A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
Hello there. Welcome to The Power of Zero show. I am your loyal and faithful host, David McKnight. I am appreciative to you for carving out a portion of your day to listen to this podcast that today is going to go between 12 and 15 minutes, I should think. I am the bestselling author of The Power of Zero, Look Before You LIRP, and The Volatility Shield. You can find me on Twitter at @mcknightandco, I would love it if you gave me a follow. If you are looking for Power of Zero advisor, someone to help you navigate the pathway to the 0% tax bracket, by all means, go to davidmcknight.com, we can help you out with that. If you are an advisor looking for help in transitioning your practice to a Power of Zero practice, go to powerofzero.com.
We got a great show for you today. Today we're going to talk about what I call the holy grail of financial planning. Did you know that there was such a thing as a holy grail of financial planning? Now let me start off by saying that when I am working with a client, my recommendation on how to get to the 0% tax bracket typically involves anywhere from five to seven streams of tax-free income. What might be a typical recommendation? It might be a Roth IRA, Roth 401(k), Roth conversion, RMDs offset by standard deductions, LIRP (life insurance retirement plan), and then if you have all those streams of tax-free income and you can stay below your provisional income thresholds, then your Social Security also is tax-free.
I routinely ask rooms full of advisors, “Of those six streams of tax-free income that I just mentioned, which one do you suppose is my very favorite?” and the answers I get are really all over the map. Some people say the Roth conversion because it's a real workhorse, it allows you to shift massive amounts of money from tax-deferred to tax-free. Some people say the LIRP. Some people say Social Security. Rarely will people mention that my favorite among all those is actually the RMD. Even though it's mentioned in, I believe, chapter six of the updated and revised version of The Power of Zero, people rarely guess RMDs.
Now, what makes RMDs so special? Why do I refer to them as the holy grail of financial planning? In my humble opinion, the holy grail of financial planning is any investment that gives you a tax deduction on the front-end, grows tax-deferred, and allows you to take it out tax-free. So far as I can tell, there are only—and I'm sure there's going to be someone out there who begs to differ, I've studied this far and wide—there are only two things that allow you to get a deduction on the front-end, grow it tax-deferred, and take it out tax-free. The first one we'll talk about is the HSA or the health savings account that allows you to get a deduction on the front-end, you grow the money tax-deferred, you take it out tax-free. The second one is an IRA or a 401(k) that allows you to get a deduction on the front end, grow the money tax-deferred, and then by using your standard deduction in retirement, take those dollars, or at least a portion of those dollars up to whatever your standard deduction happens to be out tax-free.
Now, typically, what we say is you want to have a balance in your IRA or 401(k) that's low enough that when you're forced to start taking money out of there, in other words, when you’re forced to start taking required minimum distributions, the amount that you're forced to take out is low enough that it's equal to or less than your standard deduction, that's Part A; Part B, and low enough that it does not cause Social Security taxation. Now, I have a calculator on my website davidmcknight.com. If you scroll down to where it says calculators, you can click on that and you can put in a series of variables, what's your rate of growth, what's your balance in your IRA or 401(k), what are other sources of provisional income, what's your investment horizon, in other words, when do you want to start taking this money out or when do you want to have your shifting done by? For a lot of people, they want to get it done by 2026 because that's when tax rates go up. If you're going to pay a tax, you might as well pay taxes while they are historically low before they go up for good. You can actually input all of this data and it will tell you two things. The first thing it will tell you is your ideal balance, in other words, how much money should you have in your IRA or 401(k) in retirement such that your RMDs will be equal to or less than your standard deduction but also low enough that it doesn't cause Social Security taxation. It will also tell you what I call is your magic number. What is your magic number? That is the amount of money that you would need to shift each and every year such that by the time you hit that investment horizon, might be 2026 like I said, so seven years from now, how much you would need to shift each and every year between now and 2026 to get down to your ideal balance. It tells you how much you should be converting or shifting to LIRPs or what have you to get down to your ideal balance in your IRA or 401(k). We've got you on that calculator, you've got your magic number, and then you've also got your ideal balance.
