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Hello there. David McKnight. Welcome to The Power of Zero show. I'm thrilled that you're with us for another week and we're looking forward to having a great show today. I am the best-selling author of The Power of Zero, Look Before You LIRP, and The Volatility Shield, all of which can be bought in bulk at powerofzero.com/Books. Also, if you need to follow me on Twitter, I would love to have you follow me on Twitter, it's @mcknightandco. If you're an advisor and you want help transitioning your practice to a Power of Zero practice, you can go to powerofzero.com and opt-in to our video series. If you're looking for a Power of Zero advisor, of course, you can go to davidmcknight.com and learn more about that.
Today, we have a very interesting show, we’re going to talk about what I call the LIRP conversion. Now, I'm going to start off by describing what the LIRP conversion is not. I get very uneasy when advisors recommend that their clients take IRAs—maybe you have $600,000 in an IRA—and that you convert every last bit of that into an LIRP, in other words, you pay the tax and you take whatever is leftover after-tax, that net amount after-tax, and you systematically shift it into an LIRP, so you might end up with a premium of $80,000 to $100,000 per year for 6 years. Not that I'm saying that there aren't scenarios where those size premiums aren't called for, but I get very uneasy when people don't take advantage of the Roth conversion and they opt almost exclusively for the LIRP. I think the LIRP has a lot of great benefits, but if you've been listening to this podcast for any amount of time, you know that I don't believe it's a silver bullet, it's not a panacea, it only works well when used in collaboration or in concert with lots of other streams of tax-free income. As I've said in past episodes, if somebody's trying to get you to put all of your IRA into an LIRP—$100,000 per year for 6 years and there's no other mention of Roth 401(k)s, Roth IRAs, or Roth conversions—I get very, very uneasy about that. I think that the LIRP is powerful only to the extent that it's used in collaboration with, in most cases, four to six other streams of tax-free income. That's when it gets really good, that's when the LIRP really shines because the LIRP, at that point, can do some things that those other streams of tax-free income can't do.
I've started off by defining what an LIRP conversion is not, now let's progress into the portion of the program where we talk about what an LIRP conversion is, when it is appropriate, and in what circumstances you may need to rely upon it. An LIRP conversion is something that I might utilize with a client when no other opportunity for Roth or Roth conversion is available. Let's talk about the first instance in which a traditional Roth conversion may not be available. Let's say, for example, that you have $1 million in an annuity, in your tax-deferred bucket, and it's already in there and we know that the annuity has a 10% free withdrawal provision, in other words, you can take out 10% without paying any penalty during that surrender charge period, you will have to pay taxes but you won't have to pay penalty. Let's say that you got $1 million in your annuity, in your tax-deferred bucket and you become convinced that tax rates in the future are likely to be dramatically higher than they are today and you say, “Okay, I want to reposition this money to a Roth IRA, I want to do a Roth conversion.” Here's the problem, most annuity companies these days say, “We're perfectly okay with you doing a Roth conversion so long as you do it all in one year.” I want you to think about the implications of doing that, what if you were to convert that entire $1 million IRA to a Roth IRA, all in one year, you would rise dramatically in your tax cylinder right up to the top of the 37% tax bracket, most of your conversion would be taxed at 37%, thrown another 8% or so for state depending on where you live, now you're looking at 45% tax on that conversion. You just lost almost half of that conversion due to taxes. There are some companies—this is pretty rare though—that may allow you to do what's called a mid-air conversion, in other words, you take a distribution from the IRA, take that 10%, so 10% of $1 million is $100,000, and then you do what's called a mid-air conversion, in other words, you tell the receiving custodian that they are going to convert that into a Roth IRA. Some companies will do this, in other words, you take a distribution from the IRA and then you convert it to the Roth IRA on the other end. That's pretty rare and you got to get the companies to agree upon that, but there's a lot of things that can go wrong and very, very few companies will participate in what's called a mid-air conversion. If you look online, Vanguard will do mid-air conversions on occasion, but for all intents and purposes, the mid-air conversion, for most of you who are listening, is probably not a viable option.
The question becomes, “You've got $1 million in this annuity, you want to take out $100,000 to be able to put it into the tax-free bucket, you don't want to convert it all in one year because of the tax implications and you don't want to participate in what we call this mid-air conversion, are there any other opportunities or any other means by which you can get that money transferred from tax-deferred to tax-free? This is the first scenario in which I might recommend doing what we call an LIRP conversion. What do we do? We get an LIRP, we get as little death benefit as the IRS requires of us, we stuff as much money into it as the IRS allows in an attempt to mimic all of the tax-free benefits of the Roth conversion but without the limitations that the annuity is posing on us. We are able therefore to take that $100,000, if we want to, we can have the tax withheld from that $100,000 so whatever is leftover net after-tax, let's just call it $75,000, that $75,000 can then go into that LIRP each and every year for however many years you want to do it.
