The Power of Zero, Revised and Updated

by David McKnight

  To give some real life application to everything we’ve discussed thus far, let’s take a look at a case study involving Bob and Sue Jones.

  Before we go on, please note that the Joneses’ situation is likely different from your own. In fact, there may even be massive disparities between your financial situation and theirs. But that doesn’t make this chapter any less relevant to you. Regardless of your financial position, there is certain to be something in this example that has very real application to your retirement planning. Having said that, let’s dive in.

  Bob and Sue’s financial profile is as follows:

  Before we dig into the Joneses’ situation, you should know that I’ve trained thousands of financial advisors on the tax-free retirement planning process. In doing so, I’ve sat in on their client meetings and listened to them as they talked to clients just like Bob and Sue. Because of this experience, I can tell you exactly how an initial conversation might go in the “traditional” world of financial planning. It might sound a bit like this:

  “Mr. and Mrs. Jones, I have to applaud you. You have $500,000 in your collective IRAs. Congratulations! You’ve done a great job saving for retirement. There’s only one problem. Last year when you were down the road at XYZ Company, you only earned 7% on these IRAs. We think we can get you 8%. So, roll all your money over to us.”

  Sound familiar? It gets better:

  “As far as the $100,000 in your mutual funds goes, that’s a great emergency fund. Problem is, last year you only got 4%. We think we can get you 5%, so let us manage that for you as well. As for your 401(k) with no match, keep on doing it. When you switch jobs, give me a call. We’ll roll your 401(k) into your IRA and get everything under one roof, maybe save you some fees. As for your term insurance and long-term care—well, it’s not really what we do, but who are we to say you shouldn’t keep doing it?”

  Over the years, I’ve heard this conversation time and time again. There are a couple of problems with this type of approach. First and foremost, all the emphasis is on rates of return. “You’re getting X. I think I can get you X+1.” Second, this approach takes no thought for the types of accounts within which that growth is taking place. By letting these accounts grow in an unbridled way, you unleash a storm of unintended consequences during retirement, the most severe of which is the reality that you may never be in the 0% tax bracket.

  To understand the other potential pitfalls, let’s address these accounts one at a time.

  Traditional IRAs: $500,000

  I’m not so much concerned with what’s in Bob and Sue’s IRAs today as what their IRAs will be worth 15 years from now when they retire at age 65. If these IRAs grow at 8% annually over that time span, they’ll have a little over $1.5 million by retirement time. “What’s the problem?” you may be saying. “Who wouldn’t want to have that type of balance in their IRA at retirement?”

  The problem is taxes. In fact, the RMDs alone on $1.5 million would put Mr. and Mrs. Jones in one of the higher marginal tax brackets. At that point, the IRS has them exactly where they want them, and there’s very little Bob and Sue can do about it. What’s worse, because their RMDs are greater than their standard deduction, it would be impossible for them to be at the 0% tax bracket. Instead, they would be exposed to the whims of the IRS.

  To make matters even worse, because their entire RMD is counted as provisional income, up to 85% of their Social Security would be taxed at their highest marginal tax bracket. As a result, Bob and Sue will have to take even higher distributions out of their tax-deferred bucket to compensate. This, in turn, accelerates the rate at which they spend down their retirement assets.

  What’s the solution? Bob and Sue must bridle the growth of their IRAs. We want to prevent these IRAs from ever getting to $1.5 million. Notice, I didn’t say that we don’t want Bob and Sue’s money to grow. We do want it to grow, just not in that type of account. In order to bridle the growth of this money, they must reposition a portion of it into the tax-free bucket.

  A popular solution that people often discuss in this situation is the traditional IRA to Roth IRA conversion (commonly known as a Roth conversion). Roth conversions can be very powerful shifting tools, but not necessarily when you’re 50 years old. In order to convert that $500,000 IRA, Bob and Sue would have to pay taxes. To make our math easy, let’s assume a tax rate of 40%. Like we discussed in Chapter 4, many 50-year-olds don’t have $200,000 just lying around earmarked to pay taxes.

