Ep 66: The Difference Between Tax-Deferred and Tax-Free with David McKnight

February 5, 2020
David gets the same question nearly every single week. Someone invariably asks about how if they do a Roth conversion, won’t they have less money working for them in the tax-free bucket and need more time to catch up compared to had they just left the money in the tax-deferred bucket? If the governm...

Episode Transcript - The Difference Between Tax-Deferred and Tax-Free with David McKnight

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. We're grateful that you are spending a small portion of your day with us every week. I am the best-selling author of The Power of Zero, Look Before You LIRP, and The Volatility Shield. As I announced in the last couple of weeks, I'll be having a new book coming out. It's actually February 9th, 2021. It's being published through Penguin Random House. These things take time. It's a slow and arduous process so I appreciate the patience as we get that manuscript completed and get the process rolling over there in New York with Penguin Random House.
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It won't be a super long podcast today but I want to talk about something that advisors, clients, members of the general public bring up to me almost on a weekly basis. Almost on a weekly basis, I'm going through this. The question that people come up to me with is they say, “Hey, Dave, if I do a Roth conversion or I shift money from tax-deferred to tax-free and I pay all that tax, I'm not going to have nearly as much money working for me in the tax-free bucket. I'll need much more time to be able to grow money in the tax-free bucket to be able to ever catch up with what's going on had I just left the money growing and compounding in my tax-deferred bucket.”
Now before I get into deconstructing why this is a major financial planning fallacy, let me go back to something that Don Blanton said in the movie The Power of Zero: The Tax Train Is Coming. He gives you an analogy and says, “Hey, if the government came up to you and said, ‘Hey, I'd like to loan you some money,’ and you say, ‘That's great, what's the percentage rate?’ And they say, ‘Ah, don't worry about it, when we need the money, we'll come let you know what the interest rate is.’” Oh, by the way, we're currently $23 trillion of debt and some experts say we're actually $239 trillion in debt, so the question becomes “Would you cash that check?”
If the answer to that question is a resounding no, then you have to ask yourself why so many Americans are investing so much money in tax-deferred accounts. Remember, there are $23 trillion in the cumulative IRAs and 401(k)s of Americans, there's about $800 billion in the cumulative Roth IRAs, Roth 401(k)s, Roth conversions of Americans. If you are not likely to cash that check yet, you are putting money hand-over-fist into your 401(k) or IRA, you have to ask yourself why. Are you not, in fact, taking a loan from the federal government and not knowing what the interest rate is? We're giving the federal government the flexibility to come back to us years down the road to assign the interest rate to that loan.
This is exactly what we're doing. When we put money into a 401(k) or IRA, we're saying, “It is okay for you to let me know what the tax rate is years down the road when you need the money. When I'm ready to spend that money, I am perfectly okay with you letting me know what the tax rate is going to be.” Oh, by the way, we are $23 trillion of debt, that's only the publicly stated debt. According to fiscal gap accounting, we’re $239 trillion in debt and that's growing each and every year. According to episode 63, the true fiscal debt, if we wanted to not only pay for everything over the next 75 years and bankroll all of the expenses that we've promised starting in 2092, we'd actually have to have $1.6 quadrillion, or in layman's terms, $1.6 zillion sitting in a bank account today earning Treasury rates to deliver on all these things that we promised.
Why is it that the vast majority of Americans are okay with that deal? Why do we keep accepting this deal? Why do we keep putting money into 401(k)s and IRAs when we know that the fiscal situation of our country is on the brink of collapse, it's calamitous, it's grim, it's sobering, and we're almost certainly past the point of no return, we're almost certainly to the point where we can't tax our way out of this, we can't reduce spending because the debt will take on a life of its own? Given these realities—and if you don't believe me, watch our movie, go read the paper that I put in the show notes in episode 63, I'm not overstating my case at all—why do we keep accepting this deal? That's my question.
People keep coming back to me saying, “Dave, I don't want to do a Roth conversion because I won't have as much money working for me in the tax-free account.” Let's go through the math behind this. Even if we weren't facing fiscal calamity as a nation, let's go look at the math behind this. Let's compare two people. One person, if you've envisioned a whiteboard, the person on the left has a bucket of money, there's $1 million in it, and it's an IRA. Let's just assume that effective tax rates are 30% now, they're always going to be 30%, let's just work on that premise for this first example.
Somebody decides to do a Roth conversion. They now have $700,000 in their tax-free bucket. The person on the left has $1 million in their tax-deferred bucket, it could be an IRA or 401(k). The person on the right has paid the 30% tax. They think that that's a good deal and they never want to be taxed ever again. They now have $700,000 in their tax-free bucket. The question for you is this, which one has more money? Are we able to look at these two buckets and identify which one has more money?
It reminds me a little bit of that joke that people come up to, this happened when I was a kid, they say, “Hey, Dave, what weighs more, a pound of rocks or a pound of feathers?” I'm like, “Duh, it's a pound of rocks.” They're like, “No, it weighs exactly the same amount. You just have to have much more feathers to add up to a pound than you do rocks.” In other words, the feathers are going to take up a lot more space than the rock does. I feel like this is an apt analogy for IRAs in the tax-deferred bucket and Roth IRAs or even LIRPs in the tax-free bucket. Who has more, $1 million in the tax-deferred bucket or $700,000 in the tax-free bucket?
