The Power Of Zero Show

Over the years David has noticed a number of advisors who have professed to be Power of Zero advisors, but there are a number of significant shortfalls in their approach. A true Power of Zero advisor believes that tax rates are going to be higher in the future than they are today and knows how to defend that position. They understand the national debt and the true amount of the unfunded liabilities as well as the implications of those things. In a rising tax rate environment, there is an optimal amount of money to have in your taxable and tax-deferred buckets. Regardless of the direction tax rates go in the future, your taxable bucket should contain about six months of living expenses. The real litmus test for the Power of Zero paradigm is in how much should be in the tax-deferred bucket. For most people that number is around $350,000. You can have too much money in your tax-deferred bucket, and when you do it unleashes a cascade of unintended consequences that could potentially lead to social security taxation. A true Power of Zero advisor believes in the idea of multiple streams of income. If your advisor says all you really need to get to the zero percent tax bracket is a Life Insurance Retirement Plan or something similar, that’s a tipoff that they haven’t really embraced the paradigm. It’s nearly impossible to get to the zero percent tax bracket by relying on just one stream of tax-free income. Each type of tax-free stream of income has a strength and is able to accomplish things that the other types can’t. They should be used in conjunction with one another to get to the zero percent tax bracket. The holy grail of financial planning is when you can use your standard deduction to offset your required minimum distribution from your IRA. The LIRP has its own set of advantages. It allows your money to grow safely and productively, has low fees as long as you keep the plan for your lifetime, and you get a death benefit that doubles as long term care insurance. Social security helps mitigate against a number of risks, including longevity risk, sequence of returns risk, inflation and deflation risk, and the longer you live the greater your return on the program. An advisor should be able to talk about all the advantages and disadvantages of all these things. A true Power of Zero advisor recognizes the importance of the date Jan 1, 2026, when tax rates revert to what they were in 2017. You’re going to have to pay taxes now or later, so why not pay them when they are at historically low rates? When the tax sale is over January 1st, 2026, it’s over for good. According to Tom McClintock, in eight years the US will be in the same boat as Venezuela. A true Power of Zero advisor would never lock up a significant portion of your assets in the tax-deferred bucket in the form of an annuity that didn’t have Roth conversion features. Annuities have a lot of benefits in retirement but there are unintended consequences associated with having that income in your tax-deferred bucket and have it be stuck there forever. If you’re giving up a portion of your Social Security or other guaranteed lifetime stream of income to taxation, you’re going to have to spend down all your other assets that much faster. A true Power of Zero advisors wants to create those streams of tax-free income but they want to do it in the tax-free bucket. Once you start taking a stream of income from your tax-deferred bucket, your ability to get it out of the tax-deferred bucket is gone. Absent any one of these worldviews, you have a hole in your Power of Zero retirement game.

Social Security can indeed be taxed, despite the feeling that you’re getting taxed twice. This year, 89% of all federal tax revenue is only going to go towards four things: Social Security, Medicare, Medicaid, and interest on the debt. These are non-discretionary spending items. It would take an act of Congress to choose not to pay for them and doing so would result in a worldwide depression. That means that only 11% is left to fund everything else in the budget and that doesn’t include the additional trillion dollars we spend above and beyond the federal tax revenue. We are going to come to a point where we have a sovereign debt crisis and will have to either dramatically reduce spending, increase tax revenue, or some combination of both. Provisional income is the income that the IRS keeps track of to determine if your Social Security will be taxed. Any 1099’s coming out of your taxable bucket, including investments that generate income or dividends, count as provisional income. The same is true for any distributions from qualified plans and 401(k)’s in your tax deferred bucket. Most people have no basis in their 401(k). They used pre-tax dollars to fund those accounts and when they take that money out the IRS is going to count 100% of it as provisional income. Any sort of taxable income that accrues to you during retirement will count as provisional income. The kicker is one half of your Social Security counts as provisional income. If, as a single person your provisional income adds up to $25,000, or as a married couple it adds up to more than $32.000, up to 50% of your Social Security can become taxable to you at your highest marginal tax bracket. It’s important to remember that your standard deduction has nothing to do with your provisional income. Interest from your municipal bonds counts as provisional income, which is the reason we aren’t very keen on them since they don’t count as true tax-free investments. There is a longform process you can use to determine your provisional income, but there is also a short cut. Many people think that provisional income is based on a threshold and if they exceed that number, they are taxed at their highest marginal tax bracket, but that’s not how it works. It’s graduated, so you have to get well above the threshold to feel the full brunt of the tax. Somewhere between $80,000 and $85,000 in provisional income is where your Social Security will be taxed at your highest marginal tax bracket. Many financial advisors think about provisional income incorrectly. We have to recognize that provisional income works in a graduated system and there are ways to keep your provisional income low enough to make your Social Security tax-free. You have to remember that even before you take the first dollar out of your IRA, you are already at the 50% mark, so you have to keep the balance of your IRA low enough that the RMD coming out of it will keep you below the threshold. For most people, the magic number is around $350,000. Why is it such a big deal to keep your Social Security tax-free? The way that most Americans pay taxes on their Social Security is by taking more money out of their IRA’s and 401(k)’s, but what happens if tax rates double? When your Social Security gets taxed, you run out of money 5 to 7 years faster than someone that isn’t having the Social Security taxed. The act of compensating for Social Security taxation forces you to spend down your other assets that much faster.

