The Power of Zero, Revised and Updated

by David McKnight

  The problem is, Social Security went from being insurance against living too long to an expensive retirement program that Americans rely upon for nearly a quarter of their lives! As of 2017, the Social Security program costs the government over $945 billion per year, or about 23% of the federal budget.*2 And the consequences for the United States couldn’t be more devastating.

  “A promise made is a debt unpaid.”

  —ROBERT A. SERVICE

  The math behind the Social Security problem is emblematic of a much broader crisis facing our nation. Over the years, our elected officials have increasingly made promises, like Social Security benefits, without any thought for how they were going to pay for them. David Walker calls these promises “unfunded obligations.” The greatest of these unfunded obligations is the universal healthcare system for seniors implemented as part of Lyndon Johnson’s “Great Society” domestic programs of the 1960s. Medicare suffers from the same demographic challenges as Social Security. As of 2017, it costs the government over $590 billion per year, and these costs continue to spiral out of control. According to Walker, the fiscal strain of these two programs alone could bankrupt the United States of America.

  According to the Medicare Trustees Report for 2017, Medicare is running a deficit and has started to dip into the trust fund accumulated over previous years. The graph above displays the Federal Hospital Insurance Trust Fund balance at the beginning of each year as a percentage of annual expenditures on the Y‑axis, and time in years (both historical and future) on the X‑axis. These projections indicate that the trust fund will be depleted by 2030.

  Source: Medicare Trustees Report, 2017

  A closer look at the numbers explains why David Walker has become so alarmed. To quantify the actual cost of these unfunded liabilities, the government employs its own unique (and creative) accounting method. Instead of telling us the actual cost of a program, they express the cost as the present value of a future obligation. For example, the government tells us that the cost of Social Security and Medicare is $42 trillion. What this really means is that we would have to have $42 trillion sitting in an account today, earning Treasury rates, to be able to afford these programs. But the government doesn’t actually have $42 trillion today, and if you look beyond 75 years, the real cost is much greater. All told, some experts put the actual cost over time at much closer to $120 trillion.

  Present Value: To better understand this concept, let’s look at the following example. Suppose you believe that your car will need to be replaced in 10 years. You estimate that in 10 years a new car will cost you $20,000. So you ask yourself what amount of money would have to be invested today at a reasonable rate of growth (say, 5%) to be able to have $20,000 10 years from now. A quick calculation shows that $12,892 growing at 5% over that time period will give you $20,000 in 10 years’ time. In other words, the present value of the future cost of your car is only $12,892!

  Let’s look at the math behind our country’s fiscal problems from a different angle. The United States currently spends roughly 76 cents of every tax dollar it brings in on four items: Social Security, Medicare, Medicaid, and interest on the National Debt.*3 Absent any action on the part of Congress, however, the percentage of the government’s revenue required to pay for these four big-ticket items could balloon to 92 cents of every tax dollar by the year 2020.*4 As these four expenses grow and compound, they begin to crowd out all other government expenditures.

  Source: Center on Budget and Policy Priorities

  Here are just some of the programs the government would have to pay for with the remaining 8 cents: Child Nutrition Programs, Homeland Security, Food Safety and Inspection Service, U.S. Forest Service, Drug Enforcement Administration, Public Housing Program, Animal and Plant Health Inspection Service, Bureau of Indian Affairs, Army, National Endowment for the Arts, Air Force, Rural Development, Coast Guard, Supplemental Nutrition Assistance Program (aka food stamps), National Park Service, Department of Family Services, U.S. Geological Survey, Environmental Protection Agency, Centers for Disease Control and Prevention, Immigration and Customs Enforcement, Secret Service, Supportive Housing for the Elderly Program, Federal Railroad Administration, Navy, Bureau of Land Management, Peace Corps, State Department, National Science Foundation, Congress, Fish and Wildlife Service, White House, Smithsonian Institution, Small Business Administration, Federal Highway Administration, disaster relief, federal courts, federal student loans, federal pensions, income assistance, IRS, NASA, FEMA, FAA, FCC, SEC, FBI…

  And the list goes on. Can you see why David Walker and a growing contingent of economists are so concerned?

