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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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Hello there. David McKnight. The Power of Zero show. Thanks for being with us this week. I am the best-selling author of The Power of Zero, Look Before You LIRP, and most recently, The Volatility Shield. All three can be purchased on Amazon or in bulk at powerofzero.com. Today, it's not going to be a long show, but we are going to talk about three critical mistakes that most people make when preparing for retirement. These are things that you really need to resolve really well before you retire, these are things that you need to be thinking about now, so let's dive in.
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The first mistake—and this is not going to be a surprise to any of you—the first mistake that people make is to assume that you will be in a lower tax bracket in retirement during your working years. This is what has fed into a lot of the contributions to 401(k)s, IRAs over the years, this has been something that has been hit upon by some financial gurus online and in other media sources. They say, “Hey, look, you are going to be in a much lower tax bracket in retirement, therefore you should get a deduction during your working years by putting money into 401(k)s and IRAs because you will postpone the payment of that tax,” yes, but you'll end up paying that tax any period in your life when you're likely to be in a lower tax bracket.
0:01:54
We've hit on this issue on a number of occasions throughout the history of this podcast, that is a misnomer and it is likely to be a miscalculation on the part of a lot of people that are preparing for retirement here in America, and let's dig into why. I don't want to spend too much time on this, I've done a whole podcast on the looming tax storm facing Americans or whatever analogy you want to choose, the tax freight train is bearing down on us, but we have $22 trillion of debt, we are hitting the trillion-dollar deficit, soon to become $2-trillion deficits. We have 10,000 baby boomers, we’re marching out of the workforce onto the roles of entitlement programs every day, that number’s going to be increasing as time wears on. They're going to stop putting money into Social Security, Medicare, and Medicaid. They're going to start taking money out, and that's when the “math” that David Walker often refers to catches up to us, because 2026, Medicare goes broke, 2032, Social Security goes broke, this is not just that they can't pay their bills, they literally go broke, there's nothing left, no money left.
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How do we account for these massive discrepancies in so-called entitlement programs that were required by law to pay for? How do we fill the hole, the massive gaps in the underfunding of these programs? By the way, Larry Kotlikoff updates his fiscal gap number every year, last year was $200 trillion, this year it's $239 trillion, what does that mean? That means we would have to have $239 trillion sitting in a bank account today earning Treasury rates in order to be able to pay for all of the promises that we've made to Americans in the form of Social Security, Medicare, Medicaid, and to be able to pay the interest on the national debt.
0:03:49
We have all of these obligations, and to suggest that we are going to be in lower tax brackets even 10 years from now is to be completely ignorant of the math. I've had arguments online with the likes of Clark Howard, The White Coat Investor, and indirectly with Dave Ramsey where they questioned whether we really need to raise taxes, The White Coat Investor has gone so far as to say, “We're simply going to inflate our way out of the problem, we are going to print money, and when we print money, that will take care of the problem.” What that doesn't account for, of course, is this idea that Social Security, Medicare, and Medicaid are all pegged to inflation. As inflation goes up, the amount the federal government is required to pay by law also goes up. How are we supposed to inflate our way out of the problem when as money inflates, the price of these programs increases commensurately? We can't borrow our way out, we can't put our way out, we can reduce expenses, it doesn't look like that's the track that we're on, the only thing that's left is raising taxes.
0:05:03
Retirement mistake number one is a huge one, it's buying off on this old conventional wisdom that suggests that you should be getting tax deductions today and postponing the payment of those taxes till some point much further down the road. The reality is you may not be in a lower tax bracket in retirement. Of course, this is a personal decision, you have to believe it, I'm not going to foist my beliefs on anybody, however, I think that when we look at the fiscal landscape of our country, it's hard to arrive at any other conclusion. That's huge mistake number one.
0:05:44
Huge mistake number two, having an IRA and 401(k) balances that are so big in retirement that required minimum distributions alone of those two accounts cause Social Security taxation. A lot of people don't even realize that your Social Security can be taxed, some people don't realize the impact of Social Security taxation. If you have too much provisional income and it's over $44,000 for married couples, over $34,000 for single people, then up to 85% of your Social Security can become taxable to you at your highest marginal tax bracket. Why is that a big deal? It's a big deal because, for most people, that means you're going to be paying, say, $6,000 and $7,000 in Social Security taxation, so guess what, you now have a $6,000 to $7,000 hole in your Social Security. How do most people go about plugging that hole? They start taking more money out of their IRAs and 401(k)s, and guess what, if you have a $6,000 hole in your Social Security and taxes go up to 50%, how much money are you going to have to take out of your IRA to be able to pay the 50% tax to the IRS and then be leftover with $6,000 with which you can then plug the hole in your Social Security? It's $12,000.