When you come from a tax-deferred paradigm, it can really skew how you view the types of accounts that you are accumulating dollars in. The main thrust of the reviewer’s critique is that we shouldn’t focus on minimizing taxes if that means that investment fees will leap up over the course of retirement. Of course, you shouldn’t build your financial plan while only considering taxes. If you look at the financial path the country is on, we can make some educated guesses on the future of tax rates and adjust our financial strategy based on that. The Power of Zero paradigm essentially means that if tax rates are going to be higher in the future than they are today, then there is a mathematically ideal amount of money to have in your taxable and tax-deferred buckets. Anything above that should be systematically transferred to tax-free. Life insurance policies do have higher fees than other potential investments, but only if you don’t keep the policy for your entire life. If you do keep it for your whole life, it becomes very inexpensive. To say that you can go out and get useful advice about retirement for less than one tenth of 1% is to say that you are working with an advisor that isn’t making any money. The key is that if you’re going to work with someone who is going to help you navigate all the pitfalls that stand between you and the zero percent tax bracket, that person is not going to work for free. The average rate of return of the S&P 500 over the last 30 years is about 8%, but the average return enjoyed by most investors is between 1% and 3% because they make decisions emotionally. If you’re paying 1/10th of 1% to an advisor, you are getting what you pay for, and you will definitely not get any advice on when to move money from taxable and tax-deferred to tax-free. When you take a loan from your life insurance policy, it’s not actually coming out of the policy, it’s coming from the insurance company with your policy, being used as collateral. There is a reason why hedge fund managers and banks are the biggest purchasers of life insurance. All life insurance loans are tax-free, but not all of them are cost-free and we’re looking for both. Roth accounts are mentioned all throughout the Power of Zero book because they come with a lot of advantages, but one of the things you can’t get is the safe and productive growth you can get from the LIRP. The biggest selling point of the LIRP is the death benefit that doubles as long-term care. Baby Boomers are recognizing that one of the single biggest risks they face is long-term care. David has never argued that the LIRP should be used instead of Roth accounts, it should always be used as another stream of tax-free income alongside those accounts. We know that 53% of our country pays all of the taxes, with 80% of that being paid by the top 20%. In order to keep social security, Medicare, and Medicaid, we have to widen the tax base because we just don’t have enough people paying enough to keep them going. If the highest marginal tax rate goes up, that has historically been a signal that the other tax rates will likely be going up as well. With the money that has been promised for those programs, there is not enough money available if we just tax the rich so that means the other tax brackets will have to go up in tandem. David Hays found his mother’s tax return from the year he was born where they were paying around 30% of their income in taxes, despite not making much money. Even middle class people in the past paid comparatively high taxes, so don’t rule it out. There are different viewpoints when it comes to the Power of Zero paradigm but you have to understand the relevant data before dismissing everything.

The IRS has a test called the seven pay premium test. It basically states that it’s possible to put too much money into a life insurance policy. If you fail that test than any loans that you take from your life insurance policy get treated differently. Traditionally, if you obey the rules of the IRS you put money into a life insurance policy after tax and if you take the money out the right way you can do it tax free, typically by way of a loan. The alternative is to take the money out of a non-MEC life insurance policy with a policy withdrawal. This happens on a first-in, first-out basis, which essentially means that you can take out the money in your basis tax-free, but anything from the growth portion of your account will be subject to ordinary income taxes. Anything above the basis, you would take out in the form of a loan from the insurance company itself. However, there are some policies that allow you to take out variable or participatory loans against the whole amount. Many people do Modified Endowment Contracts on purpose. In either case, the money will go to the heirs tax-free. The big difference is the order of the withdrawal structure. With an MEC policy, the order is last-in, first-out which means you will pay tax on the growth first before getting to your tax-free basis. If you’re younger than 59 and a half, you will also pay a 10% penalty on any loan or withdrawal from a MEC policy. This can have major implications if you end up using the contract the way that most people do, as it can end up being the worst investment you will ever make. The advantage to a MEC policy is that you can get a large lump sum into the policy early on and take advantage of the time value of money. You just have to recognize that you want to have the right amounts of money in the right accounts in a rising tax rate environment. If you want to change your existing life insurance policy you can do a 1035 exchange and roll that money tax free into a new policy, but there are some things to watch out for. Once a MEC, always a MEC. There is another thing you can do with a 1035 exchange where you can take the money in a non-MEC life insurance policy and roll that into an annuity. Once it’s an annuity, you will lose any ability to take money out tax-free, but the option is there if you need an escape hatch from your current life insurance policy. The shift only goes one way, you can’t take an annuity and roll it into a life insurance policy.