  But Surely Taxes Could Never Double!

  The mathematical reality is that, absent any spending cuts, tax rates would have to double. Come on, let’s get serious, you must be saying to yourself. Could tax rates really double?

  A study of the history of taxes in the United States lends a bit of perspective. Over the last 100 years, tax rates in our country have been nothing short of a roller-coaster ride. When the government first began dipping its toe in the waters of income taxation back in 1913, it seemed harmless enough. In fact, the very first federal income tax rate was only 1%. But soon the thrill of income taxation became so addicting that the government got hooked.

  By the time 1943 rolled around, the highest marginal tax bracket in our country had skyrocketed to 94%. These exorbitant rates were levied on any portion of your income that exceeded $200,000.

  But did anyone really make that type of money back then? Actually, there was one person with whom you may be familiar. He was an actor who later became a politician. His name was Ronald Reagan. If you look at Reagan’s filmography, you’ll find that he never made more than two full-length movies in a year. You see, he made about $100,000 per movie, and, for anything he made above and beyond $200,000, he only kept 6 cents on the dollar. Truth be told, he didn’t even get to keep that—it went off to the State of California for state tax. So, if you study the life of Reagan, you’ll find that he never worked more than six months out of the year. Mathematically, it just didn’t make sense.

  By the ’70s, things had improved, but not by much. Americans were still paying an astounding 70% on anything they made above and beyond $200,000.

  Fast-forward to today. The top marginal rate at which the wealthiest Americans pay taxes is a mere 37%. How does 37% stack up against some of the tax rates in the past? You could make the case that taxes haven’t been this low in nearly 80 years! This is interesting because I routinely ask rooms full of people across the country, “How bad are taxes today?” And you know what they tell me? “As bad as they’ve ever been!” Truth is, taxes today are just about as good as they’ve ever been! The real question is, how long can these low rates last?

  According to the Congressional Budget Office, if Social Security, Medicare, and Medicaid go unchanged, the government could be forced to adopt a three-bracket system in which some of your income gets taxed at 25%, some at 63%, and some at an astounding 88%!*5

  For you skeptics out there, let me take you back in time. From 1960 to 1963, the lowest marginal tax rate was 20%, the middle bracket was 69%, and the highest marginal tax rate was an astounding 91%!*6 Folks, this is a path we’ve been down before. What’s that old adage? Those who don’t study history are destined to repeat it?

  A few years ago I was watching the Road Runner with my kids. In this particular episode, Wile E. Coyote was up to his usual tactics in trying to subdue the Road Runner. He was building a bomb—made by Acme, of course—inside a shed also made by Acme. The Coyote was so intent upon completing the bomb that he didn’t realize that the Road Runner had pushed his shed onto a train track. What’s worse, he didn’t realize until the very last moment that a huge freight train was bearing down on him.

  Now, if you found yourself on a track with a huge train bearing dow
n on you, what would you do? You’d jump off, right? Well, when the Coyote saw the huge freight train approaching, he didn’t jump out of the way. He simply pulled down the window shade, thinking that the act of doing so would make the problem go away. Did the problem go away? Of course not. There was a huge explosion and, let’s face it…does the Coyote ever die? No, but as the smoke cleared, we could see the Coyote limping away from the wreckage, very much the worse for wear.

  What possible application could a Road Runner episode have to my financial life? you must surely be thinking. Well, as Americans who have grown accustomed to investing in tax-deferred accounts such as 401(k)s and IRAs, we find ourselves standing on the tracks with a very real train bearing down on us, and it’s coming in the form of higher taxes. Now, given this reality, we have a couple of options. We can pretend like the problem doesn’t exist and simply pull down the window shade. Or, we can implement some proven strategies that can help remove us from the train tracks.

