0:00:05
A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
0:00:19
Hello there. David Knight. Welcome to The Power of Zero show. Grateful that you're with us for another week. As you know, 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. You can also follow me on Twitter at @mcknightandco. I would love a follow. Also, you can watch my movie, it's actually Doug Orchard’s movie, he's the creator of the movie, I just tagged along for the ride, you can watch our movie, The Power of Zero: The Tax Train Is Coming, pretty much anywhere that you screen movies. But you can also get DVD/Blu-ray Combo Packs at thetaxtrain.com. If you are looking to navigate all of the pitfalls and roadblocks that stand between you and the 0% tax bracket, mosey on over to davidmcknight.com and reach out to us, we'd be happy to help you. If you are a financial advisor looking to transition your practice to a Power of Zero practice, go to powerofzero.com, opt in to our video series, and we'll tell you all about the steps you need to take to make that happen.
0:01:43
Today won't be a long podcast, but we're going to talk about why it's so critical to really, really focus on these last weeks of December in terms of taking advantage of any last opportunities to do Roth conversions for the tax year 2019. Now, the big caveat I'm going to give you is that a lot of people think you can just go right up to December 31st, 2019, and pull the trigger on a Roth conversion. Now, in theory, that's how it could work, but in practicality, that's not really how it works. In fact, some companies will say, for example, you can no longer submit Roth conversion paperwork past, say December 15th. They have these deadlines in place.
0:02:42
Why do they have these deadlines in place? Because they know that there's a big rush at the end of the year to give a lot of these Roth conversions done. Not only that, but Roth conversions can take some time, it takes some time to process paperwork. It's such a time-sensitive decision that they don't want to be up against the December 31st deadline and miss it, not file a piece of paper properly, or be looking for a signature at the last minute and then have you miss out on the opportunity to do the Roth conversion for that tax year. That could actually have major tax repercussions if you miss that deadline.
0:03:20
Remember, with a traditional Roth IRA, you can fund that thing right up until, basically April 15th of the following year. That's not the case with a Roth conversion. Roth conversions have to be done basically by December 31st of this year. A lot of people say that's not really fair because I don't know what my tax liability is going to be. I don't know how much space I have in my tax cylinder. I don't know how much I should convert to be right up to the top of my 22% or 24% tax rate or even 12% tax bracket for the matter. Whatever tax bracket you're trying to maximize, it's really hard to be precise about how much you should be converting if you don't yet know what your taxable income is for the year, you don't know how much space you have in your tax cylinder before you hit the tax bracket that starts to give you heartburn.
0:04:22
Now, this is especially difficult because the IRS no longer allows you to do Roth recharacterization. You can't, for example, in 2020, go back and say hey, I got way more taxable income than I thought, therefore that Roth conversion that I did is actually going to be pushing me into the 32% tax bracket that does give me heartburn, therefore, I'm going to undo it. What do you do? You have to give it your best eyeball, your best guesstimate. You have to say hey, what was my taxable income last year? How much difference is my situation this year than it was last year? Do I have more or less space in my tax cylinder to do more or less Roth conversions?
0:05:07
Remember, if you should be doing a Roth conversion in 2019 and you don't, you now no longer have seven years within which to get all that Roth converting done. Remember, the whole goal with Roth conversions is you want to stretch that tax liability out over as long a period as possible. There are really two things you want to look at, you want to get all of the converting done before tax rates go up for good, and we've maintained that January 1st, 2026, is really the deadline by which you want to get that done. You want to get all the heavy lifting done before 2026, but you don't want to do so much converting that it causes you to rise in your tax cylinder, such that you get heartburn. Those are the two competing thresholds that we have to worry about.
