The Power of Zero, Revised and Updated

by David McKnight

  Tax-Free Stream #1: Roth IRAs

  The first thing that I’d recommend is that Bob and Sue fully fund two Roth IRAs. In 2018, two 50-year-olds can contribute $6,500 per year for a total of $13,000. I love Roth IRAs because they meet both of the attributes required of a truly tax-free investment:

  No Taxation: Distributions from Roth IRAs are free from federal, state, and capital gains tax, so long as you’re 59½ or over.

  No Social Security Tax: Roth IRA distributions don’t count against income thresholds that cause Social Security benefits to be taxed.

  By contributing $13,000 to Roth IRAs, we’re left with $23,500 that needs to be shifted into the tax-free bucket on an annual basis. But what tax-free vehicle allows us to contribute $23,500 per year?

  Tax-Free Stream #2: The LIRP

  Remember, the LIRP is a tax-free vehicle that enjoys all of the tax-free qualities of the Roth IRA, without the traditional constraints. Let’s briefly summarize the attributes that make the LIRP an effective tax-free accumulation tool:

  Access to cash value prior to 59½ with no penalty

  Growth of money does not generate a 1099 tax bill

  Distributions are taken out tax-free regardless of age

  No contribution limits

  No income limitations

  No legislative risk (if history serves as a model)

  The attribute that is most relevant to our discussion at this point is #4: No contribution limits. Since we need to find a tax-free home for $23,500 on an annual basis, this attribute becomes essential to our strategy. Given the LIRP’s flexible contributions limits, we can now move all $23,500 into the tax-free bucket.

  As you’ll recall, the LIRP is not just a tax-free accumulation tool, it’s also a way to hedge against the risk of premature death. That explains the “Life Insurance” in “Life Insurance Retirement Plan.” The IRS allows you to contribute nearly unlimited amounts to the LIRP, as long as you’re willing to pay for the cost of term insurance out of these contributions. Imagine a bucket with a spigot attached to the side of it. You shift dollars into the bucket on an annual basis. In the meantime, the cost of term insurance drips out of that spigot.

  In our scenario, Bob and Sue have already budgeted $2,000 per year for the cost of term insurance. Instead of sending that $2,000 off to an insurance company in the form of a term insurance premium payment, why not contribute it to the LIRP, let a portion of it drip out of the spigot in the form of expenses, and then avail Bob and Sue of a huge bucket of tax-free dollars that wasn’t previously available to them?

  Depending upon the insurance company you decide to use, this death benefit can also double as long-term care insurance. Many companies that sponsor LIRPs say that in the event that you can’t perform two of six activities of daily living (such as eating, bathing, dressing, etc.), they will give you a portion of the death benefit while you’re alive for the purpose of paying for long-term care.*5 This feature allows us to give Bob and Sue long-term care coverage without the traditional costs of long-term care insurance.

  *Distributions from these accounts are taxable. We assume a rate of 30%.

  Because Bob and Sue both have the need for life insurance and long-term care coverage, they’ll each need their own separate LIRP. We must divide that $23,500 between their respective LIRPs so that they both have the appropriate level of life insurance and long-term care protection.

  Tax-Free Stream #3: A Tax-Free Traditional IRA

  That’s right, you read it correctly: Tax-Free Traditional IRA. Hold the phone, you must be thinking. Surely there’s no way to take money out of an IRA tax-free…at least not legally, right? If you’ll recall from our earlier discussions, Bob and Sue will likely be using their standard deduction in retirement. If they retired today, that would amount to $24,000. Because the IRS has historically adjusted this number to keep up with inflation (3% per year), this deduction will be more than $37,000 by the time they retire in 15 years at age 65.*6 Because of this, Bob and Sue will be able to take over $37,000 out of their IRAs without paying any taxes at all.

