A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
Hi there. David McKnight. Welcome to The Power of Zero show. I hope you guys are off to a great new year. Looking forward to a prosperous 2020. Once again, I’m the best-selling author of The Power of Zero, Look Before You LIRP, and The Volatility Shield. You can buy all of those books in bulk at powerofzero.com/Books. Of course, if you have seen our movie, you know all about The Power of Zero: The Tax Train Is Coming. If you want to see the movie, you can go really to anywhere movies are streamed and you can check it out for yourself. Also, I would appreciate any reviews that you can make on Amazon or wherever you buy my books. I really appreciate those reviews. They really do help.
If you are looking for a Power of Zero advisor to help you navigate all of the pitfalls that stand between you and the 0% tax bracket, mosey on over to davidmcknight.com, fill in the contact form, and we will be happy to get back with you and give you a hand with that. If you are an advisor looking to transform your practice into a Power of Zero type practice over the course of 2020, we're here to help you with that as well. Go to powerofzero.com.
This episode, we are going to be talking about the much-anticipated arrival of the SECURE Act. It passed a couple of weeks ago and we are here to give you the implications of the SECURE Act on Power of Zero type planning. Maybe a month or two ago, we talked about the implications of this, but now we have the SECURE Act in its final form. It's been signed into law, it's going to take effect 2020. We now know what its implications are, so we're going to talk about those implications, how you can plan for its implications, be able to preserve as much of your hard-earned capital as possible, and make sure that your heirs are not giving away a disproportionate amount of that money that they inherit to the IRS.
First of all, let's talk about the main tenets of the SECURE Act, what actually got passed into law in its final form. Of course, the big one that everyone's talking about is the elimination of the lifetime stretch provision for non-spouse beneficiaries of inherited IRAs and also 401(k)s, but more importantly, also Roth IRAs, we'll talk about that here in a second. You no longer have the ability to stretch those distributions out over the life expectancies of multiple beneficiaries.
Let's talk about IRAs first, if you're leaving your IRA or 401(k) to a child—not your spouse but to a child that's over the age of majority—then they will have to distribute, in other words, realize as income that IRA within 10 years. Now, they don't have to do it year-by-year, they just have to have it all done by the 10th year.
Just to give you some implications on that, let's say your non-spouse beneficiary—it could be your kid—inherits your IRA—let's call it $1 million growing at 6%—and they do so at a period in their lives when they are at the apex of their earning years, tax rates are higher than they are today—remember, if you're listening to this podcast, maybe you're a baby boomer, maybe you're 65, you're probably not going to die for, at least, 20 years, therefore, ask yourself what tax rates will be 20 years from now. Do you think they’ll be higher or lower than they are today? I think we've made the case abundantly clear that tax rates, 20 years from now, will be substantially higher than they are today—that child who inherits that IRA, will they be at a higher tax bracket or a lower tax bracket than they are today? What if they inherit that IRA when they're 60 at the apex of they're earning years? Guess what, that money that they distribute will be piled right on top of all their other income. They'll pay tax on it at their marginal tax bracket.
Let's make no mistake about this, folks, this is a backdoor tax increase, this is a money grab by the IRS unless you do something about it. Now, let's talk about the Roth IRA real quick because this does apply to a Roth IRA. It used to be you could just take distributions on a Roth IRA over your lifetime if you inherited that Roth IRA, that's great because you now get to experience the tax-free benefits of that Roth IRA over your lifetime so the IRS was losing out on a lot of tax dollars that could have been maybe accumulating in a taxable bucket and they could have been earning revenue on that year after year. Guess what, if that money gets distributed during those 10 years and the beneficiary is not spending that money, what's going to happen to it? It's probably going to go into a taxable account, it could be an investment, it could be a savings account, whatever the ultimate destination of that money, it's probably going to be a taxable account. The IRS is going to start earning money on the growth of that money over the balance of that person's life until it's been down to nothing.
