The Power Of Zero Show

David gets a number of emails from listeners saying that he’s been wrong for years and the central thesis of the Power of Zero paradigm is incorrect. The question is, do the tax cuts of 2016 delegitimize what he and others have been saying? In reality, the problem has only compounded since the tax cuts came into effect. You have to consider whether the US government is prone to making bad financial decisions and has just kicked the can further down the road. David Walker says that anytime you have tax cuts, they should be accompanied by a commensurate decrease in spending. The Republican Congressional Budget Office says that the tax cuts will cost $1.5 trillion over the next ten years. Notice what’s happened to the deficit. Since the tax cuts have been put in place, the deficit has only gone up. When we get to the point where we have trillion dollar deficits, that’s the canary in the coal mine for a sovereign debt crisis. If anything, we have just covered up the problem and deferred it into the future, but in the process have made the reality of future tax hikes all the more inevitable. What happens if we don’t increase revenue or cut spending? We will get to a crisis point where we will have to have immediate and dramatic increases in taxes just to pay for social services. The federal government has a history of waiting until the very last minute to address these problems. Just because the government behaves irresponsibly, that doesn’t mean the math to which David Walker and other economists refer doesn’t add up. Every year that goes by where the government fails to reduce spending, spending reduces its effectiveness. We will get to a point where the interest on our debt consumes such a large part of the budget that we won’t be able to pay out Social Security and Medicare benefits without raising taxes. We are financing our spending with debt, and eventually the interest on that debt will become so prohibitive that it will crowd all the other expenses out of the budget. Has the central thesis been disproven? Of course not! If anything, the tax cuts have made the Power of Zero paradigm more important. Every day that goes by where the federal government fails to reduce spending means the reality of higher taxes down the road becomes all the more imminent.

When someone is talking about a risk multiplier, they are essentially talking about longevity risk. The longer you live, the more likely it is for you to experience a subset of risks that could completely derail your retirement plan. There first major risk is the long term care risk. In many ways, you are better off dying than needing long term care, because a long term care event can completely decimate your savings and put your spouse into a very difficult spot. Historically, long term care policies are how people have mitigated this risk, but these policies have a number of disadvantages. They tend to get more expensive over time, often to prohibitive levels, and it can be very difficult to qualify. People also find the chance of paying for a long term care policy but never using it pretty irritating. Insurance companies started exploring the idea of giving people their death benefit in advance of their death in the event of a long term care event. This puts people in the scenario where if they die peacefully in their sleep their beneficiaries will get the death benefit completely tax free. This is why the L.I.R.P. is the recommended way of dealing with the risk of a long term care event. The second major risk is withdrawal rate risk. This risk basically says that there is an ideal amount of money to take out of your stock portfolio each year to avoid running out of money. The previous rule of thumb used to be withdrawing 5%, but that was found to be generally too risky. The current recommendation is somewhere closer to 4%. The sequence of return risk is closely related to withdrawal rate risk. If you are withdrawing money during a down market in the first ten years of retirement, you could send your portfolio into a death spiral where it never recovers. Combined with withdrawal rate risk, sequence of return risk can really mess with your retirement plan. The Wall Street Journal is saying the 4% rule is now actually the 3% rule if you want to mitigate your risk. To shield yourself from sequence of return risk and withdrawal rate risk, to fully mitigate them you need to have a massive amount of money saved by the time you get to retirement. There is another way to mitigate this risk without accumulating a giant amount of money and that is through a guaranteed form of income through an annuity. If you have a pension from your work or are a fan of social security, you are also a fan of annuities because they operate on the very same premise. If you’re going to live a 40-year retirement instead of a 5-year retirement, then you are much more likely to run into these risks. Take a portion of your stock portfolio and give it to a company that pools your risk with other people’s risk in exchange for a guaranteed stream of income until you die. In the case of a down year, you can avoid taking money out of your portfolio and rely on the annuity instead. The answer to the three basic risks in retirement are having an L.I.R.P. and an annuity. Mathematically speaking, your money lasts longer, you’re able to spend more money in retirement, you’re able to effectively mitigate longevity risk by having some guarantees in your portfolio. Longevity risk is the risk multiplier, it will make the other subsets of risks even more likely to derail your retirement. If you want to eliminate stress from your retirement and have peace of mind, then pooling risk and offloading it to insurance companies is the way to do it.

