A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
Hello there. David McKnight. The Power of Zero show. I’m grateful that you're spending a few minutes out of your very, very busy day to learn more about The Power of Zero paradigm. I'm the best-selling author of The Power of Zero, Look Before You LIRP, and The Volatility Shield, all of which can be purchased in bulk at powerofzero.com/Books. If you are looking for a Power of Zero advisor and need some help navigating all of the pitfalls standing between you and the 0% tax bracket, you can go to davidmcknight.com. If you are an advisor looking for more training on how to prepare your clients for the eventual dramatic rise in the tax rates, you can go to powerofzero.com and opt in to our video series.
I'm actually pretty excited to talk about the subject today. Today, we're going to be talking about the hallmarks of a true Power of Zero advisor. If you're looking for a Power of Zero advisor or you are an advisor that's hoping to embrace The Power of Zero paradigm, I'm going to lay out a few things for you today that are must-haves. The thing that has provoked this conversation is that over the years, I have noticed a number of advisors who hold themselves out as Power of Zero advocates or fans of The Power of Zero book or believe in their heart of hearts that tax rates in the future are going to be higher than they are today, yet there are a number of significant shortfalls in their approaches, so I thought I would layout today, if somebody accused you of being a Power of Zero advisor, would you be able to be convicted in a court of law of being a Power of Zero advisor? What I'm going to lay out today are the five or six qualities of a Power of Zero advisor that would be a surefire tip-off to the jury that you are, in fact, a true dyed-in-the-wool Power of Zero advisor.
The first thing we're going to talk about is that a true dyed-in-the-wool Power of Zero advisor believes that tax rates are going to be higher in the future than they are today and knows how to defend that position. The true Power of Zero advisor understands the national debt, understands what the true national debt is, we know that the publicly stated national debt is $22.5 trillion but we know that there are a number of off-the-books obligations that are not included in that number, and were we living in any other country in the world that does normal accounting practices—which is really 95% of developed countries—our national debt would not be $22.5 trillion, it would be closer to $239 trillion if we follow what we call fiscal gap accounting which is what Dr. Larry Kotlikoff out of Boston University has pioneered which really seeks to understand the present value of all of our future obligations, in other words, what is the difference between what we've promised versus what we can actually afford to deliver, put it in a bank account today or in Treasury rates, how big would that number have to be to be able to pay for all this stuff, and the number is not $22.5 trillion, it's actually $239 trillion. A true Power of Zero advisor understands that, understands the implications of all of these things, recognizes, very clear-eyed about the reality that tax rates have to either double, expenses have to be cut in half, or some combination of the two. That's the first hallmark of a true Power of Zero advisor, although that, in and of itself, is not enough to convict you of being a true Power of Zero advisor.
The second thing that we're going to talk about I think is much more indicative of whether someone is a true Power of Zero advisor is this, in a rising tax rate environment, there is an ideal balance to have in the first two buckets, the taxable and tax-deferred buckets. We know that actually, regardless of what direction tax rates are going, the ideal balance in the taxable bucket is six months worth of basic living expenses. If you really wanted to adhere to the CFP definition of the perfect balance in the taxable bucket, it would look a little bit like this, if you have two income earners in the house, then you could probably get away with three months worth of basic living expenses, if you have one income earner, you are probably getting any closer to six months, and if you are a business owner, you're probably better off with six months to a year, but we average it all out, we say, “Hey, look, generally speaking, financial experts say six months is the basic amount that you should have in the taxable bucket,” that is not really a question that's up for debate, the real thing that would be the litmus test for a Power of Zero advisor is if they can tell you what the ideal balance on the tax-deferred bucket is. What is the ideal balance on the tax-deferred bucket in a rising tax rate environment? You should be able to wake up a true Power of Zero advisor in the middle of the night and put a gun to his head and say, “What is the ideal perfect balance to have in the tax-deferred bucket in a rising tax rate environment?” You should be able to say, “The ideal balance in the tax-deferred bucket is low enough that required minimum distributions are equal to or less than standard deductions but also low enough that it does not cost Social Security taxation, in other words, for most people that don't have pensions or other sources of residual income, it's about $350,000.” Why? $350,000 will create an RMD that is below your standard deduction but also low enough that it does not cause Social Security taxation with all of the compensating spend-down that goes along with that. I have a hard time finding advisors outside of those who I train week in and week out that can articulate that particular concept clearly. I think that if you are aspiring to be a Power of Zero advisor in the truest sense, this is a principle that you should embrace, understand, be able to articulate to your clients, you can have too much money in your tax-deferred bucket and when you do, it unleashes a cascade of unintended consequences that could lead potentially to Social Security taxation, and of course, expose you to massive amounts of tax rate risk.