  The purpose of this book is to share with you the proven strategies that will help you get off the train tracks and insulate your money from the impact of higher taxes down the road. Which brings me to the title of this book: The Power of Zero. You see, the only real way to protect yourself from the impact of rising taxes is to adopt a strategy that puts you in the 0% tax bracket in retirement. Why is the 0% tax bracket so powerful? Because of that same four-letter word: math. If you’re in the 0% tax bracket and tax rates double, two times zero is still zero! By implementing these concepts before tax rates rise, you can effectively remove yourself from the train tracks and protect your hard-earned retirement savings from the gathering storm that’s looming on our country’s horizon.

  *1 “Social Security Online—HISTORY,” Social Security Administration, http://www.ssa.gov/​history/​ratios.html.

  *2 Fiscal year 2017 budget of the U.S. Government, Office of Management and Budget.

  *3 “Policy Basics: Where Do Our Federal Tax Dollars Go?” Center on Budget and Policy Priorities, last modified October 4, 2017, www.cbpp.org/​research/​federal-budget/​policy-basics-where-do-our-federal-tax-dollars-go.

  *4 Jeanne Sahadi, “Running the government on 8¢,” CNNMoney, January 21, 2011, http://money.cnn.com/​2011/​01/​21/​news/​economy/​spending_taxes_debt/​index.htm.

  *5 “Long Term Economic Effects of Some Alternative Budget Policies,” Congressional Budget Office, May 19, 2008, 8–9.

  *6 “Tax Foundation,” U.S. Federal Income Tax Rates, http://taxfoundation.org/​article/​us-federal-individual-income-tax-rates-history-1913-2013-nominal-and-inflation-adjusted-brackets.

  TWO

  THE TAXABLE BUCKET

  Getting to the 0% tax bracket is not something that happens by accident. Enjoying a retirement free from taxation takes proactive and strategic planning, and it must begin today. The longer you wait to get off the train tracks, the less time you have to haul yourself to safety. And let’s face it, taxes are not likely to stay at historical lows forever.

  Critical to your journey toward the 0% tax bracket is an understanding of the three basic types of investment accounts. For our purposes, we’re going to refer to these three accounts as buckets of money. The three buckets are taxable, tax-deferred, and tax-free. Contributing dollars to these accounts in a willy-nilly or haphazard way during your accumulation years can have enormous unintended consequences during your retirement years and can even prevent you from ever being in the 0% tax bracket. The goal during your working years should be to allocate the right amount of dollars to each bucket so that during retirement all your streams of income are tax-free. Defining the pros and cons of each bucket can help you understand the correct amounts to allocate to each one. This chapter will focus on the taxable bucket.

  A taxable investment is one that requires you to pay taxes on the account’s growth each and every year. Included in this bucket are common, everyday investments like money markets, CDs, stocks, bonds, and mutual funds.

  How can you tell if your investment is taxable? The tip-off is the love letter you get from the financial institution at the end of every year. It’s called a 1099. Simply put, it’s a tax bill. It tells the IRS how much taxable income you earned from a given investment.

  Consider the following example: If you have $100,000 in a CD and it grows 2%, you have a taxable event. You will have $102,000 in your account at the end of the year, but you will have to pay federal and state tax on every last bit of that 2% growth. So, $2,000 gets thrown right on top of all your other income and is taxed at your highest marginal tax rate. Assuming marginal tax rates of 30% (24% federal, 6% state), you would owe the IRS $600. So you didn’t really experience $2,000 of growth, you only experienced $1,400. Thus, your after-tax rate of return on that $100,000 is only 1.4%. This annual taxation is one of the perils of the taxable bucket.