  Once again, if they pay that $200,000 tax out of the IRA itself, it is counted as a premature distribution and incurs a 10% penalty.*1 Because of this, I wouldn’t recommend that Bob and Sue do a Roth conversion prior to 59½. They simply don’t have the liquid cash to pull it off.

  As stipulated by the IRS, funds contributed to investment vehicles such as IRAs or non-qualified annuities are locked into the investment until the money “matures.” Money in these accounts typically matures when the investor turns 59½. Any and all funds taken out of these accounts prior to their maturity date are subject to 10% prematurity fees in addition to any income tax incurred by the withdrawal. Section 72(t) essentially allows investors to forgo the 10% fee by making SEPPs, or a series of substantially equal periodic payments.

  Source: “72(t) 72(q) SEPP Introduction,” 72 on the Net, http://www.72t.net/​72t/​Introduction.

  So how can Bob and Sue get money out of their IRAs pre-59½ without paying a penalty? They would have to avail themselves of a little-known section of the IRS tax code: 72(t). Section 72(t) allows you to take substantially equal periodic payments (SEPP) on an annual basis before age 59½ without paying a penalty.*2 According to the IRS, you need to take money out for 5 years or until 59½, whichever is longer. In the case of Mr. and Mrs. Jones, they would have to take money out for 9½ years, or until 59½.

  This shouldn’t be a sticking point, because they’re already convinced that they need to suppress the growth of this account through asset shifting. Shifting these dollars over 9½ years spreads the tax liability over a longer period of time.

  The Case for Paying Taxes Today

  Paying taxes on IRAs before the IRS requires you to pay them is a leap of faith for a lot of folks. It just seems so counterintuitive. Why not postpone the payment of those taxes until the IRS forces you to pay them later on in life? When faced with this impulse, you have to crowd emotion out of the decision. There are three very good mathematical reasons for paying those taxes today:

  Historically Low Tax Rates: Remember from our earlier discussion that, with the exception of two years in the early ’90s, we haven’t had tax rates this low in 80 years. This is a window of opportunity that should be taken advantage of before taxes go up for good. Further, we know what tax rates are today. They’re a known quantity. Do we pay the taxes now, given their historically low levels, or do we roll the dice and hope that sometime down the road our country somehow manages to liquidate trillions of dollars of debt without increasing government revenue? Most would say that a bird in the hand is worth more than two in the bush, so take advantage of historically low tax rates while you still can.

  Deductions: If you’re still working, there’s a good chance that you have quite a few deductions left. Your house may not be completely paid off, giving you much-needed interest deductions. You may also still have dependents living with you. If your itemized deductions today are substantially higher than your standard deduction ($24,000 for a married couple), then you’ll have the ability to offset a lot of those taxes.

  Cash Flow: If you do utilize the 72(t), you can spend the distributed money on whatever you like. This gives you the option of paying the taxes on the distribution out of the distribution itself. So, for example, if your 72(t) gives you $25,000 per year, your taxes (at 30%) would be $7,500. Pay the taxes out of the $25,000, then shift the remaining $17,500 into your tax-free bucket. This become
s a welcome alternative to those who are younger than 59½ who would prefer to do a Roth conversion but who don’t have the money in their taxable bucket with which to pay the tax.

  Remember, paying taxes is not the end of the world (though some say you can see it from there). What is the end of the world? Having to pay taxes at double the rates at a period in your life when you have very few deductions and can least afford to do so.

  For Bob and Sue, I would recommend the 72(t), because it allows them to suppress the growth of those IRAs, mitigating the consequences of having a balance in retirement that’s too large. Remember, our goal is to keep their balances small enough that RMDs at 70½ can be offset by the standard deduction.