The number one criticism of the Life Insurance Retirement Plan online is that the fees are simply too prohibitive, but the question is really what are they expensive compared to? The best way to compare the fees is to think about where else you could be putting your money, in most cases that’s going to be some sort of investment. When it comes to typical investment fees, you’re looking at an expense ratio of 1.5%. The baseline number to compare the fees with the LIRP is that 1.5%, which means you have to consider whether the LIRP is more or less expensive than the traditional 401(k) account. The LIRP is a bucket of money that grows tax free, there is no contribution limit or income limitation, you don’t pay taxes if you take the money out in the right way, it doesn’t affect provisional income and there isn’t likely to be any legislative changes down the road. The IRS requires that a certain amount of money flows out of your LIRP in order to pay for certain expenses. The expenses in the LIRP are likely to be much cheaper than what you are paying in your 401(k) or IRA. The fees are a little bit higher in the early years of the LIRP compared to other accounts, but the fees drop off a cliff after the eleventh year. When you average out the fees over the life of the program, it’s going to cost you less than the 1.5% baseline. Don’t do an LIRP if you don’t plan on keeping it for your whole life. There are a lot of benefits to the plan that only make sense if you keep it until you die. If you do plan on keeping it for your whole life, why would you be concerned with the higher fees in the beginning instead of considering the impact over your lifetime. Since the plan isn’t a short term investment, it doesn’t make sense to only pay attention to the negative return in the first six years. The longer you keep the plan the closer your internal rate of expense gets to 1%. If the internal rate of return reflects a 1% expense over the life of the program, it might as well have been that rate for the entire time. The costs are significant over the first ten years, but if you stick with it for the rest of your life the more dramatically the expenses reduce and the better the internal rate of return becomes. The LIRP may come with expenses but you also get advantages by paying those expenses. If you could get a 6.5% return without taking any more risk than you are accustomed to taking in your savings account, would you? The expense issue with LIRPs is overblown. We have to contextualize the expenses within the broader picture and also consider the benefits it conveys over the course of our lifetime. LIRPs are not a silver bullet, they should complement your other tax-free streams of income. If you put it all together just the right way you get to be in the 0% tax bracket. When you have the right levels of money in the right accounts, that’s how you reach the 0% tax bracket, but if some of those levels are off you are not going to make it so make sure you work with a trained professional. The LIRP also operates as a solution for long term care in addition to all the other advantages that it comes with.

You will find articles on the internet that claim that if you are going to do a Roth Conversion you have to do it a number of years before retirement, because you must have the ability to recuperate the dollars you’ve paid towards tax, but that doesn’t stand up to the math. David goes over the example of two brothers, each taking a different approach to investing $100. One goes for the tax deduction on the front-end approach, and one for the tax-free approach. The moral of the story is that most people believe that if they have $100 in an account and it doubles to $200, that $200 is theirs, but they don’t actually have $200 because the IRS is going to take their cut one way or another. As your portion of the invested money grows over time, the IRS’s portion grows over time as well. In a level or stable tax environment, both the IRA and the Roth IRA are worth the same amount of money. The value of the Roth IRA has nothing to do with having enough time to recover from the taxes you pay on the Roth Conversion. The same math holds sway no matter the approach you take. It comes down to whether you think the taxes you pay on the front end will be greater or less than the tax you will pay on the back end. The only variable that really matters is expected tax rates. If taxes are higher in the future, the Roth IRA is the better choice. If you believe tax rates will be lower in the future, than go for the IRA or 401(k). Always be asking yourself where you think tax rates will be in the future. This is why David focuses on conveying the financial reality of the US. The unfunded liabilities of the country are close to $239 trillion at this point. If you think that tax rates are going to be higher in the future to help keep our country solvent, then the tax free worldview is the way to go. It’s okay to keep some money in your tax deferred bucket to offset your standard deduction in retirement, but for most people the sweet spot is somewhere between $250,000 and $350,000. The people who aren’t sure if the Roth IRA is worth it or not need to crunch the numbers year by year, and see that there is no catch-up period. The myth around Roth Conversions is not accurate. If after examining all the evidence and you believe that tax rates will be higher in the future, don’t believe all the nonsense around Roth Conversions. The math is always on your side if tax rates are going to be higher down the road than they are today.