Keep in mind, as your annuity balance goes down, in theory, if the annuity is growing every year, you should be able to take money out without having that shrink, it may not grow 10% every year so you're just taking the growth right off the top. In theory, 10% of that annuity is going to get smaller and smaller and smaller as time wears on so you'd have to structure the LIRP just the right way, but by taking that 10% per year, you could then stuff that into that net after-tax amount into an LIRP and let that LIRP grow in a completely tax-free environment. I have made the case in numerous podcasts that I believe that the average expenses per year over the life of an LIRP are about the same, if not a little bit less expensive than a typical IRA or 401(k), so the difference in this LIRP conversion scenarios, you're getting something very, very useful in exchange for that 1.5%, you're getting a death benefit that doubles as long-term care. Not only are you able to shelter that money from taxes, you're able to grow it in a tax-free environment, but you're also able to get a death benefit that doubles as long-term care, this should be something that's very, very interesting for folks who are over age 50 and recognize that one of the greatest risks they are likely to experience in retirement is a long-term care risk. That is the first scenario which I might recommend doing an LIRP conversion.
What is the second scenario in which I might recommend doing an LIRP conversion? That is if you are having an inherited IRA. I'm talking about a non-spouse inherited IRA. If you are a spouse and you inherit an IRA, there's no problem at all with doing a Roth conversion, if you inherited an IRA from a deceased spouse, you can certainly do a Roth conversion in that scenario. When are you not allowed to do a Roth conversion? We got to remember this, sometimes, this detail eludes us if you are a non-spouse beneficiary on an IRA, you now have an inherited IRA, you're now required to take RMDs by December 31st of the year after the death of the person who originally owned the IRA. You're now taking RMDs on that IRA over your life expectancy. The thing we got to always remember when it comes to inherited IRAs is you cannot convert an inherited IRA to a Roth IRA, you cannot do a Roth conversion on an inherited IRA. Could you take that money and put it into a traditional Roth IRA? You almost certainly could, you pay the tax on the distribution and then you put whatever is left over into the traditional Roth IRA. The problem with that, of course, is there may be some earned income limitations, if you're not working and you're retired, you wouldn't have access to the Roth IRA, so that's one potential limitation. Of course, the other limitation is that you can only put in $6,000 per year pre-50 or $7,000 per year with the catch-up provision if you're over age 50. This is where the LIRP conversion can be very, very useful.
You've got two options here, you can take the net amount after-tax of that RMD and you can put that into your LIRP, or you could say, “Hey, look, I don't want to be constrained by just doing the RMD alone on my inherited IRA, I believe that tax rates in the future are likely to be much higher than they are today. I've been listening to Dave for a while and I'm convinced I've seen the lay of the land, I see the handwriting on the wall, tax rates are going up, therefore, I am convinced that I need to be a little bit more aggressive with how I am converting money from my inherited IRA to tax-free bucket.” Then you could have a scenario where you take really as much as you want, you can say, “I want to convert up to whatever tax bracket does not give me heartburn and I want to get all the heavy lifting done before tax rates go up for good,” so you can then start being much more aggressive in how you convert this money from tax-deferred to tax-free. Keep in mind, you can't do a Roth conversion so the natural place that we could put that money is into the LIRP. Why? Because the LIRP has no income limitations, it's got no contribution limits, and it can be a very, very compelling place to warehouse capital, it can be a very, very compelling place to grow money in a safe and productive environment where it's growing tax-free. Of course, keeping in mind that you get a death benefit in exchange for those little drips that are coming out of your spigot each and every month, you get a death benefit that doubles as long-term care.
By the way, is there such a term as LIRP conversion? No, it's only something that I fabricated myself, an LIRP conversion, unlike a Roth conversion, is not an official IRS sanctioned term, but the principle very much holds true that if you are in a situation where the Roth conversion is not available to you, doing a strict Roth IRA may not be available to you or may not be impactful enough to really change your financial situation, then the LIRP conversion can become very, very useful. It's not a tool I would recommend for putting all of your money, I think the LIRP works very, very well when used in concert with a Roth conversion, but by itself, I get very, very uneasy if all you're doing is taking all of your IRA and stuffing it into LIRP. In scenarios where the LIRP is the only alternative, I think that the LIRP conversion works very, very well.
In summary, if you have an annuity that only allows you to take out 10% per year during that surrender period, that is a great place to start shifting money to the LIRP. If you have an inherited IRA and you don't have the ability to do a Roth conversion on that, then the LIRP becomes the hero in that scenario because it's the only tax-free solution left that would allow you to get that money from tax-deferred to tax-free.
That's the program for today, folks. Don't forget to subscribe. If you subscribe, wherever you listen to this podcast, then you'll get a little note every week when the podcast is ready. It's usually on Wednesday and you'll know ahead of time what we'll be talking about so you'll know that you'll want to tune in. Again, if you want copies of any of my books in bulk, go to powerofzero.com/Books, if you want to follow me on Twitter, please do, I would love to have you follow me on Twitter, go to @mcknightandco and follow me there. If you haven't watched the movie yet, you can stream it on pretty much anywhere you want to stream movies, The Power of Zero: The Tax Train Is Coming. Again, if you are looking for help navigating the path to the 0% tax bracket and you want help circumnavigating all of those pitfalls and roadblocks that stand between you and the 0% tax bracket, go to davidmcknight.com. If you're an advisor who wants help on transitioning your practice to a Power of Zero type practice, go to powerofzero.com and opt in to our video series. Other than that, thanks so much for listening this week and we will look forward to talking to you next week.