found and that we've learned through our experience with meeting with clients as well as our associates in the public is that most people have not heard of this concept before, it's fairly new, in fact, even amongst advisors, we're finding most advisors have not been trained in it nor understand how to be able to utilize the tax code for this specific strategy that you've just shared with us. Why is that? Why do we find so many families have, perhaps, the lowest percentage of their assets in this category?
David: You got to be able to understand it, you got to be able to explain it, you got to be able to help a client understand what the implications are and what the benefits are. I also think that historically, there's been a lot of negative online chatter about these types of programs, and I think that some of it have been justified because frankly, some of these programs over the years have been loaded down with onerous expenses and frankly, your money just doesn't accumulate all that quickly in these types of programs. But in the last 15 years or so, these policies have been re-engineered, the expenses had been dropped way down, they've pioneered from ways to grow the money safely and productively and to take distributions out of these things very, very productively in ways that can far outpace even the Roth IRA. It's changed in the last 15 years, and not everybody has kept the price of those changes and it really has turned into a very dynamic tool that we recommend to many of our clients because of all of the things that it can do that none of these other assets can do.
Like I said, I keep saying it over and over and over again, it's not perfect, it has to be the right situation, and it can't be jamming a square peg in a round hole, but when we find the right situation, it can be very, very productive, it can do some great things when it comes to long-term care, growing money safely and productively, shielding our clients from what I call from my third book The Volatility Shield, it can give your stock market portfolio a bit of a rest so you can draw money out of your LIRP during years when your stock market is down so that you can allow your stock market portfolio to recover while you're living off of your LIRP. It does a lot of different things that people aren't aware of and I think that these innovations have really come about in the last 10 to 15 years and I think that as more and more financial advisors investigate it, maybe they want to read each of my three books, The Power of Zero, Look Before You LIRP, and The Volatility Shield, when they start to investigate the math behind it, math has got to vindicate and corroborated whatever strategy you do, when they start to investigate the hardcore math behind it, they'll see that the math really does win the day when it comes to these programs.
Jonathan: Absolutely, and you did an excellent job in your books as well as in Look Before You LIRP that explains what are some of the features and benefits of a product design to really be able to maximize the efficiency of the tax code for the benefit of the individual. For almost a decade, I worked with a company that focused solely on buy a term and invest the difference, and that was my mantra, that was a crusade and I found that after almost a decade of analyzing whole life policies and life insurance policies, that of 2000 policies I’d analyzed, there had only been four that actually worked in the manner in which you described in your book Look Before You LIRP, and coming into making a reform really from my own mindset of how to be able to look at the tax codes and also product design, we have to start identifying the anomalies within the industry that benefited the consumer when engineered or crafted correctly for, as a fiduciary standard, making sure it's in the client’s best interest. Most advisors were unaware of those topics or even how to do that until after reading your book or getting a better idea of how they could implement that for their own clients.
The Roth, being one way to be able to have those funds grow tax-free and tax-exempt, what I found as a portfolio manager is that when you structure an insurance policy correctly, we could actually manage the funds with less risk for less than what actually cost to manage them in the market through our trading platform. That was just amazing when we average that out over any 10 to 20-year time frame that the costs were relatively low, on average, if structured correctly, about 1% to 1 1/2% and that can make a tremendous difference to what we found, David, in the accumulation of wealth for emerging affluent families but also for helping families reallocate dollars from their tax-deferred bucket into their tax-exempt bucket. Thank you for really championing that cause and that message because it really challenged us to think back through what we've traditionally perceived as an invalid solution for an optimal opportunity for each of our clients, whether it be income purposes or legacy purposes down the road.
Mark: David, this all sounds great and we are practicing this in our own firm and providing this kind of advice like Jonathan just said. It seems the time to act is growing shorter and the tax train is coming, so how would you suggest that folks get started in creating a plan to move assets from the first two buckets to this tax-free bucket? Are some folks simply too advanced of an age already to benefit from this approach now?
David: I think the first thing is you've got to find a qualified tax-free retirement expert, you guys obviously fit the bill very well. I would start, if somebody gave you a copy of The Power of Zero, start asking them some questions and if they answer those questions to your satisfaction, it means they probably understand the concept of the paradigm. Not all financial advisors are created equal, not all of them understand The Power of Zero paradigm. I've had people call me up and say, “Hey, Dave, someone gave me a book, The Power of Zero, and they couldn't even tell me what provisional income is.” Start by asking some basic questions of your financial advisors and make sure that they understand the concept, because you really need a seasoned hand to help you avoid the pitfalls and roadblocks that are standing between you and the 0% tax bracket. There's a right way and a wrong way to do it, there are all sorts of different thresholds, provisional income threshold, standard deduction threshold that you have to obey, all of these different streams of income have to fit together perfectly, I describe it as a puzzle, you want to have five or six different streams of tax-free income, none of which show up on the IRS’ radar, but all of which contribute to being in the 0% tax bracket. As those puzzle pieces fit together perfectly, then the 0% tax bracket starts to come into focus. I would say start by making sure that you have a steady hand that's guiding you down this path.