  Because we did the 72(t) on their IRAs, we bridled the growth of these accounts. If we did an exceptionally good job of keeping those accounts from growing, then they would still have $500,000 left in their IRAs at age 65. Bob and Sue could then take distributions out of their IRAs up to the level of their deductions ($37,000) without paying a dime in tax.

  Remember, had we allowed Bob and Sue to grow these IRAs in an unbridled way, they would have been worth somewhere north of $1.5 million by the time they retired. The RMDs on this amount alone would have overwhelmed their standard deduction, at which point they would show up on the IRS’s radar. It would then be impossible for them to be in the 0% tax bracket.

  By keeping Bob and Sue’s IRAs at $500,000, we keep their RMDs below their annual deductions. And, so long as we keep these RMDs below their annual deductions, we preserve the tax-free nature of these assets.

  Caveat: Now, just because Bob and Sue can take $37,000 out of their IRAs tax-free, doesn’t mean that they should. Remember, any distributions coming out of their IRAs will count as provisional income, increasing the likelihood that their Social Security will be taxed. The threshold at which up to 50% of their Social Security becomes taxable is $32,000. The threshold at which up to 85% of their Social Security gets taxed is $44,000. The IRS has not traditionally adjusted these thresholds to keep up with inflation (though my fingers are crossed that they will in the future). Unfortunately, half of Bob and Sue’s Social Security already counts against this threshold. If their combined Social Security is $30,000, then they’ve already eaten up $15,000 of that $32,000 amount. To avoid hitting that $32,000 threshold, the maximum they could take out of their IRAs that year is $16,999. At $31,999 of provisional income, Bob and Sue can still receive their Social Security 100% tax-free.

  $15,000 + $16,999 = $31,999

  Tax-Free Stream #4: Social Security

  Because Tax-Free Recommendations #1, #2, and #3 either do not count as provisional income or do not exceed the minimum IRS thresholds for provisional income, Bob and Sue’s Social Security benefits will not be taxed. Not having your Social Security benefits taxed is one of the single greatest things that could ever happen to your retirement. This fact alone can extend your retirement by five to seven years! Remember, if you do have to pay taxes on your Social Security benefits, you’ll have to take an additional contribution out of your IRA to compensate for it. If your Social Security benefits are tax-free, not only do you get more money but you extend the life of all your other assets!

  In Summary

  Once you know the ideal balance to have in the taxable and tax-deferred buckets, you can then reposition any surplus dollars into the tax-free bucket. In Bob and Sue’s case, we were able to create four streams of tax-free retirement income, none of which show up on the IRS’s radar and all of which contribute to their being in the 0% tax bracket.

  Roth IRAs: tax-free

  LIRPs: tax-free

  IRAs: tax-free

  Because the first three streams of income are tax-free and below provisional income thresholds, we can now count on a fourth stream of tax-free income:

  Social Security: tax-free (as long as IRA distributions are below $16,999)

  If Bob and Sue have four streams of tax-free income, what tax bracket does that put them in? You guessed it: the 0% tax bracket. So, is it possible to be in the 0% tax bracket in retirement? Not only is it possible, it’s crucial to the success of your retirement plan.

  Why do I make such a big deal about being in the 0% tax bracket? Because the next best alternative isn’t very attractive. Let’s say that Bob and Sue only implement half of my recommendations and end up missing the 0% tax bracket. What’s the next best ta
x bracket? It isn’t the 1%, 2%, or even 5% bracket. In 2018, the next best tax bracket is 10%. Throw in another 6% for state tax, and you’re looking at a best-case scenario of losing 16% of your tax-deferred bucket to taxes. And if what David Walker says comes true and taxes have to double just to keep our country solvent, then that 16% becomes 32%. All of a sudden, second place isn’t looking all that great.