There are a number of ways to get money out of an IRA before you are 59 and a half years old. One is a Roth Conversion, but the problem with that is you have to pay tax and potentially a penalty. The only other way is something called a 72(t). The 72(t) basically means separate equal periodic payments. What this means is that you can take money out of your IRA before your 59 and a half years old as long as you do it in separate equal yearly distributions that last for at least five years, or until you are 59 and a half, whichever is longer. With the 72(t) you can take out about 5%, but that number ebbs and flows with interest rates. The IRS gives you three different income options when it comes to the 72(t). The first two options are fairly similar, amortization and annuitization. The third option is the required minimum distribution method. The RMD method is different because it’s recalculated every year, and is designed to get bigger each year. With the first two methods, you are locking in to a level payment. If you don’t keep the payment for a minimum of five years, you are going to pay a penalty. The only way to waive the penalty is to die or become disabled, but you do have a chance to change the method once if you see an issue in the future. The number one reason to do a 72(t) is to fund an LIRP and there is no other money anywhere with which to do so. Number two is you can’t do a Roth Conversion because you have no money in your taxable bucket. Number three is to stymie the growth of an IRA prior to the 59 and a half year mark. Only one of ten will be a candidate for the 72(t), but for those who can take advantage of it, it can be a powerful tool to get money flowing to your tax-free bucket. Beyond funding an LIRP, you can spend the money however you want. David recommends putting the money into a tax free account. The point is to start growing dollars in the tax free bucket. Letting the tax deferred bucket grow in an uncontrolled way complicates your tax picture down the road, especially in a rising tax rate environment. You can be too young to use a 72(t) since you are committing to a lengthy time and your situation may change. There are also older ages where the 72(t) doesn’t make sense. The closer to 59 and a half years old you are, you may as well wait instead of getting locked in and risking a penalty. The 72(t) should only really be used when there are no other options to fund the Roth Conversion or the LIRP, and the ages between 50 and 57 is the sweet spot for it. It’s a great concept that allows you to start getting money into the tax free bucket, but it should only really be used in prescribed scenarios.

There are three critical mistakes that most people make when preparing for retirement that really should be resolved beforehand. The first mistake is to assume that you will be in a lower tax bracket in your retirement years. This has been pushed by more than a few financial gurus online that tell people to get a deduction during their working years by putting money in 401(k)’s and IRA’s. This is likely a miscalculation on the part of many people getting ready for retirement. The country is $22 trillion in debt with $1 trillion deficits every year, plus 10,000 Baby Boomers retiring every day. In 2026, Medicare goes broke. In 2032, Social Security goes broke. The question is, how do we account for the massive gaps in these programs? To suggest that we will be in lower tax brackets ten years from now is to be completely ignorant of the math involved. Some experts have even claimed that we will just print and inflate our way out of the problem. The trouble is these programs are pegged to inflation. We can’t borrow or print our way out, we aren’t going to reduce expenses, so the only likely solution at this point is raising taxes. The first mistake is listening to the wisdom of yesterday without considering that times have changed, but if we look at the fiscal landscape of the country, it’s hard to arrive at any other conclusion. The second huge mistake is having IRA and 401(k) balances that are so big in retirement that required minimum distributions cause your Social Security to be taxed. Most people don’t realize the impact of Social Security taxation. If you have more than $44,000 in provisional income as a married couple, then up to 85% of your Social Security can become taxable at your highest marginal tax rate. Most people start taking more money out of the retirement accounts to make up for the shortfall which can have serious long term impacts. People who have their Social Security taxed will, on average, run out of money 5 to 7 years faster than people who don’t get taxed. The way you avoid this is by shifting your money to tax free accounts and pay the tax now before you retire. The third mistake is not taking advantage of Roth IRA’s and Roth 401(k)’s while you still can. Every year that goes by that you fail to take advantage of these accounts is an opportunity you will never get back. There are opportunity costs associated with not contributing money to these kinds of accounts. If you have a lot of money sitting in your taxable bucket, there are only so many ways to get the money out of there, like paying taxes on Roth conversions or a life insurance retirement plan. Roth IRA’s have great liquidity, so every year that goes by that you don’t fund these accounts is a mistake. The cost of admission to a tax-free account is paying a tax, and taxes are currently in a period where they are historically low. You can’t go back in time and recuperate the lost years where you didn’t contribute to your tax-free accounts. More people should have a balance between their buckets, also known as income tax diversification. By being aware of the three mistakes, you will be less likely of needing to make massive expensive shifts to be tax free later in life.

