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 McKnight, The Power of Zero show. Thank you so much for spending a few moments of your day. To learn more about The Power of Zero worldview, I am the best-selling author of The Power of Zero, we just eclipsed 200,000 copies in all mediums, that's a book, Audible, and Kindle. We've also got the much-anticipated sequel to The Power of Zero, came out a few years ago, it's called Look Before You LIRP, and also most recently, The Volatility Shield. If you have not had a chance to watch The Power of Zero: The Tax Train Is Coming documentary, please do so, you can watch it pretty much anywhere; Amazon, YouTube—YouTube you do have to pay, I think it's $3.99, $2.99, something like that—you can watch it on Google Play, pretty much everywhere you want to go. If you want to gift a copy to someone to watch, you can go to reelhouse.org and you can actually gift a link to a friend or a colleague and they can actually watch that, basically, you're gifting a view of the movie. There are all sorts of different resources that are out there that you can utilize to help bone up on The Power of Zero paradigm. Of course, please subscribe to this show when you have a chance, that way, every time a new episode comes out, you will get a little notice in your email inbox which is always nice to know when it is completed, when you can start viewing it, and what it's going to be about.
Today, I want to dispel what I call the “Great Roth Conversion” myth. It goes a little bit like this, you will find articles on the internet or your so-called financial gurus that say that if you do a Roth conversion, you have to do it a number of years before retirement because you have to have the ability to recuperate those dollars that you paid towards tax, in other words, you need enough time to be able to allow your account to make up or to grow to the point where you offset the tax that you had to pay. It just doesn't stand up to scrutiny. That four-letter word that David Walker talks about all the time, “math”, it doesn't really stand up to the math and I'm going to show you in a very succinct way that you can use with your friends and colleagues to illustrate my point.
The point I'm going to give you is a variation on the example I gave in The Power of Zero book. Let's say we got two brothers, I will call them John and Michael. John decides that he's going to put money into an IRA, he's just going to put $100 into his IRA. He gets a tax deduction on the front end so he can put the full $100 in. He puts it in an investment where, over the course of, let's call it 10 years, he's able to double his investment. He now has $200 in his IRA. At the time that he decides to take the money out, let's just pick a nice round number, he pays 30% tax. Now, after having grown his money to $200, he now takes a tax hit of 30%. If you pay your taxes at 30%, you'll find that he's left over with a $140.
His brother, Michael, decides that he wants to go the tax-free approach, so instead of putting the full $100 into the account, he decides to pay taxes on those dollars, he's going to pay tax at 30%, that's the same rate at which John experienced the tax deduction. Michael pays tax at 30%, he's leftover with $70. He then puts his money into the very same investment, in that very same investment also doubles over the course of the next 10 years. How much money does Michael have left in his investment if it doubles over that 10 years and he doesn't have to pay tax on the back end—because remember he opted for tax-free? He now has a $140.
The question is which one has more money at the end of that 10-year time frame? John or Michael? If you were following along with me, you'll find that they both had exactly the same amount of money. John has $140, Michael has $140.
What's the moral of the story? The moral of the story is that most people believe that if you have $100 in that account and it grows to $200, that on paper you really have $200, and the answer is, of course, you don't. If all things being equal, tax rates being equal on the front end or the back end, you really have the exact same amount of money as the tax-free alternative, because if your taxes starting off are 30%, then of that $100, you really only own $70 because $30 technically belongs to the IRS. As your portion, that 70 cents, grows over the course of time, the IRS’ portion grows right along with you. Which one's more valuable in a level or stable tax environment? Guess what, they're worth exactly the same amount of money. The IRA is worth exactly the same as the Roth IRA.
This is where we come to the moral of the story. The moral of the story is this: There aren't calculators on the internet that can show you which one's better, the IRA or the Roth IRA, it has nothing to do with, “Do you have enough time to catch up and allow your IRA to recover from the taxes you paid on that Roth conversion?” Because regardless of whether you do your conversion or your shift from tax-deferred to tax-free, whether it's year 1, year 2, year 5, year 10, the same math hold sway, you're going to have the same amount of money in either account in years 2, 5, 8, or 10. This whole idea that you have to take this tax hit on the front end and then you have to have enough time to allow the tax-free account to catch up to where the tax-deferred account would have been, it's just a bunch of malarkey.
It all comes down to, “Do you think that the taxes that you are going to pay on the front end are going to be greater or less than what you would pay on the back end?” If you think that the taxes on the front end are greater, you do the IRA, if the taxes on the back end are greater, then you do the Roth IRA. That's the only variable that really matters is what the tax rate is going to be, because remember, if you started on the front end with a 30% tax and they go up to 40% tax on the back end, who wins in that scenario? Of course, the Roth IRA wins because if you're paying 40% tax on the back end, then you only have $120 left in the example that we gave you, whereas the IRA still has $140.
The question you should always be asking yourself is where will tax rates be in the future? That is exactly why I go to such great lengths to try to explain to people the fiscal trajectory of our great country. Our country is great, the fiscal trajectory is not so great. Given the unfunded obligations for Social Security, Medicare, and Medicaid, given the fact that we really don't owe $22 trillion of debt that's a publicly stated debt, we really owe, according to Larry Kotlikoff out of Boston University, we owe closer to $239 trillion of debt, do you really feel in your heart of hearts that your tax rate down the road is going to be lower than it is today? If you think that's true and you think that it's mathematically possible for that to be the case, then, by all means, do IRAs and 401(k)s to your little heart's content. If, however, you think conversely that tax rates have to go up just to keep our country solvent, then really you should be opting for tax-free.
Remember, it's okay to have some money in your tax-deferred bucket because you're going to need some money in there to be able to take money out and have it be offset by the standard deduction when you retire, but that's really a finite amount for most married couples without any residual income like pensions, rental income, or farm income, that's really going to be between $250,000 and $350,000, that's really the sweet spot, you shouldn't have more than that amount in your tax-deferred bucket.
I just wanted to really drive this point home because I hear it a lot and I think that the people who put forth these ideas about whether a Roth IRA is a good idea or not really need to sit down and go year-by-year what the after-tax net you would experience from an IRA versus a Roth IRA, go through year-by-year-by-year and see what the net after-tax amount is that you'd be able to spend, I think what you'll find is it's exactly the same year-by-year-by-year, there's no catch-up period, you don't have to recuperate the tax because as your IRA grows, your portion of it grows, but the IRA’s portion grows right along with it.
I didn't want to do a podcast that was too terribly long today, but I just wanted to drive that one point home that there is a grand myth when it comes to Roth conversions or for that matter shifting money out of an IRA into, for example, an LIRP. Whether it's going to the Roth conversion or to the LIRP, the question is not, “Do I need to be able to have enough time to recuperate?” the question is, “Will I pay a higher tax in the future than I will today?” Guess what, if you take stock of what's going on in our country and you do the math and you say, “Look, I think that I'm going to be in a higher tax bracket today then I will down the road,” then you can be completely at peace with a decision to put money in your IRA or 401(k), but if after having examined all the data and all the evidence you feel like tax rates down the road are going to be higher, then by all means, don't succumb to all this other malarkey that I hear on the internet and from some of these financial gurus that you need to recuperate the tax and you need to have enough time to do, so don't buy into it because remember, math is always on your side if tax rates down the road are going to be higher than they are today.
That's the show for today. Thanks for spending a small portion of your day with me. If you want to have help getting to the 0% tax bracket, please certainly go to davidmcknight.com and we're happy to help you navigate all the pitfalls that stand between you and the 0% tax bracket. Again, subscribe, subscribe, subscribe, that's going to put you in a position to get every single one of our podcasts.
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