  Diversifying Your Tax-Free Streams of Income

  Am I recommending that you put all your eggs in one basket? No, I’m advocating multiple streams of income, none of which show up on the IRS’s radar. One of the reasons that we do this is because, at any point, the IRS could legislate any one of your tax-free streams of income right out of existence. By having a combination of tax-free alternatives, you insulate yourself against legislative risk. A well-balanced approach to tax-free retirement planning can rely on as many as six or more different streams of tax-free income. Just as you diversify your investments, you should likewise diversify your tax-free streams of income.

  *1 “Retirement Plans FAQ Regarding Substantially Equal Periodic Payments,” IRS, March 5, 2013, http://www.irs.gov/​Retirement-Plans/​Retirement-Plans-FAQs-regarding-Substantially-Equal-Periodic-Payments.

  *2 John T. Adney, “New IRS Letter Ruling Provides Guidance on Substantially Equal Periodic Payments from Immediate Variable Annuities,” Davis & Harman LLP, September 2008, http://www.davis-harman.com/​pub.aspx?ID=VG5wclBRPT0=.

  *3 “Roth IRA Contribution Limits 2013,” Roth IRA Central, http://roth-ira-contribution-limits.com/​roth-ira-contribution-limits-2013.

  *4 “Massachusetts Long Term Care & Medicaid frequently asked questions answered by Attorney Stephanie Konarski,” Stephanie Konarski: Estate and Elder Law, http://www.massestateandelderlaw.com/faqs/#80.

  *5 “Long Term Care Insurance Activities of Daily Living Defined,” ExplainMyClaim.com, http://www.explainmyclaim.com/​adls.html.

  *6 This assumes that Congress extends the 2018 tax cuts in 2026.

  EIGHT

  PENSIONS AND THE 0% TAX BRACKET

  One of the most common questions I hear at the end of a workshop is, “What if I have a pension?” If you do have a pension, the first thing that I recommend is: “Don’t panic!” Although a pension is generally something you have little or no control over from a taxability standpoint, there is much you can change about the rest of your retirement assets through shifting.

  The first thing that you need to do is focus on the assets that can be moved into the tax-free bucket. The amount of your investable assets that needs to be repositioned to tax-free depends entirely upon the size of your pension.

  If Your Pension Is Less Than Your Standard Deduction

  If your household’s combined annual pensions during retirement are less than or equal to your standard deduction ($24,000 in 2018 dollars), then it’s still possible for you to be in the 0% tax bracket. Your pensions would be offset by these deductions and would therefore not be taxable. For example, if your pension at retirement is projected to be $10,000 per year and your standard deduction at that point is $37,000 ($24,000 adjusted for inflation over about 15 years), your pension would be tax-free.

  In this example, you would still have $27,000 of deductions remaining, which means that you should still have some money in your tax-deferred bucket. The ideal balance would generate an RMD at 70½ small enough to be offset by your remaining deductions ($27,000). At age 70½, your RMD is 3.65% of your IRA balances. So, $27,000 represents 3.65% of what number?

  In order to arrive at this ideal balance, you would likely have to start shifting some of those tax-deferred dollars into the tax-free bucket today, using either a 72(t) or Roth conversion. By postponing this shift until retirement, you risk tax rates being much higher than they are today. Additionally, you would disqualify yourself from being in the 0% tax bracket during the retirement years when that shifting is taking place. You may also find that you have to shift much larger amounts of money because your assets by that time will have grown and compounded. Further, when you shift assets during retirement, the additional provisional income causes your Social Security to be taxed.

  My only caveat is that when you have a pension, it may not always be possible to get your Social Security tax-free. If you are married and your pension in retirement is $20,000 per year and one-half of your Social Security is $15,000, then your total provisional income is $35,000. That’s greater than the $32,000 threshold, at which point up to 50% of your Social Security gets taxed at your highest marginal tax bracket. Just remember, we worry about the things that we can control, not the things that we can’t!

