114: How To Retire in the 0% Tax Bracket with David McKnight
David McKnight is a champion for the American people. He’s not only warned us all about why we should expect taxes to get higher in the future, he’s also taught people how to be in the 0% tax bracket when you retire. It may sound impossible, but today, David’s going to walk you through exactly how to do it.
David has appeared in Forbes, USA Today, the New York Times, and on CNBC. His bestselling book, The Power of Zero, has sold over 140,000 copies. The updated edition, published in September of 2018, is now the number two most sold business book in the world. It’s even been turned into a full-length documentary film also entitled The Power of Zero, which we’re going to spend some time talking about today.
Today, David joins the podcast to talk about why tax rates may double after you retire (and what you can do about it), how to protect your assets from future legislative changes, and the whens, whys, and hows of Roth conversions.
In this podcast interview, you’ll learn:
- What made David so passionate about telling Americans about looming tax increases – and how drastically things have changed since the national deficit was zero in 1997.
- Why having less income in retirement doesn’t necessarily mean paying less taxes – and how much drastically higher tax rates were before Ronald Reagan’s presidency.
- Why David thinks taxes are all but guaranteed to go up on January 1, 2026 – and what you should be doing before then to safeguard your money.
- The reason so many CPAs are unwilling to have proactive conversations about tax rates – and the times it can be advantageous to shift temporarily into a higher tax bracket.
- How to enter the so-called 0% tax bracket by proactively and preemptively paying taxes in a higher tax bracket – preferably 24% – now.
- How to use a Life Insurance Retirement Plan to complement other streams of tax-free income, no matter how much you earn.
- “We have this window of opportunity during which to take advantage of historically low tax rates. We finally have some certainty dispelling the doubt around the future of tax rate, so why not take advantage of it?” – David McKnight
- “The true purpose of a retirement account is not to save you money in taxes. It’s to increase. It’s to maximize your retirement income at a period in your life, when you can least afford to pay the taxes. That’s the true purpose of retirement income.” – David McKnight
Casey Weade: I’m very excited to offer you today’s guest, David McKnight. I’ve been following David for quite a few years as he has been a champion for the American people when it comes to ringing the warning bell of higher taxes in the future, and what to do today so you can be in the 0% tax bracket in retirement. That’s what I said, 0% tax bracket. It may sound impossible, but David’s going to walk you through exactly how to accomplish it in our discussion today. This is a guy that has made frequent appearances on television. You’ve probably seen him before actually. He’s been in Forbes, USA Today, the New York Times, CNBC, and numerous other national publications. His bestselling book, The Power of Zero, has sold over 140,000 copies. And his revised version launched in September of 2018, becoming the number two most sold business book in the world, which has now been turned into a full-length documentary film also entitled The Power of Zero, which we’re going to spend some time on today.
David will cover why tax rates are destined to not only increase, but potentially double during your retirement years and what you should be doing about it. One of my favorite topics covered is something David likes to call legislative diversification, how to protect your retirement assets from potential legislative changes in the future and one of the most heavily discussed topics in the tax world today, Roth conversions, why, when and how to do it. Without further ado, I give you, David McKnight.
Casey Weade: Dave, welcome to the podcast.
David McKnight: Thanks for having me.
Casey Weade: Hey, I’m really excited to have you here. Our whole office was really jazzed up to have you here because we’ve all watched your movie. Many of us have read your book. I’ve followed you for many years and have found your research, the information you provide to the public and to advisors out there incredibly valuable. And I know you’ve been doing this for a really long time. Now you’ve made this transition from being an author to somewhat of a movie producer. And now you have this new movie about the tax train coming. Why this passion for just, I mean, you do a lot of traveling in order to get the word out about the future of tax rates. Why this passion?
David McKnight: Well, it’s really interesting. Back in 1997, Bill Clinton stood before the country during the State of the Union. He said, “Hey, I got great news. The national deficit is now zero and here we are 20 years later. Not only is the national deficit not zero, it’s about a trillion dollars per year and growing, but also our national debt is $22 trillion and it’s growing by leaps and bounds. And during a period of relative prosperity, while all the other nations in the world are getting their financial houses in order, we just keep plowing things onto the National Credit card, and the debt just keeps getting bigger and bigger and more and more unsustainable. So, it seems strange to me that as our fiscal condition of our country sort of spins out of control, and the likelihood of higher taxes down the road to be able to liquidate all this debt becomes more and more reality, it seems strange to me that we have 75 million, 78 million baby boomers who continue to grow the lion’s share of their assets in tax-deferred vehicles, like 401(k)s and IRAs, meaning they haven’t paid taxes on those assets yet.