Concept number three, a true Power of Zero advisor believes in this idea of multiple streams of income. In other words, if you have an advisor who professes to be a Power of Zero advisor who comes up to you and says, “The only thing you really need to get to the 0% tax bracket in retirement is a life insurance retirement plan, cash value life insurance, indexed universal life, or whole life,” what have you, that should be an immediate tip-off that they are not fully embracing, actually, not even close to fully embracing the concepts in my book The Power of Zero. I've been doing this for over 20 years, I've helped thousands of people on the road to the 0% tax bracket and I can tell you this, it's nearly impossible to get to the 0% tax bracket by relying on just one stream of tax-free income, you can't get there with just an LIRP alone, you can't get there with just traditional Roth IRA alone. To get to the 0% tax bracket typically requires multiple streams of tax-free income, none of which show up on the IRS’ radar but all of which contribute to you being in the 0% tax bracket. One of the reasons why this is the case is because of the five or six streams of tax-free income I typically recommend to my clients, each one of those tax-free streams of income has a strength, has a quality, is able to accomplish something that none of the other streams of tax-free income can do. I'm going to breeze through this very quickly because I know we've reviewed this in past episodes but I think it's important to really understand this.
For example, I love the traditional Roth IRA, you can only put in $7,000 each for those who are over age 50. But the thing that I love about the Roth IRA is its instant liquidity, whatever you put in, you can take out immediately, you are not like a 401(k) or an IRA, you are not tying that money up until you're 59 1/2. The Roth IRA is tax-free but it gives you liquidity. Now, remember, if you take it out and don't get it back within the proper time frame, you lose out on the ability to make that contribution for that year so you need to be very cognizant that if you're using this as an emergency fund and you don't return the money to the Roth IRA within the 60-day time period, then you lose the ability to make that contribution for that year with all of the unintended consequences that go along with that.
Second stream of tax-free income, Roth conversion. I love Roth conversions because even if you had $10 million sitting in your IRA, you could still get to the 0% tax bracket. For a lot of people, Roth conversion is going to be one of the real workhorses doing a lot of the heavy lifting to help them get to the 0% tax bracket. With Roth conversion, you don't have income limitations, you can convert as much as you want, none of the other streams of income we'll be talking about today have the sheer workload capacity that the Roth conversion has.
Third stream of tax-free income, Roth 401(k). I love the Roth 401(k) because you get free money. Put in up to the match, at the very least, in your Roth 401(k), that match will go into your tax-deferred bucket, everything else will go into the tax-free bucket. There's no beating 100% return on your money in that first year so definitely something that none of these other streams of income can do.
Let's talk about RMDs. By using Roth conversions to get your IRAs down to the ideal balance, then that IRA will then create a required minimum distribution that gets offset by the standard deduction. This is what I call the holy grail of financial planning. None of the other tax-free streams of income do this. In this scenario, you would get a deduction on the front end so you get a deduction when you put the money in, it grows tax-deferred and when you take the money out by using that standard deduction to offset the income coming out, then that money is tax-free. I love that because none of the other streams of tax-free income we've been discussing so far can do that. In that regard, the RMDs are very, very unique and there's something that needs to be part of the puzzle.
Penultimately, the LIRP. We love the LIRP because it is tax-free, yes, but that has that in common with all the other things we've talked about. It's safe and productive, we like that, you could, in theory, get that and say, an annuity inside a Roth IRA, but one of the things I really love about the LIRP is what you're getting in exchange for that 1.5% average expense per year over the life of the program. What you're getting in exchange for that is you're getting a death benefit that doubles as long-term care or what we call a chronic illness rider. You are getting your death benefit in advance of your death for the purpose of paying for long-term care. I've said this over and over and over again, people aren't opposed to having long-term care insurance, they're just opposed to paying for it. Show them a way that they can get long-term care insurance without feeling like they're paying for it, i.e. pay 1.5% expenses per year which is similar to what they might be paying in their 401(k), show them how to get that without feeling like they're paying for, now we can have a meaningful conversation and lay out a meaningful strategy on how to deal with long-term care in a way that's not going to give everybody a heartburn.
The last one we'll talk about, Social Security. Social Security helps mitigate against a number of risks, it helps mitigate against longevity risk, sequence of return risk, inflation risk, deflation risk. The longer you live, the better it gets, the longer you live, the more you take out and the greater the return on your investment relative to what you put into the program. I love programs that reward you the longer you live.
A true Power of Zero advisor should be able to rattle all of this off, be able to tell you what the benefits of all these different tax-free streams of income are, this is basic Power of Zero 101. If an advisor is not able to do that, then they need to really get back to the basics in terms of what The Power of Zero paradigm is.
Next concept, a true Power of Zero advisor recognizes the importance of this following date, January 1, 2026. I say this all the time, prior to 2018, people would say, “Dave, when are tax rates going up?” I was like, “Gosh, I don't know, maybe 10 years from now, tax rates are likely to be higher than they are today,” guess what, because of the Tax Cuts and Jobs Act of 2017, we now know the year and the day when tax rates will go up, that tax cut went into effect January 1, 2018 but it had an expiration date, it had what we call a sunset provision so we know that January 1, 2026, tax rates will revert back to exactly what they were in 2017, this has massive, massive implications. The reason it has massive implications is because for a lot of Americans, by not taking advantage of the next seven years of historically low tax rates, postponing the payment of those taxes until after 2025, they will be missing out on a massive window of opportunity. We will not ever see in our lifetimes the window of opportunity, the likes of which we are seeing today. We have seven years of historically low tax rates, you're going to have to pay your taxes now or you're going to have to pay them later. Why not pay your taxes while taxes are on sale?