Now, all of a sudden, the IRS is making more money off of our IRAs and they're also going to ultimately going to be able to make money off of our Roth IRAs. These are major, major developments and they're things that we have to account for. How do we account for this? I think it's very, very important, first of all, that the people that have IRAs start to ask themselves a question that they maybe have not traditionally asked themselves. The question is this: Will I have money left over at the end of our joint life expectancy, husband and wife, will they have money left over that will go to a non-spouse beneficiary? For example, will my children be inheriting my IRA? Will there be a substantial amount in that IRA that they're going to be inheriting?
I think historically, we haven't had to necessarily ask ourselves this question because we always had the back-up plan of the stretch IRA. Our children could stretch those RMDs out over their life expectancies and it wasn't a big deal. Guess what, they now no longer have that luxury. They're going to be forced to distribute every last dollar by the 10th year following the death of the IRA account holder. What this does is it underscores the importance of doing Roth conversions during your lifetime. Now, I think that people historically have said, “Hey, look, I don't want to do Roth conversions because maybe I'm not absolutely convinced that tax rates down the road are going to be higher than they are today.” That's the primary motivation behind doing a Roth IRA is you think you're going to pay a lower tax today than you will some time down the road. Guess what, if you have a large IRA and you plan on leaving some to the next generation, you should also now be asking yourself “Is your tax bracket today the tax rate at which you could potentially be paying taxes on that Roth conversion higher or lower than what your children could potentially be paying when they're forced to pay taxes on it over that 10-year time frame?
Remember, if you have $1 million IRA, it's grown at 6% per year, and they want to spend that down in equal increments—they're not required to—but if they wanted to spend it down in equal increments over 10 years, that would be about $125,000 per year that they would have to realize as taxable income. Ask yourself what that tax rate is going to be versus the tax rate that you could pay performing a simple conversion today.
Now, there's been an estimate that this new law will generate $15.7 billion in tax revenue over the next decade alone. This is $15.7 billion more than they would have otherwise generated had the old law persisted. There's no question about it that the SECURE Act has been lauded as the best overhaul of the retirement system since they lasted an overhaul in 2006 that the implications for retirees are going to be largely positive, but we have to really ask ourselves what is at the heart of this law? I'm actually convinced that what's at the heart of this law is they don't want people, in a scenario where the country is slowly sliding into insolvency, they don't want people to be able to enjoy the tax benefits of drawing down these IRAs over 30, potentially even 40 years. They want to force you to be able to pay tax on those large inherited IRAs over a 10-year period of time at the apex of your earning years when tax rates are likely to be higher than they are today when you can least afford to pay that tax.
One of the other implications, I think, that this law has is for the beneficiaries of these huge accounts. When they inherit these IRAs, they're going to be forced to take the money, whether it's a Roth IRA or a traditional IRA, they're going to be forced to receive this income whether they need the income or not. Let's assume that these beneficiaries realize the income, in the case of the Roth IRA, they're not going to have to pay tax but they're going to have to put the money somewhere. In the case of the inherited IRA, they're going to have to pay some tax but once they pay the tax, they're going to have to put that money somewhere. Whether it's tax-free or taxable, that money's going to have to go somewhere. The question is what kind of planning can we do for these beneficiaries once they start to inherit these accounts that they probably are not going to be spending? Think about it, if you're a 50-year-old and you inherit your mom’s or your dad's traditional IRA and it's $125,000, you probably aren't necessarily going to be spending that. The question is where do you put it?
Not only does the IRS get paid the tax upon the distribution of these dollars but if you don't need the money—and there's a good case you won't—you will then simply put it into a taxable investment. Why? Because the traditional tax-free investments have these contribution limits. You say, “Well, I can't stick $125,000,” for example, “into a Roth IRA.” You can't, the contribution limits are too prohibitive. What do you do? You reflexively put all that money into a taxable bucket where the IRS continues to get a tax bill year after year. In the IRS’ perspective, this is actually a pretty brilliant move, not only do you force people to pay tax on this that may potentially double what they were planning on paying, but they're now forced to put the excess that they don't need to fund their lifestyle, or what-have-you, into a taxable account because there's really no other tax-free accounts that can accommodate these size of contributions.