When it comes to shifting money from tax-deferred to tax-free, Chapter 6 of the updated revised version of The Power of Zero talks about the tax sale of a lifetime. It used to be that when people would say, “Hey, Dave, when are tax rates going to go up?” I'd say, “In some distant unknowable future, maybe 10 years from now, tax rates will likely go up,” well guess what, we now know the year and the day when tax rates will go up, January 1, 2026. When they go up, they're going to go up quite a bit. We've got the seven-year window of opportunity during which to take advantage of historically low tax rates. People say, “Dave, tax rates are a little bit lower under George W. Bush, the highest marginal tax rate was 35% back then, and today, it’s 37%.” I'm here to tell you that even though the highest marginal tax rate is 2% higher today, the income parameters that define today's tax brackets are much, much better than they were under George W. Bush, under Clinton. We have good deals of historical proportions when it comes to taxes, so you want to stretch the tax liability out over the full seven years, in other words, you don't want to shift so much every year that you bump up into a tax bracket that gives you heartburn, you also want to get the shifting done quickly enough that you get all the heavy lifting done before the tax train comes in 2026. It’s going to be a tiny tax train but I can guarantee there will be a much bigger tax train in 2028, 2030, and beyond as we start to have these days of reckoning when it comes to our national debt and these unfunded obligations.
Jonathan: David, if you could leave our listeners with just one key thing you'd want them to remember and act on from these two podcasts, what would it be?
David: If this were prior to the Trump tax cuts, I would say, “Hey, look, just get your house in order before tax rates go up.” Right now I have to say that if you let a single year go by without taking advantage of historically low tax rates, then your window narrows. If you wait until next year, now you only have six years to get the heavy lifting done, and if you only have six years, you might have to rise into a tax bracket that gives you heartburn to be able to get all the shifting done. If you wait until you only have three years left, you're almost certainly going to be in the highest marginal tax bracket, which means you spend less money in retirement because of your procrastination. I would say, not to get too philosophical here, but let's just strike while the iron's hot, let's take advantage of this window of opportunity while it's still around. I happen to think that the tax sale is going to last until 2026 because to change it would require democrats to get control of the House, the Senate, and the presidency, I don't think that's going to happen but it could, just make sure you're taking advantage of the next seven years because this tax sale, when it's over, it's going to be over, and we will never ever see these types of low tax rates ever again in our lifetime.
Mark: David, great advice. Thank you so much for that. As we close, what does Living a Richer Life by Design mean to you?
David: You've asked me this question before and I think it's an outstanding question and I love those two words “by design”, it simply says, “Let's be proactive.” When you do something by design, it has some intentionality, some proactivity, some thoughtfulness, so let's not just let it fly, let's not just take our retirement as it comes. If we do some proactive things today, we can really extend the life of our investments, we could wring a lot more tax efficiency out of our investments in retirement versus just kicking the can down the road and say, “Let's build this tax-deferred bucket up as big as we can, and when the IRS forces us to take money out, we'll just take our stripes.” Let's be proactive. When we do so, we'll find a way to actually have more money to spend in retirement.
Jonathan: David, thank you. We like to give you a special thanks for joining us in such a rich discussion for the last two sessions. Thank you for joining us today, appreciate your time, it's been incredibly valuable.
David: Thanks for having me, it's been a lot of fun.
Jonathan: Yes, Sir. For our listeners, thank you for listening to Living a Richer Life by Design. If you would be interested and be able to have your own tax-free roadmap or really be able to analyze your current situation, how to be able to maximize some of these strategies that David has shared with us today, please go to our website, you can go to lionsgateadvisors.com/podcasts or call 314-222-2788 or reach out to your financial advisor and ask them for assistance. If they're not able to answer those questions or provide you with a tax-free roadmap, we're going to encourage you to give us a call. Again, thank you for listening to Living a Richer Life by Design where our goal is to provide our listenership with a real-world practical solution so that they can care for the ones they love and serve those in need.
Mark: We hope you enjoyed today's show. At LionsGate Advisors, we believe a truly rich life entails much more than financial prosperity, it means crafting a life of purpose and intention. Be sure to subscribe to Living a Richer Life by Design to receive an update when a new episode is published. You can learn more about LionsGate Advisors by visiting us online at lionsgateadvisors.com.