The Power of Zero, Revised and Updated

by David McKnight

  So, What’s the Solution?

  Now that we know that Steve and Jennifer’s perfect IRA balance in retirement is zero, they can begin shifting these dollars to the tax-free bucket, taking advantage of low tax rates while they’re still around. Let’s assume that the Johnsons’ taxable income this year is $80,000, putting them at a marginal tax bracket of 22%. As of 2018, the 22% tax bracket maxes out at $165,000. Assuming that tax rates stay level, this means the Johnsons can shift $85,000 per year out of their IRAs into the tax-free bucket. By shifting $85,000 per year, they will have reduced their IRAs to zero before they reach retirement (assuming asset growth of 6.5% per year).

  By beginning the shifting process today, the Johnsons take advantage of our historically low tax rates and get most of the heavy lifting done before tax rates are likely to rise.

  Assuming a federal tax rate of 22% and an additional 6% for state, this shifting strategy would incur additional annual taxes of $23,800. Remember, the Johnsons can pay that tax out of the IRAs themselves because they’re both age 60, but they may not want to. Because they have $200,000 in taxable mutual funds, they could easily pay that $23,800 tax bill out of that bucket. By doing so, they would be taking their least valuable dollars (taxable) and using them as a catalyst to springboard their second-least valuable dollars (tax-deferred) into their most valuable bucket (tax-free). After paying that $23,800 tax bill out of their taxable bucket, they can now shift all $85,000 into the tax-free bucket.

  Before we discuss which combinations of tax-free alternatives will best meet their needs, let me highlight an important aspect of the Johnsons’ financial profile. As you can see, most of the Johnsons’ major assets are in Steve’s name.

  It’s important to assess who owns which assets, because this has major repercussions for long-term care. If Steve were to need long-term care, for example, all the assets in his name would be earmarked for the long-term care facility. The only problem is that Jennifer was planning on using these assets to support her lifestyle in retirement! Now she must try to get by on her IRA ($100,000), her Minimum Monthly Maintenance Needs Allowance (MMMNA), and any money remaining in her taxable mutual funds, up to $120,900.*

  Should Jennifer need long-term care, only her smaller IRA ($100,000), her Social Security income ($1,000 per month), and a portion of their joint mutual funds (anything above $120,900) would go to the long-term care facility. Once her IRA was consumed, she would then qualify for Medicaid. If that were to happen, Steve could easily survive on his $72,000 pension, his IRA, and the exempted portion of his Social Security. Given this reality, Steve has a glaring need for long-term care protection—much more so than Jennifer.

  If that’s the case, it could make sense for Steve to divert a portion of the $85,000 annual shift, say $20,000, to a Life Insurance Retirement Plan (LIRP). When structured properly, this could give him all the tax-free growth opportunities available within the Roth IRA while providing a death benefit that could be accelerated for the purpose of paying for long-term care. The remaining $46,400 could then be converted to a Roth IRA on an annual basis.

  While it is not possible for the Johnsons to get to the 0% tax bracket because of Steve’s pension, we’ve maximized the tax efficiency of their portfolio by doing the following:

  We reduced their IRAs to the perfect balance (zero) through asset shifting while taking advantage of historically low tax rates.

  We utilized their least valuable assets—their taxable mutual funds—as a catalyst to reposition their IRAs into the tax-free bucket.

  We protected the Johnsons against a long-term care event on Steve by utilizing a LIRP while at the same time accumulating tax-free dollars for retirement.

  We utilized a Roth conversion to help reposition their IRAs into the tax-free bucket in order to protect against tax-rate risk.

  In summary, having a pension is not a good reason to throw in the towel when it comes to protecting yourself against the threat of rising taxes. While it’s true that you have no control over your pension’s taxation in retirement, there is still a lot you can control. By knowing your pension amount in advance, you can determine the right amount of money to have in your tax-deferred bucket. Once that’s determined, you can begin a shifting program that will get you as close to the 0% tax bracket as is mathematically possible. Although your pension may always be taxable, you can still be in the 0% bracket as it relates to your other assets. Begin by identifying which shifting needs to take place today, and then systematically reposition these dollars into the tax-free bucket before tax rates go up. An experienced tax-free retirement specialist can help you navigate the complexities and pitfalls you may encounter during the shifting process.

  * For a reminder of these concepts, see Chapter 5.

  NINE

  THE TAX-FREE ROAD MAP

  Even under the “traditional” tax-deferred approach to retirement planning, I’m a big fan of having a financial advisor. The fact is, unless you have an expert to help you manage your road to retirement, emotion can often impede the process and erode rates of return. You’ve heard the old adage “Buy low and sell high,” right? Well, when investors succumb to their emotions, they typically do just the opposite. As an example of this, look at the investor carnage in the wake of the 2008 market crash. I can tell you countless stories of investors who, absent a financial advisor, waited until the market had fallen 50% to 60% before they decided to pull out. Then, having been so traumatized by their losses, they kept their money on the sidelines as the stock market rebounded and returned to its near-2007 highs.