A true Power of Zero advisor recognizes the historical implications of the tax rates that we are currently experiencing, there's a reason, in the updated and revised version of The Power of Zero, Chapter Six, I call it the tax sale of a lifetime, and the reason I say that is because when the tax sale is over, January 1, 2026, it's over for good. Tom McClintock, Republican congressman out of California in Sacramento area, when we interviewed him in and off the movie, I don’t want to say it's off the record but part of the conversation that was not in the movie was that in eight years, we are going to be Venezuela. Guess what, folks, if in eight years, we're going to be Venezuela, we are not going to have any more tax cuts, the likes of which we’re seeing today after 2026. Your financial trajectory can't run off the rails, the likes of which we are likely to experience in seven or eight years without having to raise more revenue to fix the situation. If it's true that what all these experts are saying and in our movie, The Power of Zero: The Tax Train Is Coming, then in eight to ten years, we are going to run into serious, serious fiscal straits, absent a dramatic rise in tax rates or a dramatic reduction in spending, then guess what, there are not likely to be any future tax decreases. Once this thing is over, it's over, people, and you will have missed out on an opportunity had you not taken advantage of it. It's a pretty big date. A true Power of Zero advisor is going to be bringing that date up all the time helping you understand the urgency of taking advantage of these low, low tax rates.
The last one I want to talk about today is a true Power of Zero advisor would never lock up a significant portion of your assets in the tax-deferred bucket in the form of an income annuity that didn't have Roth conversion features. Here's what I mean, a lot of people don't realize this but there are significant benefits associated with having a portion of your income guaranteed for life in retirement, it protects you from all sorts of things, it protects you from longevity risk, withdrawal rate risk, sequence of return risk, it takes a lot of stress out of retirement and a lot of advisors shoot a lot of financial periodicals, Ph.Ds, people who've done Monte Carlo simulations for years, they all say that the math and science of retirement suggest that having a portion of your income guaranteed in retirement will optimize your results, there's no disputing that. However, there are unintended consequences associated with having that income guaranteed within your tax-deferred bucket, and have it be stuck there forever, it's tantamount to having a pension, it'll cause Social Security taxation. If tax rates go up, it'll force you to spend down all your other assets that much faster because remember, if you're giving up a portion of your Social Security to taxation, if you're giving up a portion of this guaranteed stream of lifetime income to taxation, what are you going to have to do to compensate? You're going to have to spend down all your other assets that much faster which is why a true Power of Zero advisor wants to create those streams of tax-free income but wants to do it in the tax-free bucket. You might have an annuity, for example, that's designed to create that stream of tax-free income, but that annuity will have conversion privileges that allow you to convert that annuity to a Roth IRA and then elect to receive that lifetime guaranteed stream of income out of the tax-free bucket.
If you had $1 million and an advisor came up to you and said, “Let's put that into your tax-deferred bucket, let's start the income immediately,” by the way, once you start the income, your ability to get it out of the tax-deferred bucket is done, it's a fait accompli, once it's in there and the income starts, you can never ever get it out of there and get it into the tax-free bucket, it will be a tax-deferred stream of provisional income for the rest of your life with all of the unintended consequences that go along with that. A true Power of Zero advisor recognizes this and recognizes that there should be a period of transitioning dollars from tax-deferred to tax-free, can take place in the right kind of annuity, but that annuity has to have provisions within it that allow for Roth conversions. Then once that money gets to tax-free, you can then elect the income and have that income come out in a tax-free nature that's not exposing you to tax rate risk and is not exposing you to potential Social Security taxation. These are really the five or six things that I would look for in a true Power of Zero advisor, and absent any one of these attributes or any one of these beliefs or worldviews, you have a little bit of a hole in your Power of Zero game. Whether you’re a Power of Zero advisor and you’re looking to up your game or whether you are just an average pre-retiree looking to find a Power of Zero advisor, these are the types of things that you should be looking for.
That's the podcast for today. Again, subscribe. If you want to know what our message is going to be each week and when it's ready for your consumption, you should subscribe. Like I said at the beginning of the podcast if you are looking to become a Power of Zero advisor, go, take a look at our video series at powerofzero.com, you can get books at powerofzero.com/Books. If you are someone that is simply looking for a Power of Zero advisor to help you navigate the pitfalls that stand between you and the 0% tax bracket, check us out at davidmcknight.com, we're happy to hook you up with an advisor who's experienced, who subscribes to everything that we talked about on the podcast today, and can help you get to the 0% tax bracket before tax rates go up for good.
Thank you for sharing a few of your valuable minutes with me this week and I really, really look forward to talking to you next week. Have a great week everyone.