Episode 35: Part 2, Jonathan Krueger from Living a Richer Life By Design, interviews David McKnight

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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?

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.

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.

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.

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?

Mark: David, great advice. Thank you so much for that. As we close, what does Living a Richer Life by Design mean to you?

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.

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.