The Power of Zero, Revised and Updated

by David McKnight

  Any contributions that are currently earmarked for the first two buckets need to be reevaluated according to the guidelines discussed in the previous chapters. For example, if you already have six months’ worth of income in your taxable bucket yet you’re still making contributions on a monthly basis, you should redirect those dollars to the tax-free bucket. Likewise, if you’re making contributions to your 401(k) above and beyond the match, these surplus dollars should be diverted to the tax-free bucket. Roth IRAs and LIRPs can be useful investment tools for doing so.

  Remember, if your goal is to be in the 0% tax bracket in retirement, it’s critical that you have the ideal amount of assets in each of the three buckets. If you contribute to any of these buckets in a haphazard way, you might unwittingly disqualify yourself from being in the 0% tax bracket. As a result, you expose yourself to tax-rate risk which could ruin your dreams of a tax-friendly retirement. Again, a tax-free retirement specialist can help you analyze your first two buckets and make recommendations for shifting assets to your tax-free bucket.

  *1 “Final Report—November 1, 2005,” TaxReformPanel.gov, November 6, 2005, http://govinfo.library.unt.edu/​taxreformpanel/​final-report/​index.html.

  *2 Medicaid is a federally funded program that is administered on the state level. As such, each state has different rules governing Medicaid eligibility, Community Spouse Resource Allowances (CSRE), “countable asset” exemptions, etc.

  *3 This exemption from spend down for the community spouse’s qualified plans varies from state to state. Check the applicable laws in your state for further guidance.

  *4 The MMMNA varies from state to state.

  *5 David Pitt, “Shining a Light on 401(k) Fee Reports in 2012,” USA Today: Money, http://usatoday30.usatoday.com/​money/​perfi/​retirement/​story/​2011-12-30/​401-k-disclosures-to-increase/​52294254/​1.

  *6 David McKnight, “Equity Indexed Universal Life—The Rest of the Story,” Signature Financial Group, January 5, 2012, http://www.signatureadvise.com/​2012/​01/​05/​equity-indexed-universal-life.

  SIX

  THE TAX SALE OF A LIFETIME

  When The Power of Zero was first published in 2014, the national debt was $15 trillion and climbing. Baby boomers were marching out of the workforce and onto the rolls of Social Security and Medicare at the alarming rate of nearly 10,000 per day. At the time, nationally renowned economists were sounding the warning cry about the crippling and unsustainable costs of these so-called entitlement programs. Simply put, our government had promised way more than it could afford to deliver. The solution at the time was both draconian and severe: We could either double taxes, reduce spending by half, or some combination of the two. Failing to act quickly would only compound the pain of the eventual fix.

  Now, four years later, even as our national debt has ballooned to $21 trillion and the evidence for higher future tax rates continues to mount, Americans still have a hard time paying their taxes before the IRS absolutely requires it of them. Why? Because there’s still a small part of us that says maybe, just maybe, our taxes will be lower in retirement. Maybe the math to which David Walker referred doesn’t really add up after all. And if that’s the case, why pay taxes at full price if a tax sale might just be lurking around the corner? I mean, come on, could tax rates in the future really be higher than they are today?

  This question got answered with a resounding “Yes!” when Congress passed the Tax Cut and Jobs Act of 2017. With a stroke of the pen, our federal government inaugurated an eight-year period starting January 1, 2018, during which you will experience the lowest tax rates you’re likely to see in your lifetime. Because of the sunset clause that was built into this legislation, the tax sale ends on January 1, 2026. As soon as the clock strikes midnight, taxes will revert to their pre-2018 levels. All Congress has to do in order for your taxes to go up eight years from now is, well…nothing.

  You now have math and certainty in your corner when it comes to making a critical tax payment decision that may well determine how long your money lasts in retirement. We went from an era where we knew that in some vague and distant future taxes were likely to go up, to an era where we now know the exact year and the day when taxes will go up. Remember the story of twin brothers Gary and Doug from Chapter 4? If your tax rate in 2026 or beyond is even 1% higher than it is today, then continuing to grow and compound your retirement dollars in 401(k)s and IRAs will curtail the life of your retirement assets.

  Just How Good Is This Sale?

  To understand how good the new tax rates are for those contemplating an asset shift, we have to first understand how our country’s tax system works. To facilitate this, I want you to think back to your chemistry class in high school. Remember that long, skinny cylinder with the red lines on it? No, not a test tube or a beaker. I’m thinking of a graduated cylinder—the instrument that you used when measuring liquids.

  Our country’s tax system works much like that graduated cylinder. Prior to 2018, your taxable income (including any asset shifts) would have poured into that graduated cylinder and flown all the way down to the bottom, where some of it would have been taxed at 10%, some at 15%, some at 25%, some at 28%, some at 33%, some at 35%, and some at 39.6%. Some people don’t realize that in 2017, even Bill Gates would have had some of his earned income taxed at only 10%. (If only for about three seconds, right?) That’s how our progressive tax system works. Eventually, Gates’s graduated cylinder would have filled all the way up, and the vast majority of his earned income would have been taxed at 39.6%. But his income from the lower tax brackets would have been unaffected by the higher rate.