0:06:08
If you don't get your converting done in 2019, you now no longer have seven years within which to do your Roth converting. Now, you may be thinking ah, no big deal, I can just get it done over six years. If that was true, let's take the extreme example or the extreme version of that approach. Let's say you say ah, six years isn't a big deal, five years isn't a big deal, and you do that all the way up until 2025 and you only have one year within which to do your Roth converting—I know it's an extreme example but I'm trying to make a point here—you get all your Roth converting done in only one year. Let's say that the amount that you were supposed to shift over that time frame was $1 million. What are the implications of doing a Roth conversion all in one year if you need to convert $1 million? Guess what, you are going to rise dramatically and rapidly in your tax cylinder, most of that money will be taxed at 37% federal, plus whatever your state tax happens to be, and it'll happen all in one year which means that you could give away upwards of 45% including state tax of that Roth conversion.
0:07:24
Remember, the whole idea behind this planning is we want to reduce taxes over time, we want to help you avoid a potential doubling in tax rates over time. Now, it doesn't make sense to double your tax rates in the short term in order to avoid a doubling of tax rates over time. Obviously, doing your entire Roth conversion in one year doesn't make a whole lot of sense. How about two years? What if you had to convert $500,000 over 2 years? Look at your effective tax rate, still, most of your money is being taxed at 37%, some are being taxed at 35%, some at 32%, potentially somewhat 24%, 22%, so your effective tax rate has gone down a tiny bit. Remember, the effective tax rate is the average of all of your tax brackets. The marginal tax rate is the top tax bracket at which a Roth conversion might be taxed.
0:08:18
But really, what we're trying to figure out here is what is the effective tax rate on the portion that's converted. If we average it out over two years, yes, your effective tax rate goes down but not by a ton. Let's take a look at three years. Three years, your effective tax rate goes down a little bit more. The further you stretch out that Roth conversion—and here's my point—the lower the effective tax rate on the conversion because you're able to have more money that gets taxed at the lower rates and fewer dollars which get taxed at the higher rates. If it holds true that a one-year conversion we want to avoid at all costs in two years is not much better, three years gets a little bit better, guess what, if you can get that money converted over seven years, the effective tax rate on that conversion is going to be much lower than if you did it over one, two, three, four, five, or even six years.
0:09:19
The bottom line is that if you feel like tax rates in the future are likely to be higher than they are today and you feel like it makes sense for you, mathematically speaking, to get dollars systematically repositioned from tax-deferred to tax-free, then every year between now and 2026 counts. It all represents a little mini window of opportunity during which to take advantage of historically low tax rates. Every year that goes by where you fail to take advantage of historically low tax rates is potentially a year beyond 2026 where you could be forced to pay the highest tax rates you're likely to see in your lifetime.
0:09:57
Remember, there are worse things in the world than simply paying taxes at what the rates will be in 2026, I mean, the 22% goes to the 25%, the 24% goes to the 28%, yes, that's more taxes but frankly, there are worse things in life than having that slight increase in tax rates come 2026. What I really worry about is what's going to happen 2028, 2030, and beyond when we get to the point where we hit a crisis moment in our country where we’re forced to be able to define some way to deliver on all of these promises that we've made for Social Security, Medicare, and Medicaid.
0:10:33
By the way, there is a proposal going through the House of Representatives right now, I believe it's the House or it’s a congressman out of Connecticut, it was called the Social Security 2100 Act. One of the ways that they're looking to shore up Social Security—not to get too far off the beaten path here—is by raising the wage-base upon which they tax you for Social Security from, I think it's $136,000 and change this year, all the way up to $400,000. That would represent, for most Americans, a 7.65% tax increase. For business owners, that would represent a 15.3% tax increase. There's some Medicare in there as well but that's a pretty big deal. I'm worried that come 2026, 2028, or 2030, somewhere in that range, when we hit this crisis moment that tax rates are going to rise dramatically and that the tax rates that we enjoyed in 2017 which will be coming back in 2026, I fear that those tax rates will still be good deals of historic proportions.