David is generally very reluctant to recommend something that would cause someone to bump from a 12% tax bracket into a 22% tax bracket. We’re trying to avoid the tax apocalypse that’s coming down the road, and that means thinking about the future. There are some circumstances where it makes sense though. A scenario to compare is between two 65 year olds with similar amounts of money in their three buckets. The first thing to do is figure out what their taxable income is by crunching the numbers on the income from their pensions and other sources, as well as their standard deductions. In this scenario, both people are in the 12% tax bracket, which is great for them. The 12% tax bracket will be looked back upon as the deal of the century. But we have to acknowledge the remaining $700,000 in their tax-deferred bucket and they only have $24,000 left before they hit the top of the 12% tax bracket. We could shift some of their money from tax-deferred to tax-free each year to keep them in the 12% tax bracket, but would that really solve anything? How big will their IRAs be once they turn 70 and a half, when they are forced to take the money out? There may be a scenario where it makes sense to go into the 22% tax bracket. We have to project into the future and see how big their required minimum distributions will be in a few years. At that point in time, the 22% tax bracket will be reverting back to the 25% tax bracket, and we may very well see that the 22% was actually a good deal. We also have to recognize that there is a scenario where someone can be bumped into the 22% tax bracket overnight. If you’re over 65 and your spouse dies, you will find yourself in the single filer tax bracket and your thresholds are reduced considerably. It’s a penalty to be single in many ways since your tax bracket gets cut in half. The third scenario to consider is the effect of the upcoming SECURE Act. Starting next year, it could force a non-spouse beneficiary to spend down an inherited IRA or 401(k) over the course of ten years. This could mean that your beneficiaries could inherit your money at the apex of their earning years, at a period of time when taxes are going to be higher than they are today, and when they can least afford to pay the higher taxes. If you are afraid of the 22% tax bracket right now, your children could be paying tax on your money at the 32% or 35% tax bracket, or the future equivalent. Whereas you could have paid the 22% tax now and allowed them to receive the money in the future tax-free. Consider the three circumstances where it may make sense for you to bump yourself into the 22% tax bracket. If you find yourself as a widow prematurely, you could find yourself spending a fair amount of time in the single filer tax cylinder. If the SECURE Act gets legislated into law, your children will inherit your money and end up paying a much greater amount of taxes.

Rule #1: Everyone’s situation is different, and there is no cookie cutter approach. You can’t pick up the Power of Zero book and have the exact recipe for success. It will need to be tailored to your personal situation. Rule #2: It is unlikely that you will be in a lower tax bracket in retirement. The closer you are to 2029, the less likely you are to be in a lower tax bracket. We know when the tax cuts will end and when tax rates will go up. When you look at the ten-year horizon, it’s really tough to make the case that tax rates won’t be higher. This turns conventional wisdom on its ear. We are marching into an uncertain future, and that doesn’t bode well for people that have the majority of their money in the tax-deferred bucket. Rule #3: There is an ideal balance to have in your first two buckets in a rising tax rate environment. Your taxable bucket should contain around six months worth of expenses and your tax deferred bucket balance should be low enough that RMD’s are equal to or less than your standard deduction, as well as not cause social security taxation. Rule #4: Anything above and beyond the ideal balance in those first two buckets should be systematically repositioned to tax-free. Preferably you don’t do it all at once but you do it quick enough to get all the heavy lifting done by 2026. Rule #5: Anything with the word Roth on it is your best friend. These vehicles give you the ability to shift nearly unlimited money from tax deferred to tax-free. Rule #6: Social security taxation is a big deal and you should do everything you can to get your social security tax-free. If your social security is taxed, you will have to spend down all your other assets even faster. In many cases, your money will run out five to seven years faster if your social security is taxed. Rule #7: The best way to deal with long-term care in retirement is not through a traditional long-term care policy. An L.I.R.P. is a much better option. If you die peacefully in your sleep never having used the long-term care, at least someone is still getting a death benefit at the end. L.I.R.P.’s are great way to take the sting out of mitigating the long-term care risk. Rule #8: You will need more than one stream of tax-free income in retirement. You never know when the IRS is going to legislate one of your tax-free streams of income out of existence. You need multiple streams of tax-free income working together. Rule #9: You really want to get all your heavy lifting done before 2026. You have seven years before the tax cuts end and every year you wait to take advantage of these low tax rates, is another year you will have to pay more than you need to. Rule #10: Know your magic number. Your magic number is how much you should be shifting each year from tax deferred to tax-free so that by 2026 everything is perfectly allocated. You only have so many retirement dollars, so you need to spend them in the most tax efficient way possible. Rule #11: Never, ever annuitize your retirement in the tax deferred bucket. Annuities in your tax deferred bucket will count as provisional income and cause you all sorts of problems. When you annuitize your investment, there is no going back. Rule #12: It is much better to have a guiding hand when you’re navigating the path to the zero percent tax bracket. The thresholds are always changing and there are a number of ways to get it wrong. Connect with a certified Power of Zero specialist who can help you avoid the pitfalls.