So, we’re sort of marching into this future where all of the financial experts basically agree that tax rates are going to have to rise dramatically in the next 10 years, yet most Americans aren’t really doing anything about it. So, I’ve sort of over the last five years, in particular, I really sort of taken upon myself to barnstorm across the country, try to raise the warning cry to whoever will listen. I do that a lot of different ways through the movie, through my books, through public appearances, but really just trying to get the word out and educate people on the reality of what’s going on in our country and how they can best prepare themselves as they move into their retirement years.
Casey Weade: What do you hope the end result is of all this work that you’re doing and trying to get this word out? What do you hope actually comes out of the work that you’re doing?
David McKnight: Well, I think first and foremost, I would love to raise awareness among the largest voting bloc in the country, which is the baby boomers. They have the ability to elect really every single elected official every two or four years. And they have a lot of clout, and they leave a really large footprint and if they can make it known to their elected officials, that the type of fiscal irresponsibility is being shown in Washington, it’s just not going to cut it. It’s not good for us. It’s not good for our children, certainly not good for our grandchildren. That’s really the primary hope. But I’m not very optimistic on that account. And so, absence any real fiscal restraint on the part of the federal government, the secondary goal really is to help people prepare for the inevitability that the government is not going to get their act in order. They’re probably not going to cut spending. They’re probably going to have to raise taxes dramatically over the course of the next 10 years. Therefore, what can the 75 million to 78 million baby boomers do to protect their hard-earned savings from a dramatic increase in taxes that’s bearing down on us like a freight train?
Casey Weade: Now, let’s dive into that a little bit further, because I think most retirees have been told that their taxes are going to be lower in retirement and I’m still hearing that today. People come in, and they’re saying, “Well, why would I pay taxes today? Why would I do a Roth conversion today? I’m going to be at a lower tax rate environment in retirement. My CPA told me I needed to get tax deductions today because I’m going to be – I’m going to have less income in retirement,” but you’re saying even if we have less income in retirement, it doesn’t mean we’re going to pay less taxes.
David McKnight: Yeah. I’ll give you an example. I was listening to a radio show a couple of years ago. It was one of those financial radio shows. I can’t remember if it was Dave Ramsey or who it was, but it was a financial radio show. And the lady calls in and she says, “I don’t understand. I am making less money in retirement, but I’m paying more in taxes. How is that even possible?” She was totally flabbergasted. And the radio show host says, “Well, tell me about your deductions,” and she says, “Deductions? I ran out of those a long time ago.” He goes, “Oh, I think I understand your problem.” So, even if tax rates were to stay level for the rest of our lives, this much we know, all of the deductions that you experienced during your working years literally vanished into thin air. What are we talking about? We’re talking about your house. Your house is typically paid off, by the time you reach your retirement. Your kids, that’s a huge source of tax savings, because kids are tax credits, right, though your kids have moved out by the time you reach retirement. You’re no longer contributing to your 401(k) or IRA and instead of donating money during retirement, people typically donate time.
So, all of these major sources of deductions vanished into thin air right when you need them the very most, which is retirement. So, even if tax rates weren’t going to go up, which I think is a mathematical impossibility at this point, all of the deductions that we enjoyed during our working years are gone and the only thing we’re left with is a standard deduction, which if you retired today, as a married couple, is 24,400. So, we’ve got the combination of disappearing deductions plus the likelihood the tax rates are going to go up, which make it nearly impossible for you to be in a lower tax bracket than you are right now in retirement. Having said that, everybody’s situation is different and the real catalyst that should help you understand what you should do in terms of whether you should shift money out of tax-deferred to tax-free comes down to what you believe in your heart of hearts about the future of tax rates, and that is the single overriding variable when it comes to making these decisions. I happen to think having examined all of the data and having interviewed most of the major experts on these types of things all across the country, particularly for the movie, I happen to be very, very frightened about the future of tax rates and that’s why I’m so motivated to do the types of things that I’m doing.
Casey Weade: In the movie, you cover all kinds of different reasons why we’re going to see higher taxes in the future and I think we’re just kind of overwhelmed as a society by trillion this, trillion that, social security taxes, Medicare is going to have issues, disability, OSDI. I mean, we’ve just got all these things that are going to jam down our throats that are kind of confusing and overwhelming. And I think you simplify it too in the movie. You kind of say, “Well, I think we all believe that history tends to repeat itself.” Let’s look back throughout history and see what’s happened in the past because what’s happened in the past tends to happen again in the future. I think that would be a good thing for us to provide people. It’s just kind of a little history around the tax system and historical tax rates.
