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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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Welcome to The Power of Zero show. David McKnight, your host. So grateful that you could be with us this week, carving a little bit of time out of your busy schedule to learn more about The Power of Zero paradigm. Reminder, I'm the author of the best-selling book, The Power of Zero, sold over 200,000 copies. If you just want one copy, you can find that on Amazon, most cost-effective place to get that, or if you want to buy them in bulk, you can go to powerofzero.com. Same goes for the sequel to The Power of Zero, Look Before You LIRP, and then a standalone volume fictional story couched within the story, is of an important financial principle, it tells you how you can protect yourself against a sequence of return risks, that book is called The Volatility Shield. I’m getting very, very good reviews on that, take a look at the reviews on Amazon. Again, you can buy that on Amazon if it's a onesie, twosie but if you want to buy in bulk, go to powerofzero.com. Also, a reminder that The Power of Zero: The Tax Train Is Coming movie, that's starting to grow and get more and more attention, please take a look at that, you can watch that streaming on YouTube, on Amazon, pretty much anywhere you can stream movies you can find it.
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All right, I'm actually pretty excited about today's show. We're going to talk about whether LIRPs really have high fees. The reason this is even a subject is because that is actually the number one criticism that you'll find online whether you're listening to Dave Ramsey, Clark Howard, or Suze Orman, they'll say, “You can't do an LIRP because the fees are simply too prohibitive,” and of course, the question I always raise is, “They're expensive compared to what?” I usually like to compare the fees to where you might otherwise be putting your money had you not put it into an LIRP. Where would you be putting your money if not into an LIRP? The answer is into some sort of investment. What are typical investment fees? Whether it's a 401(k), an IRA, or an investment in your taxable bucket, you're looking at an expense ratio of 1 1/2%. What is an expense ratio? That's what the fund managers are going to be charging you to manage your money. I’ll give you an example; if you have your money, your retirement account in a 401(k) that's invested in mutual funds and you are paying a 1 1/2% expense ratio—or some people might phrase that as a 150 basis points, same thing—then if your investment grows 30%, that means you really only grew at 28 1/2% because they shaved a point and a half off of your account.
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Now, the converse is true if your investment is down 30%, then they're going to subtract an additional 1 1/2% from that, so if you lost 30%, you really lost 31 1/2%. Rain or shine, they're going to charge you that 1 1/2%. When we say LIRPs are expensive, we always say, “Compared to what?” We have to use as a baseline this number of 1 1/2%, can you get cheaper investments out there? Certainly, but I’m talking about the typical, it’s actually, according to USA Today, the average 401(k) expense is 1 1/2%. The question is are LIRPs more or less expensive than a traditional 401(k) account? The way I describe the LIRP is a bucket of money that grows tax-free, there are no contribution limits, there are no income limitations, you don't pay taxes if you take the money out, take it out the right way, it doesn't affect provisional income, it's a true tax-free investment, and there's not likely to be any legislative risk down the road, meaning that if they were to change the rules somewhere down the road, they're likely grandfather, whoever has the account today, and you get to continue to enjoy whatever the rules were prior to them changing the account. This is an LIRP, it's a bucket of money, it's tax-free, it's an unlimited bucket of tax-free dollars for all intents and purposes, but the IRS says, “If we're going to give you this unlimited bucket of tax-free dollars, we're going to require that there be a spigot attached to the side of that bucket through which flows on a monthly basis on expenses.” Where do those expenses go towards? They go towards some administrative fees, they go to pay the guy who got you set up with your LIRP, and is continuing to monitor it for you over the life of the program, and helping you get to the 0% tax bracket so that guy's got to get paid. The insurance company’s got to get paid to keep their lights on and keep their doors open. You're also paying for the cost of life insurance. Why life insurance? Because the IRS says, “In order for this bucket to work, you got to be willing to pay for some life insurance, you got to have a need for life insurance, and even if it's not life insurance, if you have a need for long-term care, we know that you can get your death benefit in advance of your death for the purpose of paying for long-term care. Those are the expenses that you're paying for.