When David is working with a client, his recommendation is to reach the zero percent tax bracket is by having 5 to 7 streams of tax-free income. These can include Roth IRA’s, Roth 401(k)’s, and L.I.R.P.’s. David often asks advisors what they think is his favorite. Rarely, will anyone guess the truth is RMD’s (Required Minimum Distributions). The holy grail of financial planning is any investment that gives you a tax deduction on the front, grows tax-deferred, and you can take it out tax-free. A Health Savings Account and an IRA or 401(k) that allows you to get a deduction on the front end, grow the money tax-deferred, and then allows you to take a portion of the money out tax-free are two of the few vehicles that tick all the boxes. You want a balance in your 401(k) that’s low enough that it’s equal to or lower than your standard deduction and doesn’t cause social security taxation. You can use the calculators on davidmcknight.com to figure out your number. You can also learn your magic number, the amount of money you need to shift each year to achieve your ideal balance. Your IRA and 401(k) only becomes the holy grail of financial planning if they have the ideal balance. That’s when it becomes tax-deductible on the front end, grow tax-deferred, and the money can be taken out tax-free. If you have a high deductible health care plan, an HSA is a good idea because when you put money in, you get a deduction, and when you take money for a qualified health care purpose, you get it tax-free. If your RMD’s are equal to or lower than your standard deduction and don’t cause your social security to be taxed, they become the true holy grail of financial planning. If somebody says to you that you should convert everything you have to a Roth IRA, you have to think about what is going to happen your standard deduction in retirement. If everything is in the tax-free bucket your standard deduction will essentially be left idle. There is an opportunity cost of moving too much of your money from tax-deferred to tax-free. If someone recommends a financial plan that only features the L.I.R.P., you need to run the other way. The L.I.R.P. has significant shortfalls and is not the perfect solution, it’s only one piece in the puzzle of getting to the zero percent paradigm. The holy grail of financial planning is really about establishing the perfect amount to have your tax-deferred bucket. If your advisor can’t tell you what that number is, you’re probably not dealing with a Power of Zero advisor. The ideal approach to Power of Zero retirement planning is to call on as many of these streams of tax-free income in retirement as possible. Each account and investment is meant to be a solution to a specific situation and they only complete the picture when put together the correct way. The L.I.R.P. is for addressing the highest risk in retirement, namely a long term care event. In some cases, almost dying can actually be worse than dying by decimating the assets that would normally go to your spouse. Make sure you have lots of different streams of tax-free income, none of which shows up on the IRS’s radar but all of which contributes to you being in the zero percent tax bracket. Above all make sure you’ve got some money left in your tax-deferred bucket so your standard deduction isn’t left languishing. Determining the right amount to have in your tax-deferred bucket is critical, in a rising tax rate environment anything above that amount should be shifted over to tax-free.

There are three words that don’t get mentioned very much, but they should scare the dickens out of you. Those words are Public Pension Liabilities. It’s a problem that is largely flying below the radar, but if you live in a state with a lot of public pension liabilities, it could end up like Detroit. Public pensions often end up swallowing up the state budget until there is little left over to provide basic services. A pension is a guaranteed stream of income that is paid to you either over your lifetime or the life expectancy of you and your spouse. It used to be very popular in the private sector, but they became phased out as they became too expensive. However, they still persist in the public sector. Public pensions are a great way for politicians to get elected. It’s very easy to make a promise to perpetuate lavish benefits when they don’t have to deal with the consequences for potentially decades down the road. It will get to the point where certain states will go bankrupt because they can’t afford to pay the pensions that have been promised. California, one of the fiscally unstable states in the country, has over 62,000 pensioners that are getting over $100,000 per year. Illinois is on the cusp of bankruptcy because of all the unfunded obligations they have in regards to pensions. These public employees deserve competitive pay, but people are living longer and cities are now in a unique position where they have to fund their current budget. However, they also have to pay one or two generations of retirees. When we ask the states to total up their unfunded obligations they say it adds up to $1.4 trillion, but the Federal Reserve and others put that number as high as $5.3 trillion. You have to realize the precarious position that states are in. They can only raise taxes so high before people start fleeing their state. They can’t print money, so their budget is limited to what they bring in. They will eventually have to cut services. Some believe the federal government will intervene, but that’s not going to play out the way most people believe. We often focus on the broad national debt, but we often forget what’s going on at the local level. If the federal government opts to bail out the states, it will be by raising taxes on everyone. There is a storm looming on the horizon. We have to keep in mind that public pension liabilities are a chicken that will come home to roost sooner or later. It won’t be the states that go into austerity to be able to deliver on these pensions. You’re going to see the federal government intervene and raise taxes to be able to deliver these pensions from the fiscal abyss into which they have descended over the last couple of years. [ There are solutions that states could look at that could potentially fix the problem. Fix number one would be to wean new employees off of pensions so less of the onus is on the state government. [ Politicians love to bend the truth and promise people a lot of free stuff, so they may not be the ones that push a real solution forward. They have to be much more transparent with the price tag associated with what they are promising. [ We can no longer afford to lavish our public sector employees with very expensive guaranteed pensions. There is a big storm on the horizon, but one of the smaller storms that doesn’t get talked about enough is the public pension liabilities that are going to be a major issue for a number of states in the near future.