I think this is where the LIRP comes into play because now, all of a sudden, you have a tax-free vehicle that is there as a receptacle for these distributions. You no longer are forced to put this money into a taxable account where you potentially would have to pay taxes an ongoing way, you can now put those dollars, maybe into a life insurance retirement plan where you have no contribution limits, you have no income limitations, you can grow that money safely and productively. Guess what, most of these people will be inheriting this money maybe between their 50s and 60s, now they have the ability to have a death benefit that goes along with all that tax-free growth, safe and productive growth, you now have a death benefit that doubles as long-term care. Right at a period in their life when they really, really could use some long-term care, they're trying to figure out how they're going to negotiate this long-term care enigma, they now have all of this money that they're inheriting, they need a place to stick it, all of the traditional avenues are not available so they're thinking a life insurance retirement plan may be a possibility to help shelter that money, allow it to grow safely productively in a tax-free way, give you a death benefit that doubles as long-term care.
Whether we're talking about people who are trying to navigate the decision of whether to do a Roth conversion or not, I think this really ups the ante, I think this really makes a compelling case that maybe even if you think you thought taxes were a little bit too high to be able to do a Roth conversion, now you're asking yourself, “Do I want to give over half of my IRA to the IRS when it passes from me to the next generation?” We've got that whole set of questions to navigate but we also have to ask ourselves what is the opportunity, what are the possibilities with the next generation who is inheriting this money? They no longer have the ability to take distributions from that Roth IRA over their lifetime have this perpetual stream of tax-free income, the IRS is saying, “Hey, that was a little too good, that was a little too sweet, we are going to force you to spend down your Roth IRAs as well.” Where can we put that money that will be distributed over those 10 years? Let's put it into a tax-free account, potentially, that's growing tax-free, growing safely productively, you can distribute it tax-free but you also get that death benefit that doubles as long-term care. Guess what, when you die, if there's money left over, that goes tax-free to the next generation and they can likewise repeat exactly what you did if LIRPs are still around in 40 years or so.
In case you couldn't tell, I think that this is a really, really big deal, I think there are lots of opportunities to do some tax planning, particularly, over the course of the next six years. Some people tell me, “Hey, Dave, it's only five years, you've got until 2025,” but if you think about it, we got 2020, 2021, 2022, 2023, 2024, and 2025, there are six years within which to take advantage of historically low tax rates. Remember, what we want to do is we want to stretch that tax liability out as long as we can before tax rates go up for good, but we want to get the shifting done to tax-free quickly enough that we get all the heavy lifting done before tax rates go up for good. We got six years, we want to stretch that liability potentially out over all six of those years.
Lots of opportunities to take advantage of Roth conversions and then for the next generation, certainly, to get those distributions funneled into, really, the only tax-free account that will allow those types of distributions to grow tax-free on an ongoing basis and that's the LIRP. That's the really big change.
The other change that we know took place with the SECURE Act being passed into laws, the required minimum distribution now goes from 70 1/2 to 72. I don't think this is a huge deal because what it means is that the ratio, we know that you had to take 1:26.5 or 3.65% of your IRA at age 70 1/2. That was the ratio that you had to take. We know that goes up a little bit every year thereafter so you just forget 70 1/2, forget 71, now we're just going straight to 72, that hasn't changed at all. Now you're letting your IRA grow a little bit more so then you have to take a little bit larger distribution at 72. I don't think this is a big deal because 80% of Americans who have RMDs are taking more than the required minimum distribution anyway so this is not really affecting them.