  If Your Pension Is Greater Than Your Standard Deduction

  If the combined annual pensions in your household are greater than the standard deduction ($24,000 in 2018 dollars), then we know that it’s mathematically impossible to be in the 0% tax bracket. Your deductions will be consumed by your pension and any additional income will, by definition, be taxable. There’s just no way around it. That’s one of the inherent risks of having a pension in retirement. If you do have a pension of this size, we will focus on the rest of your liquid assets because we still have the ability to affect these assets’ taxability in the future.

  For starters, if your pension in retirement will be greater than $24,000 in 2018 dollars, the ideal amount of money to have in your tax-deferred bucket is zero. Since your pension and one-half of your Social Security are counted as provisional income, a portion of your Social Security will also be counted as taxable income. This will push you into a higher tax bracket in retirement than you might think.

  For example, if your pension is $80,000 per year and your Social Security is $40,000 per year, then your provisional income, at the very least, is $100,000. As a result, 85% of your Social Security now gets counted as taxable income, along with all $60,000 of your pension. Even after a normal amount of deductions, you would still be in the 22% federal tax bracket. This means that anything you distribute from tax-deferred accounts, such as IRAs or 401(k)s, will be taxed right on top of your pension and Social Security. In the best-case scenario, the cost of unlocking those tax-deferred dollars would be 22%.

  What does all this mean? It means that if you’re currently in a 22% federal tax bracket and still have room before you bump up against the 24% tax bracket, you should strike while the iron’s hot. Shift dollars out of your tax-deferred bucket and into the tax-free bucket by way of a Roth conversion or 72(t), depending on your age and ability to pay the tax. You see, if the cost of unlocking your tax-deferred dollars in retirement will never be better than 22%, why wouldn’t you take advantage of that tax bracket today? By waiting to unlock those tax-deferred dollars for another 5, 10, or 15 years, you risk losing out on that 22% bracket if tax rates rise dramatically. If you wait until 2026 or beyond to unlock these dollars and your marginal tax bracket is 50%, you may look back on this period of historically low taxes and wish you had taken advantage of tax rates while they were on sale!

  To see how this might work in real life, consider the following example. Steve and Jennifer Johnson, both age 60, are looking to retire by 65. Their household taxable income is $80,000, and they think their assets can grow at a net rate of return of 6.5%.

  *with COLA and no lump-­sum option

  As we consider the Johnsons’ case, the first question we must ask is, “Is it possible for them to ever be in the 0% tax bracket?” Because Steve must receive his pension as a stream of income (there is no lump-sum option), the 0% tax bracket will be forever out of their reach. Steve’s pension of $80,000 will be much greater than his standard deduction (adjusted for inflation, about $27,000 at age 65), so he will have to be in a tax bracket, and it won’t be zero. At the very least, $53,000 of his pension will be taxable ($80,000 of pension minus $27,000 of deductions).

  Furthermore, his pension ($80,000) and half of their combined Social Security (
$18,000) is counted as provisional income. Because of this high level of provisional income ($98,000), 85% of their Social Security income becomes taxable.

  What will the Johnsons’ taxable income be before taking withdrawals from their IRAs in retirement? Well, 85% of $36,000 (their combined annual Social Security benefits) is $30,600. Add that to Steve’s pension of $80,000 and you get $110,000. Subtract $27,000 ($20,000 indexed at 3% per year for 10 years) for the standard deduction, and the Johnsons will be looking at taxable income at age 65 of $83,000. At today’s tax rates, that would put them in the 22% tax bracket. However, if what David Walker says comes true and tax rates rise dramatically over time, then that 22% becomes a best-case scenario.

  What’s the point of all this extra math? Our additional legwork helped us to determine that the Johnsons’ permanent streams of taxable income in retirement will always put them in at least the 22% tax bracket. It’s likely to be the lowest tax bracket that they’ll experience in their lifetime. Any additional distributions out of their IRAs during retirement will land right on top of all this taxable income and will likewise be taxed at that 22% rate. That’s assuming that tax rates don’t go up. If tax rates in retirement are likely to be higher than they are today, then the perfect balance in their tax-deferred bucket is zero!