David becomes very uneasy when advisors recommend that their clients take the money in their IRA and convert all of it into an LIRP. The LIRP has a lot of benefits, but it really should be used in conjunction with other streams of tax-free income. 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 really shines. An LIRP conversion is something that you would use with a client when there are no other opportunities for Roth or Roth conversions available. Most annuity companies are okay with you doing a Roth conversion, as long as you do it all in one year. What do you think the tax implications of that might be? There are some companies that allow what is known as a midair conversion, where you take a distribution from the IRA and then you convert it to a Roth IRA on the other end. This isn’t very common though and most companies shy away from this. With the LIRP we get as little death benefit as the IRS requires of us and stuff it with as much money as the IRS allows in order to mimic all of the tax free benefits of the Roth conversion. As your annuity balance goes down, you will have to structure the LIRP just the right way, but if you do, your money will be able to grow in a completely tax-free environment. The average expenses over a year over the life of a LIRP are about the same or a little less than a typical IRA or 401(k). Not only are you able to grow your money in a tax-free environment, but you’re also able to get a death benefit that doubles as long-term care. The second scenario where an LIRP conversion makes sense is in a situation where you are a non-spouse inheritor of an IRA. If you are a spouse that inherits an IRA, you can do a Roth conversion without any issue, but that’s not true for a non-spouse. They will be required to take RMD’s on that IRA over their life expectancy. You can’t convert an inherited IRA and turn it into a Roth IRA. You can put that money into a traditional IRA, but there are limitations and that’s where a LIRP conversion can be very useful. If you believe tax rates are going to be higher in the future and have inherited an IRA, the natural place to put that money may very well be in a LIRP. An LIRP conversion is not an officially recognized term, but the idea is very useful. If a Roth conversion is not available, an LIRP conversion is your next best option. With an annuity with a 10% withdrawal limitation, that is a great place to start shifting money to an LIRP.

There are two people today that are making waves in the national conversation for what they are saying about the national debt. This first is Ken Fisher. Ken says the debt to GDP ratio has been worse in the past and that we really have nothing to worry about. He also says that we borrowed some of that money from ourselves, so it’s really just an accounting issue. The trouble is, that’s all untrue. We owe the money to Social Security and that money has to come from somewhere. Social Security is underfunded and will need to be paid back, either through higher taxes or spending cuts. Ken Fisher is trying to persuade us the stock market is going to go up in perpetuity, which is basically what he said just prior to the crash of 2007. There is one person on the right side of the aisle who is the opposing voice on the debt issue. Mark Sanford is a GOP candidate running against Trump. Mark doesn’t believe we have 8 to 10 years before the coming crash, which is why he’s running now. He’s injecting the topic into the national debate by running for president, despite the very long odds he will succeed. We don’t have the luxury of waiting four years until the next presidential cycle to have this debate. The storm may already have come in 5 years. Tom McClintock has said something similar, namely that the United States will resemble Venezuela in 8 years. The financial storm will be something that we have never seen before. A sovereign debt crisis is looming, which is the straw that could potentially break the camel’s back. Our math doesn’t add up in Washington. The current financial condition of the country is like a family running up their credit cards to create the illusion of real wealth that gets wiped out when the financial storm hits. While all the other countries in the world are getting their financial houses in order, the US is just piling on their debt. This is not all the current president’s fault, but he’s not helping the situation either. We are living in a dream world if we believe that the national debt is only $22 trillion. All the other governments in the world follow fiscal GAAP accounting except the US. We would have to have $239 trillion sitting in a bank account today earning treasury rates to be able to deliver on all the promises. Who’s right? Ken Fisher or Mark Sanford? One has everything to gain where the other has nothing to gain except maybe averting a disaster. If you find yourself in the position where you or your clients have large amounts of money in tax deferred investments, you have a freight train bearing down on you. Take advantage of the next 7 years to position that money to tax free or you may not be able to keep as much of that money as you thought. The Secure Act will most likely be snuck into a spending bill at the end of the year. It means that if you die with money in your IRA’s and it goes to a non-spouse beneficiary like your kids, they will have to spend that money over 10 years. That means they will pay taxes on it at the apex of their earning years when they can least afford to pay the taxes. People will start seeing the writing on the wall and take advantage of Roth conversions, Roth IRA’s, and LIRP contributions with Power of Zero advisors across the country.