  In many cases, this happened simply because there wasn’t anyone there to “talk them off the ledge.” Study after study shows that emotion-driven investing can erode more growth from your portfolio than almost any other factor.*1,*2 For that reason alone, I’m a huge advocate of having someone to hold your hand along the way.

  Emotion isn’t the only thing that can derail your retirement plan, especially when it comes to tax-free retirement planning. As you may have observed, the pursuit of the 0% tax bracket is a bit more involved than traditional tax-deferred investing. It takes a good blueprint, constant course adjustments, and the foresight to anticipate the pitfalls that may arise along the way. In this chapter, we will discuss the value of partnering with a tax-free planning specialist who can assist you in the creation of what I call a Tax-Free Road Map. This road map can be described as an asset shifting schedule based on your current balances, contributions, and anticipated rates of growth. Having both a tax-free planning specialist and a Tax-Free Road Map is indispensable to helping you navigate the pitfalls along your way to the 0% tax bracket.

  Finding the Perfect Balance in Each Bucket

  One of the recurring themes in this book has been the importance of accumulating the right amount of money in each of the three buckets. Having the wrong balance in any of these accounts can have massive unintended consequences for you in your pursuit of the 0% tax bracket.

  The Taxable Bucket

  Determining the ideal balance in the taxable bucket is the first step. In Chapter 2, we established that the perfect balance is the amount necessary to safeguard against life’s unexpected emergencies—about six months’ worth of income. While this seems straightforward enough, difficulties arise if you have too much money in this bucket and need to reposition it to the tax-free bucket. Let’s say, for example, that your ideal balance is $50,000 yet you have accumulated $200,000. To compound the problem, you have it in mutual funds and it’s growing at 5% per year. Remember, you can’t shift the entire $150,000 surplus into the tax-free bucket all in one year. Due to the contribution limitations of the various tax-free alternatives we’ve covered, your money has to be shifted over a period of time. But how much should you shift each year, over how many years, and into which tax-free accounts? The answers to all these questions can be found in the creation
of a Tax-Free Road Map.

  The Tax-Deferred Bucket

  The real complexity emerges, however, when trying to determine the ideal balance in the tax-deferred bucket. As previously mentioned, when you fail to temper the growth of this bucket, it can be nearly impossible to be in the 0% tax bracket in retirement. On the other hand, when you do not have enough money in this bucket, you won’t be able to fully utilize your standard deduction in retirement. This means that you may have unwittingly shifted too much money into the tax-free bucket, paying unnecessary taxes along the way.

  When a tax-free planning specialist is building your Tax-Free Road Map, he will consider a number of variables in determining the ideal balance in this account. What will your standard deduction be in the year you retire? Are you contributing to your retirement plan above and beyond the match? If so, to what extent? What are your projected rates of return? Do you have a pension? If so, will it be more or less than your standard deduction? Does it have a cost-of-living adjustment (COLA)? Should you do a 72(t) or a Roth conversion?

  As I mentioned in Chapter 4, the speed with which you shift these dollars matters. You want to shift dollars slowly enough that you don’t inadvertently bump into a higher tax bracket, but quickly enough that you get all the heavy lifting done before tax rates go up. This is where a Tax-Free Road Map is indispensable. An experienced tax-free planning specialist can process all the variables unique to your situation and then determine the exact amounts that should be shifted annually to each of the tax-free alternatives.

  The Tax-Free Bucket

  Any dollars above and beyond the ideal balance in the first two buckets should be systematically redirected to the tax-free bucket. Any surplus contributions should likewise be redirected toward tax-free alternatives. A properly designed Tax-Free Road Map will incorporate the tax-free alternatives that will best meet your needs. Does a Roth IRA make sense? Do income thresholds require you to use a nondeductible IRA and then convert to Roth? Do your other IRA balances preclude you from using the nondeductible IRA conversion strategy? What about a LIRP? How can this best be utilized to meet your tax-free retirement, life insurance, and long-term care needs? How do you structure the LIRP to maximize returns within the tax-free growth account?

  A properly designed Tax-Free Road Map can also help transform your Social Security from a highly taxable stream of income into one that remains tax-free throughout your retirement. As a reminder, having your Social Security get taxed in retirement can be financially devastating. By losing a portion of your Social Security to taxes, you must compensate by taking additional distributions from your other investments. This act alone can deplete your assets five to seven years faster than not having your Social Security taxed at all.

  But making sure your Social Security is tax-free requires a tricky balance. You want to take tax-free distributions out of your tax-deferred bucket (up to your standard deduction), but only to the extent that it does not breach the thresholds that cause your Social Security to get taxed.

  Your Tax-Free Road Map can help you balance all these competing interests and ensure that the pursuit of one goal doesn’t impact the pursuit of another. Meeting with your tax-free planning specialist at least annually will help you navigate the pitfalls of the tax-deferred bucket and ensure the proper balances at retirement.