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I am prepared to make the argument that the expenses in the LIRP over the life of the program are probably much cheaper than what you’re paying in your 401(k) or IRA. This is how I explained the expenses in the LIRP, they're going to be a little bit higher in the early years because the insurance company's got to pay for all of the costs of getting the program up and running, they're paying for your medical tests, they're paying the advisor, they're paying to order your medical records, they're paying the underwriter to evaluate your medical record, so on and so forth. They're going to be a little bit higher in the early years, and when I say the early years, I'm talking typically the first 10 years, but they stay drop off the cliff in that 11th year, they become practically inconsequential that 11th year. Some companies may be the 15th year, depends on what the surrender charge is, typically 10 years, you're going to be paying expenses the first 10 years that are the equivalent of about 1 year's worth of premium but they're spread out over that 10 years. To get your program up and running, it's going to be a little bit more expensive in the first 10 years, however, like I said, they drop off the cliff in years 11 plus, and when I say drop off the cliff, I need really drop off a cliff, I'm talking going from higher down to 35 basis points or so years 11 until when you die. A little bit early, higher in the early years, much lower in the later years, but when you average it out over the life of the program, it's going to cost you less than 1 1/2% of your bucket per year.
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Now you may say, “Dave, I don't know if I'm willing to pay all of those expenses in the early years even if it gets much better further down the road,” and let me respond to that, as I say in my book Look Before You LIRP, I say it over and over and over again, don't do an LIRP if you're not planning on keeping it your whole life, it's not going to be a good deal, you may even end up having some adverse tax consequences, there's a death benefit, the component that only works when you actually die, and there's a long-term care or chronic-illness component that is going to be there for you in your waning years, but if you don't keep it until your waning years, you're not going to be able to use it. I say this over and over and over again, you have to embark on these relationships like a marriage, like I say in Look Before You LIRP—look before you leap, it's a play on look before you leap—don't embark on this marriage to your LIRP unless you're planning on keeping it for your entire life. If you're planning on keeping it your entire life, why are you getting fixated? Why are you getting hung up? Why are you getting wrapped around the axle when it comes to the expenses in those first few years of the program which is frankly what Dave Ramsey does, frankly what Suze Orman does, and is frankly what Clark Howard does? If it's something you're going to be married to, till death do you part, you should really be looking at the expenses in terms of what it does to your internal rate of return over the life of the program. Now, why is this significant? Let's say that you're growing your money at 7 1/2%, which I could show you lots and lots of historical back-tested results where you're getting at least 7 1/2%, most of the time it's 8% or above, but frankly, the government is not allowing us to show 8% and above, we can show 7 1/2%, we can show 7%, let's say 7 1/2% for today's purposes, we show a 7 1/2% rate of return. If you look at the internal rate of return in the illustration, what you'll find is that the return for the first six years is going to be negative. We don't get hung up on this because we're not doing this as a short-term thing, we are doing it as a lifetime thing so we don't get fixated on the first six years, we don't break even for the first six years if it's structured properly and we're getting reasonable rates of return. You start inching into positive territory in terms of internal rate of return probably in the 7th or 8th year and then it gets really, really good once you hit that 10th year because the expenses completely fall off a cliff, now you're paying just the cost of term insurance which is not a lot, because if you're doing what we call option 1 or option A, the amount that you're paying for as time goes on, even though you're getting older, it gets smaller as time wears on.
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By the time you reach the 25th year, if you look at the internal rate of return on a 7 1/2% gross rate of return, you are going to be in a 6% to 6 1/2% net internal rate of return. What does that mean? That means that the internal expenses on average over the life of the program were between 1% and 1 1/2%, let's just call it 1% because the longer you keep it, the closer you're going to get to 1%. If in the 25th year, the expenses on average over the life of the program are 1%, then guess what, they might as well have been 1% all 25 years because if you line this up against a different investment that has 1 1/2% expense ratio like a 401(k) or IRA, that's going to be 1 1/2% year one, year 5, year 10, year 15, year 20, year 25, it’s going to be 1 1/2% the whole time. If you look at how much money is in the LIRP after 25 years in the 25th year, if the average internal expense is 1%, you're going to have far more money in the LIRP than you would the 401(k). Why? Because if the internal rate of return reflects a 1% expense over the life of the program, it might as well have been 1% year 1, year 5, year 10, year 15, year 20, it's not the case but if the internal rate of return reflects that it might as well have been.