What are the implications of taking your pension normally versus a lump sum? A lot of companies offer the lump sum as a way to get out from under the financial obligation of paying you or your spouse until you die. As a stream of income, your pension will be coming out of your tax-deferred bucket. You also have to realize that once you opt to take your pension as a stream of income you are stuck with that choice regardless of what tax rates are in the future. It will always come out of your tax-deferred bucket, with all the unintended consequences that go along with that. That doesn’t mean you should always take the lump sum option, but it can be a good deal. You just have to crunch the numbers and understand the tax implications of your choice. When you take your pension as a stream of income, it counts as provisional income, so in most cases you can count on it causing your Social Security to be taxed. Anything you take out of your other retirement plans will land right on top of that income and be taxed as well. When 85% of your Social Security gets taxed, which is a situation many people will find themselves in, it forces you to spend down your other assets much faster. You could run out of money 5 to 7 years faster than people who do not have their Social Security taxed. You can spend your other assets down much faster than you planned, in an attempt to compensate for Social Security taxation that’s brought about by electing to take your pension as a stream of income. When you’re taking a pension stream of income in retirement, it is 100% exposed to tax rate risk because it is coming out of your tax-deferred bucket. That means you are going to have to find a way to compensate, and when tax rates increase in the future it’s going to be double hit. A lump sum distribution allows you to roll that money into an IRA. Once it’s there, you could do a Roth conversion and place it into the tax-free bucket. If you’re really bent on having a stream of income you could use a deferred income annuity, which would create that stream of income in a tax-free environment. Pensions are becoming more scarce, only 40% to 50% of the people we see everyday have one. Most people have 401(k)’s or 403(b)’s. If you do have a pension, you should explore a lump sum distribution before you opt to take that stream of income. You should be aware of your options before you have to make that choice.

Line 10 on your tax return can be a great joy for you in retirement. Before the tax cuts of 2018, you may have known it as Line 43, and it simply means your taxable income. Taxable income is important to someone trying to achieve the Power of Zero paradigm because in a rising tax rate environment there is an ideal amount of money in both your taxable and tax-deferred buckets. Anything above those amounts should be repositioned to tax free. That’s approximately six months of living expenses in the taxable bucket, and in the tax-deferred bucket. The ideal balance is low enough that your required minimum distributions are less than or equal to your standard deduction in retirement. When you’re shifting money from tax deferred to tax free, you create a taxable event, and to understand how much your going to pay in taxes, you need to know your taxable income. This is where Line 10 on your tax return comes in. Your Line 10 number will inform how much you can shift in a given year before bumping up into the next tax bracket and how much heartburn you will be exposed to. How do you get to your taxable income? Start with your gross income and then subtract your “above the line” deductions like contributions to your traditional tax deferred plans. Once you’re at your adjusted gross income, to get to your taxable income you have to decide which one is greater: your standard deduction or your itemized deductions. You need to understand the implications of any shifting you do from tax deferred to tax free and you can’t do that without figuring out what your taxable income is. The marginal tax bracket is also the tax rate at which you save taxes when you do something that generates tax savings like taking out a mortgage. Most people we meet are in the 22% tax bracket so they aren’t too upset about doing enough shifting to get to the top of that tax bracket, but they should also take advantage of the 24% tax bracket as well. The 24% tax bracket is only 2% higher than the 22% tax bracket, but it allows you to shift another $150,000 each year before hitting the top of that bracket. If you have a $1 million in your IRA right now, you’re going to need to shift $125,000 each year over the course of the next seven years to get to the right amounts in your tax deferred and tax free buckets. Ultimately you have to ask yourself are tax rates going to be higher in the future than they are today. If you believe they will go down, then hold off on the Roth conversion. If you believe they are going to be dramatically higher, then line 10 on your tax return will be a good barometer for what the implications of shifting will be. Check out your line 10, figure out what marginal tax bracket that puts you in, and then ask yourself how much room you have to shift before you get to the next level. Remember your pension and social security taxation will fill up your first two tax brackets, and any money that comes out of your IRA’s or 401(k)’s and will be taxed at the future equivalent of the 22% tax bracket.