  Taxable Bucket: The Ideal Balance

  All this unfettered taxation, of course, raises the question, “If these investments are 100% taxable, why have them at all?” The answer is liquidity. Generally speaking, it’s easy to get your hands on these investments, which means that they make for great emergency funds. Financial experts generally agree that we should have roughly six months’ worth of income in these accounts as a buffer against life’s unexpected emergencies. Having too little means that we can be forced to withdraw money from illiquid investments, incurring unwanted taxes or penalties. Having too much, on the other hand, means that we can be disproportionately affected by the rise of taxes over time. From a tax-efficiency perspective, therefore, investments in this bucket should be just the right amount: about six months’ worth of income.

  For example, let’s say that a couple needs $4,000 per month to keep their family afloat. To determine the ideal balance in their taxable bucket, we simply take this amount and multiply it by six months. So, the most they would want to maintain in this bucket at any given time is about $24,000.

  The Double Compounding Effect

  Another reason to limit investment in this bucket is what I call the “double compounding effect.” As your balance in the taxable bucket grows, your 1099 (or tax bill) grows as well. To make matters worse, as tax rates rise, the amount of taxes you owe on that ever-increasing 1099 likewise increases. So, in a rising-tax-rate environment, your tax bill can increase at alarming rates!

  Consider this example: Let’s say that you make a contribution of $100,000 to a taxable investment that earns 5% per year. Because this investment is taxable, you would pay tax at your marginal rate, both state and federal. In this example, we’ll use 24% federal and 6% state for a total of 30%. By the end of the first year, your pre-tax investment return is $5,000. But, when we figure in taxes at the 30% rate, your true after-tax return is only $3,500. In the chart below, we continue down this road for 10 years, raising taxes by 1% with each passing year. By the 10th year, you can see the true impact of this double compounding effect: a 74% increase in your tax bill!

  The above chart illustrates the “double compounding effect.” It shows the hazards of growing and compounding an investment in a taxable environment while taxing it at ever-­increasing rates.

  Social Security Taxation

  To further complicate matters, when you don’t limit your investment in the taxable bucket, it can have unintended consequences for your Social Security benefits. In 1983, President Ronald Reagan and House Speaker Tip O’Neill helped pass a law that would tax Social Security benefits in order to ensure the long-term viability of the program.* Under this legislation, the IRS created income limits, or “thresholds,” that determine whether or not your Social Security benefits will be taxed. The types of income that contribute to these thresholds are collectively referred to as provisional income. Any growth which you experience in your taxable bucket counts toward these thresholds and could potentially cause your Social Security benefits to be taxed. I will talk more about the danger
s of Social Security taxation in Chapter 3.

  Here’s a real-life example of what can happen when you have too much money in your taxable bucket. A few years ago, an elderly couple walked into my office. When they began to describe their investments to me, one little detail knocked me clean out of my chair. They had nine CDs for $100,000 each in nine different banks. That’s $900,000 in their taxable bucket! Their chief concern was their ever-increasing tax bill. I explained to them that, from a tax-efficiency perspective, they had far too much money in their taxable bucket. This huge surplus was creating unintended consequences of which they weren’t even aware!

  Source: http://inflationdata.com/​inflation/​Inflation_rate/​HistoricalInflation​.aspx

  These two graphs demonstrate why investing in CDs is commonly described as the modern-day version of stashing money under the mattress. Your money may be safe and liquid, but if those funds remain invested for any substantial period of time, they are guaranteed to see a reduction in buying power due to inflation.

  Source: www.bankrate.com/​banking/​cds/​historical-cd-interest-rates-1984-2016

  First, by having substantially more than six months’ worth of income in their taxable bucket, they were exposing an unusually high percentage of their net worth to taxes. This stymied the growth of their assets and exposed them to tax-rate risk—the risk that taxes in the future could be much higher than they are today.

  Second, by investing in a low interest–bearing vehicle, they were exposing a large portion of their assets to the eroding effects of inflation. Because their CD returns were lower than the rate of inflation, they were guaranteed to lose spending power with each passing year. Sure, some of that money is protected by the FDIC. But, if it’s not keeping up with inflation, isn’t that just going broke safely?