With your 401(k)s and your IRAs, this only becomes the holy grail of financial planning if you have the ideal balance in that account by the time you're forced to take the money out. By the time you're forced to take the money out, you want to have the ideal balance in that account and that's when it becomes tax-deductible in the front end, tax-deferred as you grow, and then ultimately tax-free when you take it out.
Now, I don't talk about HSAs as much, although I will tell you this, if you have a high deductible health care plan either individually or at your employer, I would highly recommend a health savings account. Why? Because when you put money in, you get a tax deduction, it grows tax-deferred, and then so long as you're taking it out for a qualified health care expense, you are taking it out tax-free. The only reason I don't talk about health savings accounts as much is because they do have some strings attached and the strings attached I already mentioned is that you have to take it out for a qualified healthcare purpose. The only way that you could not take it out for a qualified healthcare purpose is if you reach 65, go on Medicare, then you can take that money out without tax or penalty, otherwise, all the way up until age 65, you're going to be paying tax and penalty if you want to take that money out for reasons other than healthcare. So health savings accounts are technically an example of a holy grail of financial planning but they have strings attached, they’re not a stream of income that can be used for any type of expenses, and for some people, you may not even qualify to have one.
That's why when we're talking about the holy grail financial planning, I'm really talking about your RMDs. If you can get that balance low enough by doing Roth conversions, get that balance in your 401(k) or IRA low enough to where your RMDs are equal to or less than your standard deduction and also low enough that it doesn't cause Social Security taxation because it is provisional income at the end of the day, then you have what I refer to as the holy grail of financial planning. Of those six streams of tax-free income, it is my very favorite because it is the only one that allows you to get the deduction on the front end, none of those other ones allow you to get the deduction on the front end.
If somebody comes up to you and says, “You should convert every last dime in your IRA or 401(k) to a Roth IRA,” you should be asking yourself the question, “Have they read The Power of Zero? Do they understand that there's an ideal balance to have in the tax-deferred bucket? If I convert everything from an IRA to a Roth IRA, get everything on the tax-free bucket, what's going to happen to my standard deduction in retirement?” in other words, everything's in the tax-free bucket and nothing's in the tax-deferred bucket, what's going to happen to my standard deduction in retirement? It will sit there idle. I won't be able to use it, in other words, I will have paid taxes on dollars while shifting them from tax-deferred to tax-free that I didn't really have to pay, and guess what, when you pay a tax that you don't have to pay, not only do you lose those taxes, you lose what those dollars could have earned for you had you been able to keep and invest them over the balance of your retirement. There can be a huge opportunity cost associated with converting too much money from tax-deferred to tax-free that's why it's so important to understand what your ideal balance is in your IRA because you want that thing to be lean and mean, you want it to produce, you want it to crank out distributions that are going to be offset by your standard deduction. That, in my mind, is the perfect investment, it is the holy grail of financial planning.
Now, this is another example of why if somebody comes up to you and they give you a financial planning recommendation and it only involves, for example, an LIRP, you should run, not walk, you should run the other way. Why? Because they are making the LIRP out to be the holy grail of financial planning which it's not. I often have people who have criticized The Power of Zero, just go on Amazon if you want to see what some of those critics are, I've countered many of them on this podcast, I'm not ashamed of what they're saying because I think they're wrong on a number of fronts and I've addressed those on my blog, on this podcast, and in other places, but basically, what some of those critics are saying is they're saying that I'm all about the LIRP and that's just simply not the case. I pointed out on a number of different places that the LIRP has significant shortfalls, that it serves a purpose but is not a panacea, it's not a silver bullet, it is certainly not the holy grail of financial planning. So if somebody is attempting to make the LIRP out to be the holy grail of financial planning, I think you should run, not walk the other way, because remember, all of these streams of tax-free income work together like pieces of a puzzle and when they fit together perfectly, the 0% tax bracket comes into play.