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I repeatedly ask people who get hung up on expenses, “If you are keeping this for 45 years, 35 years, even 25 years, why are you getting hung up on the expenses in the first couple of years?” You should really be looking at what the expenses are over the life of the program. I'm not here to tell you for a second that the cost of admission to these programs is not significant in the first 10 years. I'm just telling you that when you average it out over the life of the program, which is really what you should be doing when considering a lifetime proposition like the LIRP that really pays benefits the longer you keep it, we should really not be getting hung up on what happens in the first several years. It's like when you buy a home, most of your money is going towards interests in those first couple of years, but then you get to the point in the mortgage where it really starts cranking, you really start paying down that principal, it's a little bit like that in the LIRP, maybe a gross oversimplification, but the longer you keep the LIRP, the more dramatically those expenses reduce and the better your internal rate of return and you literally get to the point where if you keep this thing long enough, i.e., the length of time that you intended to keep it when you started the program, you are going to have a really, really lean tax-free bucket of money that is far more flexible than any other tax-free bucket of money that you can get.
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Now remember, we've talked about the expense but we have to remember that you're getting something useful in exchange for these expenses. What are you getting in exchange for these expenses? You're getting safe and productive growth, guess what, if it's costing you say 1% and you're getting a gross average rate of return of 7 1/2%, you're getting 6 1/2% tax-free without taking any more risk than you're accustomed to taking in your savings account. Let me ask you that, if you could get 6 1/2% without taking any more risk than what you're accustomed to taking in your savings account, I would say that's a pretty safe and productive way to grow at least a portion of your money. If you could get 6 1/2% in your bond portfolio without taking any more risk than what you're accustomed to taking in your savings account, I would say that's a pretty good bond portion of your portfolio. What a lot of people do is they'll say, “Hey, look, if I can get safe and productive 6 1/2% growth or even 6%, growth I will make that the bond portion of my portfolio and I can, therefore, take a little bit more risk in the rest of my portfolio.” I think that's significant. In short, what I really want to tell you is that I think that the expense issue in LIRPs is way overblown, we have to contextualize the expenses within the broader picture and remember that we're only doing the LIRP because it's going to provide us benefits over our lifetime, and if it's going to be providing us benefits over our lifetime, we should not be making snap judgments on what the cost of that program is in those first couple of years.
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Anyway, that's the show for today. I just wanted to remind you that LIRPs have some amazing qualities, again, they're not a silver bullet, they should be used in cooperation and in concert with all of your other tax-free streams of income, your Roth IRAs, Roth 401(k)s, your Roth conversions, distributions up to your IRA, offset by your standard deduction, and of course, if you do it all just the right way, you get to be in the 0% tax bracket. My partner, Larry, has a great saying, he says, “Getting 0% tax bracket is like having a perfect key,” a perfect key, if you look at the key, you turn it sideways, you can see the ridges on there and the ridges have to be just the right height, some are taller, some are shorter, you got little gaps in there, you got peaks and valleys, and if all of those things are just the right height and just the right depth, then it unlocks the tumblers in that lock. Getting the 0% tax bracket is exactly the same way, you've got to have the right amounts of money in each of these accounts, some accounts are a little bit higher, some are a little bit lower, but when you have the right levels inside those accounts, it unlocks the 0% tax bracket. If you are too disproportionately allocated in one account, you're not going to get there. If you're not accounting for an inheritance that you're likely to receive somewhere down the road, then you're not going to get to the 0% tax bracket or you'll think you'll be there and then all of a sudden, the lock will seize upon you. The LIRP is not a silver bullet. It needs to be used in cooperation and in concert with all these other streams of income, and the harmony between those has got to be just right, but I'm also here to remind you that the LIRP can do something that none of those other streams of income can do, it can give you safe and productive growth, and when productive, 6% to 6 1/2% is a very productive way to grow a portion of your money, it's giving you a death benefit that doubles as long-term care, and if you die peacefully in your sleep 30 years from now, never having used it, someone’s still getting a death benefit. There's that sensation of having paid for something you never have to use and what I predict is that as we dispel a lot of these myths as it relates to the LIRP, from what you're seeing online from people that don't understand how it should be used properly, I think that you're going to see that the LIRP is going to grow in popularity, especially as people recognize how powerful it is—and Wall Street Journal’s articles bear this out—how powerful it is when operating as a solution, a risk mitigation alternative to long-term care or what we call having a chronic illness.
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Again, that's the show for today. If you need help navigating all the pitfalls standing in between you and the 0% tax bracket, we're happy to help you out, go see us at davidmcknight.com and we'll be happy to give you whatever assistance you need. Again, subscribe. If you want to get these podcasts every week, we're going to have new content coming out like we have for the past 42 weeks, every week from here on out, and if you want to know what we'll be talking about and when that show arrives, typically on Wednesday, subscribe to us and we will send you an email letting you know exactly what we're talking about and when it's going to be airing. Thanks again for being on the show and we will look forward to talking to you next week. Have a good one.