Harlon Accola is the National Reverse Mortgage Director for Fairway Independent Mortgage Corporation, and reverse mortgages are all he’s done for the last sixteen years. More recently he’s been training other professionals in how reverse mortgages mesh with overall financial planning. It is true that if you do a reverse mortgage you will lose equity, but it’s not about losing equity, it’s about spending equity. A reverse mortgage is simply a way to get your money back out in a tax free way that you can use to fund your retirement. You lose equity but you will gain cash. You won’t have to pull that money out of somewhere else, which will allow your investments to continue growing. Everything is expensive if we don’t understand the value. Reverse mortgages are more expensive than most other mortgages, but that’s because of the protection you get from the mortgage insurance. Everything costs something, no matter where you take out the money you will pay to access it. The question is “does the value justify the cost?” A reverse mortgage can actually be better for inheritors than other options. If someone gets a reverse mortgage at 62 instead of waiting, they will have more cash flow during their lifetime, they will pay less taxes, they will have a higher net worth, and a bigger legacy to pass on to their children. What decreases the inheritance to children is long life and spending down assets, not reverse mortgages. By putting that money into a more effective investment, your children will end up better off. The alternative to living off your home equity during retirement is spending down all your other assets. By using your equity, it gives your investments more time to grow at higher interest rates. There are a number of new rules that have been put in place to make sure that people don’t end up on the street after taking out a reverse mortgage. The only way to lose your house with a reverse mortgage is if you don’t pay the taxes or stop living in it. Most fears around reverse mortgages are unfounded. Banks don’t want your house. If you die early, your heirs get whatever equity is left. The bank doesn’t become the owner of the home. If the reverse mortgage goes upside down by the time you die, your heirs won’t owe any extra money. If it doesn’t go upside, your heirs get the difference. Reverse mortgages are truly tax free, because borrowed money is not taxable. Because you are not selling your house you will not pay tax. Reverse mortgages can not cause a taxation issue, it can only be a tax deduction. A reverse mortgage is a source of money that isn’t taxable so it makes Roth conversions much easier to calculate and more useful. The majority of Harlon’s clients are mainly affluent and use reverse mortgages to optimize their retirement investments and decrease their taxes. Many investment advisors say that you can’t use a reverse mortgage to fund an investment product, but that’s not what’s happening here. It’s about using cash flow properly to replace money that is otherwise going to come out of higher cost and taxable accounts. There is $7.1 trillion sitting in people’s houses. If by working with advisors, we can create liquidity. We can change the way retirement is done in this country. Everyone is skeptical about reverse mortgages at first, but you should run the numbers to see if your skepticism is valid.

Today, we continue last week’s discussion of 15 Things You Should Know about the Roth IRA, with Part 2. You can not take a required minimum distribution from an IRA and turn it into a conversion, you have to deposit it somewhere else. The ideal scenario is to preemptively convert all your IRA’s to Roth IRA’s before you would want to. Roth conversions have to be done before December 31 but that makes it a real challenge to know what your modified adjusted gross income will be for the year by that time of the year. With traditional Roth IRA’s, you have the ability to make up your mind in terms of contributions until April 15th of the following year. You can’t recharacterize your Roth IRA anymore. You now have to work with the hand the market deals you in any given year. Roth IRA’s don’t have any required minimum distributions during your lifetime and if you die that still applies, but if you die and the account goes to a non-spouse beneficiary they do have to take distributions. This may change when the SECURE Retirement Act gets signed into law at some point in 2019. Roth IRA’s have a 5 year rule. Whatever money you contribute to your Roth IRA, you can take out and return as long as you put it back in within 60 days. The 5-year rule says that you cannot touch the growth on your account until 5 years have passed or you are 59½ years old. Roth conversions also have a 5 year rule. If you convert $100,000, you can’t touch that money for a minimum of 5 years without suffering a penalty. Technically this rule is also a way to take money out your account penalty free if you are younger than 59½ years old as long as you wait 5 years. The rule no longer applies once you are over the age of 59½ years old.