  The graphic that follows shows the 2017 tax brackets and income thresholds for single filers and married couples filing jointly:

  But when the new tax cuts went into effect on January 1, 2018, this tax cylinder got an impressive makeover. Today your taxable income flows into a new graduated cylinder, where some of it gets taxed at 10%, some at 12%, some at 22%, some at 24%, some at 32%, some at 35%, and some at 37%. The cost of getting to the 0% tax bracket just got a whole lot cheaper! See the svelte new look of our country’s tax cylinder in the graphic that follows:

  Much of the media attention surrounding these new tax cuts has focused on taxpayers who are in the 10% to 12% marginal tax brackets. How much taxes would they be saving? Are the savings meaningful? How many loaves of bread can they buy with those savings? Was this tax cut really a good deal for Main Street America?

  As important as these discussions are for politicians and pundits, they aren’t as relevant to those angling for the 0% tax bracket in retirement. Here’s why: To get to the 0% tax bracket, you will need to reposition some or all of your tax-deferred assets to the tax-free bucket. No way around it. As you move assets from your tax-deferred bucket to your tax-free bucket, they will show up on your tax return as taxable income in the year you make the shift. And because that new income gets piled on top of all your other income, it gets taxed at your marginal tax bracket, and that’s usually higher than 10% or 12%. In fact, most people who will adopt the Power of Zero strategy under the new tax law will already be in the 22% or 24% tax brackets before they shift dollar one. So, the real question is, just how good are the midrange tax brackets in our shiny new tax cylinder?

  This is where things get really exciting. Prior to 2018, a typical asset shifting strategy might have landed you squarely in the 25% or the 28% tax bracket (which covered taxable income ranging from $75,900 to $233,350). The prospect of paying taxes at those rates was a nonstarter for many Americans, especially if they weren’t convinced tax rates would go up anytime soon. (I’ll give you an example in the next section to demonstrate why.) No one wanted to pay a tax before the IRS absolutely required it of them, especially at those high rates.

  During the next eight years, most asset shifters will end up paying taxes at the 22% and 24% brackets. Now you may be thinking, Wait a se
cond, 24% is only 4% better than 28%. Some tax cut! Where’s the sale? But here’s the important thing to remember when it comes to tax brackets: It’s not always the number attached to the tax bracket (in this case, 24%) that matters, so much as the income thresholds that define it.

  Here’s what I mean: In 2017, the 28% tax bracket went from $153,100 all the way up to $233,350. Today, the current 24% bracket doesn’t start until $165,000, and it goes all the way up to $315,000! Had you tried to shift up to $315,000 of taxable income in 2017, that would have landed you in the 33% tax bracket. Now, that’s what I call a tax sale!

  Are you beginning to see the unprecedented asset shifting opportunities we have on our hands here? Given how much wealth can now be shifted within that 24% bracket, you may want to evaluate the benefits of maxing it out every year between now and 2026. Again, once the sale is over, that 24% bracket (along with its stratospheric $315,000 income threshold) will be gone forever.

  Don’t Take My Word for It—Let’s Look at the Math!

  As we’ve stated throughout this book, math should be the justification behind your shifting strategy, not emotion or conventional wisdom. Consider the hypothetical case of Jack and Heather Clark, who in 2017 adopted an asset shifting strategy that pushed them to the top of the 28% tax bracket ($233,350 of taxable income). Under the 2017 tax law, they would have paid some tax at 10%, some at 15%, some at 25%, and some at 28% for a total tax bill of $52,223. That’s an effective (average) federal tax rate of 21.2%.

  Under the 2018 tax plan, they would have paid some tax at 10%, some at 12%, some at 22%, and some at 24% for a total tax bill of $44,583. That’s an effective federal tax rate of only 19.1%. While a 2.1% difference in effective tax rate doesn’t seem life-altering, the truth is that the new tax law would have saved them $7,640 in taxes! (Of course, this assumes that in 2018, the Clarks only shifted to the top of the 28% tax bracket from 2017: $233,350.) Given how generous and expansive the new 24% tax bracket is, it could make sense for the Clarks to max out this bracket by shifting up to $315,000 of taxable income. Were they to do so, they would save $14,987 over an identical shift in 2017! What’s better, all those tax savings continue to grow and compound inside their tax-free bucket, potentially adding years to the life of their retirement assets.

  At the end of the day, the cost of admission to the tax-free bucket is this: you have to be willing to pay a tax. But you’ll have to pay a tax no matter what you do. The decision boils down to this: You can pay those taxes now on your terms and at historically low tax rates, or you can pay them on the IRS’s terms at some unknown point (and tax rate) in the future. Between now and 2026, you have an unprecedented window of opportunity for paying historically low taxes. In fact, each year between now and then represents a little window of opportunity, a little graduated cylinder of its own, in which you can pay lower taxes on your asset shifts. And every year that goes by where you fail to take advantage of these little tax windows is potentially a year beyond 2026 where you could be forced to pay taxes at the highest rates you’ll see in your lifetime. When you’re on the tax clock, every year matters!