Our initial impulse is to say, “You have more money in the tax-deferred bucket. You get $300,000 more, therefore, when it grows, you have more going to work for you than the person who has only $700,000 in their IRA.” But the thing that people forget is that when you have money in your IRA, you have a business partner, you have someone that's loaned you money. Until you distribute money from that bucket, you don't really know how much you have. Assuming a 30% level tax rate environment, the portion of that $1 million dollars that's yours is only $700,000. In other words, who has more money in a level 30% tax rate environment, the person with $1 million in their IRA or the person with $700,000 in their tax-free bucket, Roth IRA, what have you? They have exactly the same amount.
But do they really? This is where we want to get into a little bit. The person who has money in their tax-deferred bucket of $1 million is almost certainly going to take distributions that count as provisional income that will cause their Social Security to be taxed. The person who takes distributions from their Roth IRA does not have any provisional income, at least, above and beyond one half of their Social Security, so their Social Security is not going to be taxed. I would submit to you in that scenario, the person with $700,000 still has more money.
But let's forget all about Social Security for this example. Level tax rate environment, they have exactly the same amount of money, however, what happens if tax rates go up by 1%? Just one lousy percent, who has more money now? I would submit to you that the person in the Roth IRA has more money. Why? Because now, if tax rates went up to 31%, the person in the IRA only has $690,000 versus the $700,000 that the person has in the Roth IRA. That's what the Roth IRA gives you, it gives you certitude, it gives you an environment in which you can reasonably expect the amount of money that you can withdraw in retirement. Why? Because a bird in the hand is worth more than two in the bush. You have paid taxes at a known quantity today. You have introduced intentionality into your retirement plan, you have preemptively paid those taxes so that you don't have to roll the dice and hope and pray that tax rates will stay low as our country slowly slides into insolvency.
Now, if what David Walker says comes true and tax rates have to double to keep our country solvent, what does this picture look like now? That $100,000, if you were currently at a 30% tax rate and that went up to 60%, how much of that money is now yours? You now have $400,000 compared to the $700,000 in that Roth IRA. By the way, there is a Wall Street Journal article that came out today, I record these about ten days prior to when you actually hear them, nine days, so if you look at the January 28th edition of The Wall Street Journal, there is an article in there, something to the effect of higher taxes are on the way. What they do is they go through all of the Democratic presidential candidates and they look at all of their tax plans. All of their tax plans add up to, at least, 50% marginal tax bracket, or in the case of Bernie Sanders, a 60% marginal tax bracket.
What do we know about the history of political power? It changes every few years. The Republicans are in control, then the Democrats are in control, then the Republicans are in control. At some point in time, the stars are going to align, Democrats are going to be able to get a hold of the House, the Senate, and the presidency, and they’re going to be able to change the tax code. When they do that, you can see all of these marginal tax rates start to go up. As marginal tax rates go up, all of these lower tax rates are going to rise right along with them.
I want everybody to be clear that you do not necessarily have more money working for you if you don't do a Roth conversion because that money is not yours, it's on the IRS’ letterhead. You have to remember that you have a business partner in the IRS. Every year, the IRS gets to vote on what percentage of your profits they get to keep, not an awesome business partnership to be in, especially when it comes to your retirement.
That's it. What does it come down to when you're trying to figure out whether it's tax-deferred or tax-free? It all comes down to this, this is not something that calculators on the internet are going to tell you, this is not something some financial prognosticator can tell you, it all comes down to this, “Where are tax rates going to be in the future when you're taking money out of these investments versus where they are today?” If the tax rate that you pay on conversion today is lower than what your tax rate will be in the future when you withdraw these dollars, then it makes sense to do a Roth conversion today. If you believe in your heart of hearts that your tax rate today, at which you would do a conversion, is higher than where it would be somewhere down the road when you take those distributions, then you should absolutely not do a Roth conversion. That is what it comes down to. It's simple math, it has nothing to do with hunches, it has nothing to do with calculators, it all comes down to that simple number, “Will that tax rate today be higher or lower than the tax rate down the road?”
That's the show we have for you today. I just wanted to highlight that because it comes up so much, I just wanted to reinforce that one principle. Again, if you need books in bulk, you can go to Please follow me on Twitter, it's at @mcknightandco. If you are a financial advisor and you need help transitioning your practice to a Power of Zero style practice, go to, opt in to our video series. If you're looking for a Power of Zero advisor to help you navigate the pitfalls that stand between you and the 0% tax bracket, head on over to
Once again, subscribe. One other thing, if you are looking to buy viewings of our movie, streamings if you will, of our movie in bulk, those are now available over at If you've always wanted to be able to email a link to a friend or to a client saying, “Hey, check out this movie,” you can do so and it only costs you $5 a view. You do have to buy 400 of them in advance but you can send these viewings out and your view count only goes down when somebody watches the movie. Check that out at Other than that, I really appreciate you being with us today and we will look forward to chatting with you next week.

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