  The amount that they can take out by way of a 72(t) fluctuates based on a number of different factors including the age of the account holder, the age of the beneficiary, and interest rates. A 50-year-old in 2018, for example, can take out about 5% per year. In this case study, I would suggest they do a 72(t) on the full IRA amount. At 5%, they would be required to distribute $25,000 every year for 9½ years. Shifting this amount every year will go a long way toward bridling the growth of their IRAs. Remember, we don’t want to stop growing their assets, just this particular bucket. Later in this chapter we will discuss how this money should be repositioned.

  Recommendation: Shift $25,000 annually from IRA to tax-free bucket by means of a 72(t).

  Taxable Mutual Funds: $100,000

  Next, let’s address the $100,000 in mutual funds that are serving as the Joneses’ emergency fund. Using the six-month rule we discussed earlier, we can see that the Joneses have about twice as much money in their emergency funds as is the recommended requirement. If they make $100,000 per year, then six months of income is about $50,000. So, not only do they have too much in their emergency fund, but they are further compounding the problem by growing these dollars in mutual funds. To address this, we must shift both growth and principal on that $100,000 into the tax-free bucket.

  Now, before we start shifting money out of the taxable or tax-deferred buckets into tax-free, it’s important to keep a few things in mind:

  You want to shift money out in an incremental stream, not all at once.

  In some cases, you must pay a tax when transferring money into the tax-free bucket. If you shift money out all at once, especially in the case of the tax-deferred bucket, you run the risk of bumping up into a higher tax bracket.

  Most tax-free investments have limits on how much you can shift in any given year. As you’ll recall, the maximum annual contribution to the Roth IRA for two 50-year-olds is $13,000 per year (as of 2018).*3 Even the LIRP ties contribution levels to death benefit amounts. Further, we can only maintain the tax-free status of the LIRP when we stream money into it over a period of time. When we make huge lump sum contributions to the LIRP, we risk turning it into a modified endowment contract (MEC). The cash buildup inside the LIRP would then be recharacterized as tax-deferred and not tax-free.

  With these considerations in mind, the Joneses need to find an amount they can shift out of their taxable bucket each and every year so that, by the time they retire in 15 years, they have the ideal emergency fund. What is the ideal balance? In Bob and Sue’s case, it’s about $50,000 in today’s dollars. So, 15 years from now, $50,000 adjusted for 3% inflation is about $78,000. If their mutual funds are growing at an after-tax rate of 5% every year, they would need to shift about $6,000 per year for the next 15 years. That would leave their taxable bucket at the $78,000 objective by the time they reach 65.

  Recommendation: Shift $6,000 per year from taxable mutual funds to the tax-free bucket.

  401(k): 10% Contributions with No Match

  Let me start by reinforcing a ground rule that I laid out earlier. The only time that it makes sense to contribute to a 401(k) is if your employer is giving you free money. We call this a match. It gives you an instant return on your investment. Free money is good! As a reminder, there is an ideal balance to have in the tax-deferred bucket. You can have too much, but you can also have too little. If you have too little money in this bucket, the best way of growing it is to make contributions up to the match, but not beyond. If you already have a substantial amount of money in your 401(k), additional contributions beyond the match could create a balance that’s too large by the time you reach retirement.

  Remember, our goal in most cases is to bridle the growth of the tax-deferred bucket. If you’re doing a 72(t) on your IRA in an attempt to do so, yet you’re putting money hand over fist into your 401(k) with no match, then you have a conflicted investment strategy.

  In Bob and Sue’s case, they are not getting a match, so I recommend that they recapture all their contributions ($10,000) and shift them to their tax-free bucket. We’ll talk about where to put this money in a moment.

  Recommendation: Recapture $10,000 annual 401(k) contribution and shift to the tax-free bucket.