There's 20% of Americans that are going to be forced to take more than they otherwise would have. I don't think this is a big deal. I think that for the 20% of Americans who are not actively taking more than the distribution, this could maybe affect them a little bit but not by much. I don't think this is a big deal. I certainly don't think that it comes even close to touching the implications of the elimination of the stretch IRA.
Last change which is not really that big of a deal either is the removal of the 70 1/2 distribution limit for IRAs. This also means that whole backdoor Roth idea which is this idea that you can make a non-deductible contribution to a traditional IRA, then do the backdoor Roth conversion, you can now do that past age 70 1/2. Remember, the Roth IRA never had that 70 1/2 contribution limit but the IRA did. Now, if you don't qualify for the Roth IRA, you can now do the backdoor Roth. What it amounts to is a non-deductible contribution to an IRA, then you convert it to a Roth IRA, and the very next step is tantamount to a contribution to a Roth IRA. You can now do that past age 70 1/2.
I think in conclusion, the big takeaway that I want people to draw from this is you really gotta ask yourself a question that maybe you weren't previously asking yourself which is this: Do you think you will have money left over in your IRA when you die? Because if you do, then that money will most likely be taxed at a much higher rate than you currently would have been forced to pay during your lifetime. We have a whole new dynamic that gets introduced into this planning process. Is the tax I'm paying today going to be higher or lower than what my children will pay on that money?
Now you may say, “Hey, I don't care, I'll be dead and gone,” do you really want to have scrimped and saved your entire life only to give half of your inheritance, half of the money that's going to the next generation that you're bequeathing to the next generation half to the IRS? Do you want half of that money that you could have spent during your lifetime now going to the IRS or do you want that to leave a legacy somehow to the next generation? That's a question that I don't think we asked as much in the past because we had that stretch IRA option that now has, for all intents and purposes, been completely obliterated.
These are things that we should be thinking about from a Power of Zero paradigm perspective. This is, of course, right up our alley. We think that tax rates in the future beyond 2026 will be substantially higher than they are today. We think that even when taxes revert back to the levels they were in 2017 and 2026, that's not a big deal compared to the tax freight train that's bearing down on us that will start to hit retirement plans, I believe, in 2028, 2030, and beyond.
Even if you think that the taxes your children will pay won't be that high, you gotta ask yourself under current tax rates, “What are tax rates going to be come 2028, come 2030?” Will your kids inherit that money before or after 2028 or 2030? If the answer is yes and they're planning on spending those dollars after 2030, inheriting those dollars after 2030—which I think that for a lot of my listeners, that is the case—then it really, really makes good sense to take a look at these tax rates that we have today, this tax sale of a lifetime that’s going to last for another six years, we need to be taking advantage of these six years.
Every year that goes by where we fail to take advantage of historically low tax rates as potentially a year beyond 2026, 2028, 2030, and beyond where tax rates could be substantially higher than what we're enjoying today, we will look back on this six-year period of time and say, “Those tax rates were a good deal of historic proportion. Why am I forcing my kids or why am I forcing myself to pay tax rates at much, much higher levels?” because, at that point, the sale will be over.
That's the show for today. Once again, if you want bulk sales, bulk discounts on books, go to powerofzero.com/Books. If you are trying to circumnavigate the challenges, the pitfalls, and the roadblocks that stand between you and the 0% tax bracket, you want a guiding hand, someone who's been down the road that understands where the pitfalls are, understands that when you violate a threshold on the one hand, it could cause a tax on the other hand, and you just need some help navigating that road to the 0% tax bracket, go over to davidmcknight.com, fill out the contact form, and we’ll be happy to hook you up with a qualified, skilled, seasoned Power of Zero advisor who can help you navigate all that. Of course, if you're an advisor who wants to become a Power of Zero advisor, we are happy to help you with that as well, go to powerofzero.com, opt-in to the video series, and that will give you the opportunity to set up a call with us to chat more about how we can help you out.
All right, folks, that is the show for today. We will look forward to talking with you next week.