  The LIRP

  Utilizing the LIRP in a thoughtful, well-balanced approach to tax-free retirement involves evaluating a number of different factors. The most important decision happens at the outset when you determine how to best grow the dollars within your LIRP’s growth account. If you’ll recall from Chapter 5, there are three basic options:

  General account of the life insurance company

  The stock market

  An indexed-based approach

  Once you determine the option that best aligns with your retirement needs, you must then find a company to partner with.

  As with anything in life, not all LIRPs are created equal. There are over 300 different companies that offer LIRPs, not all of which are ideal partners in the tax-free retirement process. Your tax-free retirement specialist can assist you in sorting through all the carriers to find the one that will best meet your specific retirement needs. In evaluating these companies, you and your advisor will need to consider the following attributes:

  Low expenses: Whatever drips out of your bucket in the form of expenses won’t help you. Not only do you lose those dollars, but you lose the ability to earn interest on them as well. Not all companies’ expenses are the same.

  Long-term care provisions: Not all LIRP carriers offer a long-term care provision. Some companies offer them but charge exorbitant fees. If you’re looking to mitigate a long-term care risk without having to pay for traditional long-term care insurance, make sure that your LIRP has this important feature.

  Cost-free distributions: All LIRPs give you the ability to take money out tax-free. But not all of them give you the ability to take it out cost-free as well. In fact, some companies charge a rate of interest which, if not repaid, gets deducted from your growth account. So it’s critical that you find a company that gives you the ability to take dollars out tax-free and cost-free.

  Financial stability: You could find a company whose LIRP has all the above-mentioned qualities, but unless they’re financially stable, you risk foiling your entire plan. Financial stability should be paramount when considering a LIRP company to partner with.

  When utilized properly, the LIRP can be a critical cog in your efforts to reach the 0% tax bracket. Finding a company that has a LIRP that aligns with your growth objectives while also conforming to the above standards can be a tricky proposition. A qualified tax-free retirement specialist understands the LIRP marketplace and can help you navigate all of the various alternatives.

  After you’ve found the right company and chosen the method of growth that best suits your needs, you can then address the structuring of your LIRP. To maximize the returns within your growth account, you must buy as little insurance as is required by the IRS. You must then contribute as much money as is allowed under the IRS guidelines. This strategy ensures that the expenses dripping out of your bucket will be small relative to the money accumulating inside your bucket. Remember, when properly structured, these expenses should average about 1.5% of your bucket per year over the life of the program. A qualified tax-free planning specialist understands how to structure your LIRP and how to incorporate it into your strategy to get to the 0% tax bracket.

  Finding a Tax-Free Planning Specialist

  As already mentioned, it’s difficult, if not impossible, to create a Tax-Free Road Map without the help of someone who’s been down this road before. A qualified tax-free planning specialist has the experience and know-how that sets him apart from an ordinary financial advisor. Most traditional financial advisors are mired in the tax-deferred approach to retirement planning: “You’re earning X, I think I can get you X+1.” In order to create a Tax-Free Road Map, an advisor must be familiar with all the pitfalls of the traditional tax-deferred investing paradigm and be well-versed in the tax-free strategies that will land you at the 0% tax bracket before tax rates go up for good.

  Begin your search by having a discussion with the advisor who gave you this book. If he gave it to you, it’s because he felt like it was critical to your financial well-being. This act alone should set this advisor apart from other financial advisors in the world of traditional tax-deferred investing. Begin by asking questions about how these principles apply to your specific situation. If the advisor answers your questions to your satisfaction, proceed to the next step—the creation of a Tax-Free Road Map. Once this road map is complete, you can begin your journey toward the 0% tax bracket!

  *1 Philip Z. Maymin and Gregg S. Fisher, “Preventing Emotional Investing: An Added Value of an Investment Ad
visor,” The Journal of Wealth Management 13, no. 4 (2011).

  *2 Brad M. Barber, Yi-Tsung Lee, Yu-Jane Liu, and Terrance Odean, “Just How Much Do Individual Investors Lose by Trading?” AFA 2006 Boston Meetings Paper (May 2007).

  TEN

  FREQUENTLY ASKED QUESTIONS

  My main reason for writing this book is to help you understand how to insulate and protect your hard-earned assets from the impact of the tax “freight train” of which I spoke in the first chapter. As I’ve said throughout the book, the best way to do so is to rearrange your assets so that you are in the 0% tax bracket when you retire. While the benefits of achieving the 0% tax bracket seem straightforward, the path along the way can be fraught with hazards, pitfalls, and unexpected detours. Because of that, I have included this final chapter in an attempt to answer the most commonly asked questions that arise during the planning process. Ultimately, the best way to answer questions that pertain to your specific situation is to consult with a tax-free planning specialist.

  General Questions

  Q: Am I too old to adopt this strategy?