  Term Life Insurance Premiums

  Bob and Sue are to be commended for having life insurance. A premature death, especially during their peak earning years, is clearly something that could derail their financial plan. There could, however, be a more cost-efficient way of mitigating this risk while enhancing their ability to contribute to the tax-free bucket. I’ll explain how shortly.

  Recommendation: Recapture $2,000 annual term insurance premiums and shift to the tax-free bucket.

  Long-Term Care Insurance: $4,000 per Year for Joint Coverage

  As mentioned earlier, long-term care protection is indispensable to most married couples during retirement. A long-term care event, in many cases, can be more financially devastating than the death of a spouse. Remember, if one spouse dies, the other spouse inherits all the retirement accounts. If a pension is involved and the survivorship option is elected, the death of the primary spouse ensures that the surviving spouse continues to receive that income in perpetuity. And, in the case of Social Security, the surviving spouse always gets the higher of the two Social Security payments on the death of the spouse.

  In the case of a long-term care event, however, the government will force you into “spend down” before stepping in to pick up the tab. In other words, if Bob needs long-term care, all the retirement accounts in his name get earmarked for the long-term care facility. In some cases, these assets can be almost entirely spent down before Medicaid steps in and pays the expense. This deprives the community spouse, Sue, of most of the assets and income that she had been relying upon for a comfortable retirement. She would be allowed to keep her Minimum Monthly Maintenance Needs Allowance (MMMNA), $120,900 of assets, one car, and one home.*4 Is this the type of retirement that she was envisioning?

  We know that long-term care is a risk that needs to be mitigated, but what’s the most cost-effective way of doing so? Remember, traditional long-term care insurance is expensive, can be hard to qualify for, and is a use-it-or-lose-it proposition. In other words, you could pay into it for 30 years, die peacefully in your sleep never having used it, and not get any of your money back. This reality can give some people heartburn. They’re paying a lot of money for something that they hope to never use.

  In Bob and Sue’s case, we might recommend recapturing this $4,000 and covering the long-term care risk in a completely different way. Whether we do so or not depends upon Bob and Sue’s health, the amount of money that they’ve already paid into their long-term care insurance, and a number of other variables. Assuming that Bob and Sue meet all of these specifications, we’ll divert this $4,000 long-term care insurance premium to the tax-free bucket. In the meantime, we’ll find a more efficient way of dealing with their long-term care needs.

  Recommendation: Recapture $4,000 annual long-term care insurance premium and divert to the tax-free bucket.

  In summary, by looking at Bob and Sue’s assets and insurance through the
prism of tax efficiency, we can identify ways to systematically reposition these dollars into the tax-free bucket. Let’s take a look at the total amount of recaptured dollars:

  Not bad. We’ve recaptured $47,000 on an annual basis that can now be earmarked for tax-free investing, right? Well, not quite. We don’t have all $47,000 to work with because some of these strategies require us to pay tax.

  The two primary taxable events are the following:

  As you can see, this strategy requires Bob and Sue to pay taxes on an additional $35,000 at their highest marginal tax rate. Assuming normal levels of deductions, they’d be paying taxes at the 24% federal rate and 6% for state. At 30%, that’s an additional $10,500 of taxes every year until they retire.

  Do you think that Bob and Sue have $10,500 just lying around that they would love to spend on taxes each and every year? Probably not. And if I recommend that they quit going out to eat, stop going on vacation, and pull back the belt a couple of notches just so they can pay this tax bill, they’ll probably stop returning my phone calls. Instead, I must find a way to help them pay that annual bill without modifying their lifestyle.

  The best way to accomplish this is to have them pay that tax right out of the $47,000 that we just freed up. That would leave us with $36,500 to shift into the tax-free bucket every year for the next 15 years.

  Now that we know how much money we can shift every year ($36,500), the question becomes, how can Bob and Sue invest these dollars so that they will grow in a truly tax-free environment? Further, how do we create multiple streams of tax-free income as part of a balanced strategy that will land the Joneses in the 0% tax bracket in retirement?