  The Sweet Spot of the New Tax Code

  I think it’s obvious by now that my very favorite tax bracket is 0%. Remember, if tax rates double, two times zero is still zero! But if I were to ask you to guess my second favorite tax bracket, what would you say? 10%? A perfectly reasonable answer. If your individual circumstances prevent you from getting to the 0% tax bracket (see Chapter 8), then 10% is not a bad place to be, right? While this might make sense on the surface, the answer is not 10%.

  Let me reveal the answer by coming at the question from a different angle. If I were to persuade you to shift money from tax-deferred to tax-free and, in the process, you bumped up from the 12% to the 22% tax bracket, how would you feel about my recommendation? Not very good! After all, in the name of tax efficiency, I nearly doubled your marginal tax bracket! My goal is to insulate you from the impact of rising taxes over time without doubling your tax rate in the process!

  Now, let’s assume you were already in the 22% tax bracket (as many Americans are), and your asset shifting strategy bumped you into the 24% bracket. How would you feel now? Not too bad, I would venture to say. After all, for a measly 2% increase in your marginal tax rate you could shift an additional $150,000 to your tax-free bucket. And so long as you don’t exceed $315,000 of taxable income, you’ll remain safely ensconced in that 24% tax bracket. We’re not doubling your tax rate in an effort to get you to the 0% tax bracket. We’re just increasing your tax rate ever so slightly, on the margin. Is an extra 2% on the margin something you could live with? The answer for most folks is a resounding “Yes!” Can you see why the 24% tax bracket is my second favorite? It’s the unheralded sweet spot in the new tax code. It’s the shining star in this new lineup of rock-bottom tax rates.

  For the next eight years, the 24% tax bracket may well play a starring role in your asset shifting strategy. If you utilize it proactively between now and 2026, it could be the catalyst by which hundreds of thousands of your retirement dollars get safely and efficiently transferred to the tax-free bucket. If you want to take advantage of this eight-year tax sale, evaluate the role the 24% tax bracket could play in helping move your tax-deferred assets off the train tracks and into the safe confines of the tax-free bucket.

  Your Magic Number

  Remember, your highly taxable IRAs and 401(k)s are sitting on the train tracks bracing for the impact of that tax freight train. We know there’s a train coming, we know in what form it will arrive (higher taxes), and we know precisely when it’s going to get here (January 1, 2026). That said, you don’t want to shift your assets off the train tracks in a willy-nilly or haphazard way. Now is not the time to panic! Asset shifting requires a steady hand and a sound mathematical approach. So, allow me to offer a rule of thumb when it comes to shifting those dollars off the tracks: Shift your money into the tax-free bucket slowly enough that you don’t rise too rapidly in your tax cylinder, but quickly enough that you get all the heavy lifting done before tax rates go up for good. In other words, there is a perfect mathematical amount to shift every year between now and 2026. That’s what I refer to as your “magic number.”

  Prior to the new tax legislation, I always recommended stretching that shift over 10 years’ time. After all, that was the hazy deadline at which the experts predicted tax rates were likely to increase. But your tax deadline is no longer a vague, amorphous bogeyman at some distant unknowable point in the future. It’s clearly defined, it’s fast approaching, and it will hit you with all the subtlety of a massive freight train. For that reason, this year is always the best time to begin moving your assets off the train tracks. If you wait until next year, you’ll have one less year to get all that shifting done. And the fewer years you give yourself, the greater the likelihood you’ll bump up into a tax bracket that gives you a bad case of heartburn!

  In short, you need to discover your magic number and act on it quickly, before your window of opportunity grows too narrow. A qualified tax-free planning specialist can help you determine the magic number required to get you to the 0% tax bracket before tax rates go up for good. To assist you in determining your magic number, I’ve also created a special “Magic Number Calculator,” which can be found at davidmcknight.com along with a number of other Power of Zero resources.

  A Final Call to Action

  The prescription for what ails our country is more revenue, less spending, or some combination of the two. With this new tax cut, however, the federal government gave us just the opposite. They gave us the dessert before the spinach. They reduced taxes over the next eight years and will borrow an extra $1.5 trillion through 2028 to pay for it. This means that the eventual fix for our economic woes will be even more painful and more dramatic than it might have been prior to the new tax cuts.

  Tax rates are slated to return to their pre-2018 levels
in 2026, but the reality is this: they’re likely to go even higher as we approach 2030 and beyond. All this tax legislation did was kick the can eight years further down the road. So, don’t let lower taxes in the short term distract you from the broader financial crisis. Taxes will go back up in eight years, but the freight train looming beyond the 2026 deadline just picked up a little more speed. You now have even more urgency to establish a solid, math-based asset shifting program today. Because when taxes are on sale, every year counts. And as of January 1, 2018, you’re on the clock!

  SEVEN

  PUTTING IT ALL TOGETHER

  A CASE STUDY

  So far, we have presented mounting evidence that points toward the need for higher taxes in the near future. We have also suggested that the best way to insulate yourself from the impact of these rising tax rates is to put yourself in the 0% tax bracket. Remember—if tax rates double, two times zero is still zero! We’ve also identified the pros and cons of the three basic types of investment accounts and the ideal amount of assets to have in each.