I've talked about my partner, Larry, who often refers to it as the little ridges on a key, if you look at a key and you turn it sideways, you've got little ridges that look like little mountains and you've got valleys, those ridges have to be just the right height and those valleys have to be just the right depth or it does not unlock the tumblers in that lock allowing you to get through the door. The same thing is true with the 0% paradigm, you have to have the right balances in all of these different buckets or you don't unlock the 0% tax bracket. You have to have just the right amount of money in your RMDs, in your tax-deferred bucket so that those RMDs are tax-free and they're not so big that it causes Social Security taxation so you can have all of these different thresholds have to respect each other and if you violate a threshold here, you might pay a tax over there. It's very, very important that you recognize that in my mind, the holy grail of financial planning is establishing the right amount of money in your tax-deferred bucket.
Ask your advisor if they know how to calculate the ideal amount of money in their tax-deferred bucket. If they don't, that may be a good sign you're not dealing with a qualified Power of Zero advisor. When we look at these six streams of income that we talked about at the beginning, Roth IRAs, Roth 401(k)s, Roth conversion, RMDs, LIRP, Social Security, a really ideal approach, a balanced approach, a comprehensive approach to The Power of Zero retirement planning really calls upon as many of these streams of income as possible. You're not always going to get six, I would love to see you get at least three, might be an LIRP, might be an IRA with RMDs offset by standard deductions, and then ultimately, Social Security, but really, we want to see probably more, we want to be doing a Roth conversion so we can get that IRA down to the right amount. We'd love to do Roth 401(k)s because Roth 401(k) is probably, in the big scheme of things, better than traditional 401(k)s, plus they give you a match. You may have too much money in your taxable bucket so we may need to call upon the Roth IRA to help us get some money out of the IRA, get it into a Roth IRA, which is in the tax-free bucket, and then ultimately, the LIRP, in my opinion, is the very best way to treat what is, I think, the number one risk in retirement and that is a long-term care risk, I mean you may think you've done everything perfectly, then you don't die, you almost died, and you need long-term care, then everything that you've worked so hard for that would have normally gone to your spouse had you died now goes to a long-term care facility. Your spouse gets to keep one car, one house, a minimum monthly maintenance needs allowance of about $2,500 a month in most states, and cash of about $126,000, that's all you get to keep. Had you died, while we would have missed you terribly, your spouse would have kept on living in a relatively comfortable financial environment, but because you didn't die, because you almost died and needed long-term care, she's now left to those meager resources. What would have otherwise turned out to be a very productive financial future turns into bare-bones subsistence type living simply because you didn't have a way to pay for long-term care. That's why I think that the LIRP is fast becoming, according to The Wall Street Journal, it's replacing traditional long-term care insurance as the way that people deal with long-term care. The LIRP, it's great, it's wonderful that it's tax-free, it's wonderful that it grows safely and productively, but I think one of the real big benefits if you’re over age 50 is that the LIRP gives you a death benefit that doubles as long-term care. That said, I don't think it is the holy grail of financial planning because you do have to use after-tax dollars when you're funding this thing.
In short, make sure you have lots of different 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, but above all, make sure you've got some money. If you don't have a pension, make sure you've got some money left in your tax-deferred bucket so that your standard deduction doesn't sit there languishing not being put to good use so the RMDs are going to be a way for you to fully utilize that standard deduction in retirement and have one more additional stream of tax-free income.
I went a little bit over but I appreciate you sticking with me. This is an important subject. Determining the right amount of money to have in your tax-deferred bucket is critical because remember, in a rising tax rate environment, you need to have the ideal amount of money in your taxable and tax-deferred bucket, and anything above and beyond that ideal amount should be systematically repositioned to tax-free, you want to reposition it slowly enough that you don't rise too rapidly in your tax cylinder such as you get heartburn but you want to do it quickly enough that you get all the heavy lifting done before tax rates go up for good.
I am your host, David McKnight. Again, you can follow me on Twitter @mcknightandco. Feel free to go to davidmcknight.com if you want to find a Power of Zero advisor. If you are an advisor yourself and you want to learn how to transition your practice to a Power of Zero practice, go to powerofzero.com, opt-in to our video series and you'll have a chance to talk to us about how we can partner with you moving forward. Subscribe, wherever you're listening to podcasts, subscribe and you'll make sure that you'll be updated, get a little push notification every time we give you a new podcast which is, for 52 straight weeks, every Wednesday, so thanks everybody for being on the podcast today and we will look forward to chatting with you next week.