0:12:02
I worry what's going to happen in 2028, 2030, and beyond because at the rate we're currently taxing Americans, there's just not enough money to pay for all the things we’ve promised. I think that if you miss out on an opportunity to convert your IRAs to Roth IRAs over seven years and you do it only over six years or potentially you say, I don't want to take the bite, I want to get it done after 2026. I want to bleed into 2027, 2028, I feel like you will look back and say we missed out on a good deal of historic proportions. Why did we not take advantage of tax rates while they were historically low? Because remember, if your tax rate goes 1% higher in 2026, 5% higher in 2027, or 10% higher in 2028, that is all the less money you get to spend in retirement. Remember, the goal is to maximize the number of dollars that you get to spend after-tax. It's not how much money you have, it's how much you actually get to spend after-tax that matters.
0:13:15
In short, folks, we are down to crunch time. It is mid-December. If you want to do a Roth conversion, now is the time to act, not even tomorrow. I mean, we're really literally getting down to the point where you have to act, you have to let your financial advisor know. If you don't have a financial advisor that can help manage all this for you, of course, get a hold of us at davidmcknight.com, we're happy to help you navigate all of these different thresholds that you have to respect when you're doing Roth conversions. But we really are down to crunch time.
0:13:47
If you want to convert your money over six years, great, but if you feel like converting in over seven years is going to lower your effective tax rate, put more money in your pocket, allow you to spend more money over the arc of your retirement, then take advantage of seven years, not six years because you will be putting more money in the IRS’ pocket and you'll have less money in your pocket. Your money just won't last as long. These are critical deadlines that we're looking at, you've got to really take a strong look at what your magic number is.
0:14:20
Your magic number is how much you need to be shifting each and every year to get all the heavy lifting done by 2026. Of course, you can go to davidmcknight.com, input all of your data, and it'll tell you what your magic number is. It will also tell you what your ideal balance is in your tax-deferred bucket. Remember, you don't want to convert everything over, you want to have some money unless you have a pension left in your tax-deferred bucket because you will have standard deductions in retirement. By the time you retire after 2026, you'll have standard deductions and personal exemptions that can be used to offset, at least, your RMDs coming out of your IRA.
0:14:56
For most Americans, I think the ideal balance in your IRA is probably in the order of $350,000 that will produce a required minimum distribution that's equal to or less than your standard deduction or after 2026, your standard deduction and personal exemptions. If you have $1 million in your IRA, you need to get down to $350,000, and maybe your money is growing by 6.5% per year, remember, if it's growing by 6.5% per year, that's $65,000 per year that you would have to convert just to keep your money at $1 million, let alone to get it spent down to $350,000.
0:15:35
Remember, the 22% tax bracket for most Americans is golden. The 24% tax bracket is only 2% more but it allows you to shift another $150,000 before bumping up into the 32% tax bracket. These tax brackets are not going to be around forever, you only have seven years to do it. You wait another week even after the publishing of this podcast, you may be in a situation where your custodian no longer allows you to do a Roth conversion. If you're serious about getting money shifted to tax-free and you are working with an advisor, lean on that advisor. If you're not working with an advisor, lean on us, we'll get you hooked up with someone who can help you facilitate that and do that in a relatively short time.
0:16:21
All right, folks, that's the show today. Once again, subscribe. We love it when we have subscribers. That will send you a push notification on email letting you know, in your favorite channels to listen to us, when the podcast has been published and what we'll be talking about. Again, if you want bulk purchases of any of our books, go to powerofzero.com/Books. If you want to watch our movie, go to thetaxtrain.com. If you are looking for help in getting to the 0% tax bracket, we're happy to lend a hand, go to davidmcknight.com and input some data and we're happy to help you out. Of course, if you are a Power of Zero advisor, go to powerofzero.com and opt-in to our video series. If you want to put reviews on any of our books, the podcast, the movie, we would love to do it, it really does help. Other than that, thanks for being on the show and we will look forward to talking to you next week. Have a great week.