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I bring this up because I've studied this for a long time and I've done lots and lots of simulations, and what I found is basically that all other things being equal when your Social Security gets taxed and you have to compensate for it by spending it on your other assets, you run out of money faster, you run out of money, in some cases, five to seven years faster than you otherwise would than those people who do not have their Social Security tax. How do you get around this? You get around this by preemptively shifting your dollars to tax-free. What do I mean by preemptively? Basically, what I'm saying is you pay taxes on those dollars before the IRS absolutely requires it of you. You do it during a period of historically low tax rates that ends January 1st, 2026, and you say, “Look, I get it, I get the tax rates today are low, they're only going to go higher as time wears on, therefore, I am going to do something painful,” and by the way, I give you permission to not enjoy it, “I'm going to do something painful, I'm going to pay a tax before the IRS absolutely requires it of me because I want to avoid higher taxes down the road, even in this case, avoid paying tax on Social Security.” This is a big deal, and the only way to get out of it is to get those dollars shifted into Roth IRAs, permanent life insurance, particularly the kind that has the long-term-care benefit or chronic-illness rider because that will allow you to spend your death benefit in advance of your death for the purpose of paying for long-term care. I'm going to do a podcast and podcast and podcast just on the long-term care issue alone.
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The third mistake—I told you this wasn't going to be a super long podcast—the third mistake is not taking advantage of Roth IRAs and Roth 401(k)s while you can. Remember that every year that goes by where you fail to take advantage of a Roth IRA or a Roth 401(k), that is an amount of money where you no longer have the ability to contribute it to those tax-free accounts in that window once it closes—it closes April 15th at least for the traditional Roth IRA, if it closes April 15th of the following year, and of course, with Roth conversions and Roth 401(k)s, you've got to get it done in that tax year, but for traditional Roth IRAs, you got to do it by April 15th of the following year—when you let that window of opportunity go by without fully funding them to the extent that you can, those types of accounts, that window closes forever, not only do you lose out on those tax dollars, but you lose out on what those tax dollars could have earned for you had you been able to keep them and grow them in a tax-free environment for the rest of your life. If you're over age 50, you can currently contribute $7,000 for you, $7,000 for your spouse, for a total of $14,000, I think we talked about this in the last couple of weeks in our Roth IRA podcast. For a Roth 401(k), if you're over age 50, you can do $25,000, if you're under age 50, it’s $19,000, and it's $6,000 if you are a traditional Roth IRA contributor under age 15. There's an opportunity cost associated with not getting money into those types of accounts.
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Remember, if you've got lots and lots of money sitting in your taxable bucket, there's only a couple ways to get it out of there, I'll give you three ways right now’ first way, you can contribute to a Roth IRA. If you are maxing out your Roth IRA, then you can contribute to a fully-funded, properly-structured life insurance retirement plan that money can grow safely productively in a tax rate environment, you can take the money out tax-free like you might a Roth IRA, the difference is you've got a death benefit that doubles as long-term care.
0:11:28
Another way you can spend down the money in your taxable bucket is you can use it to pay taxes on Roth conversions, particularly if you're younger than 59 1/2. If you want to do a Roth conversion, the only way to really do it is if you have money sitting in a taxable bucket that you can earmark towards paying that tax bill. There are only so many ways to get money out of the taxable bucket, those are three ways, but again, if you let a year go by where you're not taking, say $14,000 out of there, sticking it in your Roth IRA, you're making a big mistake. Remember, Roth IRAs have great liquidity, whatever you put in, you can take out and you've got 60 days to be able to stick it back in if you want to, if you want to use it in as an emergency fund, but you're not required to.
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I guess my point is you have the ability in this period of historically low tax rates. Remember, the cost of admission to a tax-free account is you gotta be willing to pay a tax, that's the cost of admission. You use after-tax dollars to get it into these tax-free accounts and if you are letting a year go by where you're not maxing out these tax-free accounts during the tax sale of a lifetime, during a period of historically low tax rates, I think you are really, really missing the boat.
0:12:54
Remember, we've got three different mistakes that you can make in the lead up to retirement; number one is assuming you'll be in a lower tax bracket in retirement, number two, having a balance in retirement that's so big that required minimum distributions alone cause Social Security taxation, there's massive compensation that you have to do to make up for Social Security taxation, it forces you to spend down all your other assets that much faster, and finally, not taking advantage of Roth IRAs, Roth 401(k)s, and even Roth conversions for that matter, each and every year during a period of historically low tax rates. Once that year goes by, you've missed out and it's impossible to go back in time and try to recuperate those lost years.
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Most people that come into my office, they have very little balance between their buckets, they've got a little bit of money in their taxable, they've got 90% on tax-deferred, and occasionally, they have a little token contribution to their tax-free. Gosh, I really wish that when people came into my office, they had more balance between their buckets, it's called income tax diversification. By being aware of the three mistakes that I talked about in today's podcast, you can be less likely to fit in that situation where you have to do massive, massive shifts later on in life at a period in time when tax rates are likely to be much higher than they are today.
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That is the show for today. Of course, if you want copies of The Power of Zero, Look Before You LIRP, or The Volatility Shield, go to davidmcknight.com. Subscribe to this podcast and you will get an email and your favorite channel telling you that the podcast has arrived and telling you what the podcast is about. Of course, if you need help navigating getting to the 0% tax bracket, it's not easy and there are all sorts of pitfalls that you can fall into, we're happy to help you with that as well, go to davidmcknight.com and let us know how we can help. Thanks for being on the show today and we will see you next week.