David McKnight: Yeah. Our reality attempts to be driven by the things that have happened in our lifetime. And most people don’t realize that there is a period in the history of our country where tax rates were dramatically higher than they are today. Granted, there were different deductions back in the day. You can deduct credit card interest. You can deduct interest on a car loan, those types of things that have more deductions, but that does not offset the reality that in the prime of Ronald Reagan’s career, he talked about how he never made more than two movies in a year. Reason being he made about $100,000 per movie, and any dollar he made above and beyond $200,000, he only kept $0.06 on the dollar and truth be told, he didn’t even get to keep the $0.06. That $0.06 went to the state of California. So, it didn’t make sense for Ronald Reagan to even work past the month of June, because he wouldn’t keep any of the money. So, he writes in his biography that he never made more than two movies in a year. He would go to his ranch, he’d ride horses. He pretty much just hang out until the next year, so he can start making his two movies again.
So, that was a long time ago and even as recently as the decade of the 70s, the highest marginal tax bracket was 70%. You fast forward to today, the highest marginal tax bracket is only 37%. These are historically low. You may make the case that under George W. Bush, tax rates were a tiny bit lower at 35% but the income parameters that govern tax brackets today are so much more favorable to the American taxpayer than they were even under George W. Bush. We are experiencing the tax sale of a lifetime. We don’t recognize how good it is because we don’t often think about how high tax rates were during the 40s, 50s, 60s, 70s. It wasn’t until Reagan actually got into office that tax rates started to lower dramatically. But we’re in an environment where politicians are talking about raising the marginal tax rate at 70%. I heard Elizabeth Warren talking about raising it to 90% on the wealthiest among us. And then you got to remember is when that highest marginal tax rate goes up, historically, it’s a bellwether for all of the other tax rates. As that highest marginal tax rate goes up, all of the lower ones tend to rise right along with it and that’s why we keep our eye on that highest marginal tax bracket. So, we have to, I think we’ve sort of been lulled into this false sense of security that tax rates are low, and they’ll always be low. Well, history tells a different story.
Casey Weade: Let’s get into some of the finer details, reasons why you expect taxes will be higher in the future. Outside of just history tending to repeat itself, what do you think the top reasons are that we’re going to see higher taxes in the future and somewhat dramatically higher taxes?
David McKnight: Well, we interviewed Larry Kotlikoff, who is a Ph.D. out of Boston University, and we interviewed him for the movie. He has about a seven-minute segment of the movie, which to me is one of the most compelling sections of the movie, and he talks about something called fiscal gap accounting. Now the national debt, according to the federal government, that what we call the publicly stated national debt is $22 trillion. That’s two, two followed by 12 zeros. Doesn’t seem like a big deal, because our debt-to-GDP ratio is 106%. What makes us fifth in the world doesn’t seem like a big deal, because we were actually worse in the wake of World War II. We had I think the debt-to-GDP ratio that was around 110%, 115%. Now, we’re only at 106%. So, the casual observer says, “Hey, look, it’s not that bad. In fact, it’s been worse, and we were able to recover from it.” Well, according to Larry Kotlikoff, Dr. Kotlikoff says, “There’s something called fiscal gap accounting. Fiscal gap accounting is the difference when you calculate the difference between what we actually owe, what we’ve actually promised to pay to baby boomers in the form of Medicare, Medicaid, social security, interest on the national debt versus what we can actually deliver on based on current tax rates.”
And he says, last year he said that that fiscal gap was $199 trillion. This year, he says, pardon me. It’s not 199. He says $222 trillion. This year, he says it’s $239 trillion, so it’s gone up just in one year. So, according to Dr. Kotlikoff, our debt-to-GDP ratio is actually closer to 1,000%. We’re not required by law to include in that national debt number what we call off-the-books obligations, off-the-books obligations or promises that we made for social security Medicare that we’re not technically required to include in the national debt. Well, guess what, every other country in the world uses fiscal gap accounting. So, according to all of the rankings, Japan has the worst debt-to-GDP ratio at 250%. If we were to conduct our accounting and tabulate are national debt like Japan does, our debt-to-GDP ratio would actually be 1,000%, which is breathtaking. It’s really, really out of control. And so, the only reason it doesn’t seem worse is a simple accountability. It’s a simple accounting trick that the federal government uses to not have to disclose all of their debts. So, really, things are much worse than they seem, and it’s driven by primarily promises made for Medicare, Medicaid, Social Security.
Casey Weade: Well, you use that word, trillion, a few times. We’re probably going to continue to use that T-word. And I think we’ve almost become numb to that word and it’s a really big word. And maybe you can share with us a way that you help people really wrap their minds around what a trillion really is.
David McKnight: You know, there’s a lot of different analogies that people use. I know Tom Hegna has got a great analogy, where he says, “If you spend a million dollars per second, every second for 33,000 years, you wouldn’t be able to pay off the national debt.” It’s a massive, massive number. I don’t have any of those awesome analogies to explain how big the debt is. But it’s to the point right now, that if we don’t dramatically raise taxes, I’ll give you an example Larry Kotlikoff use. He says, “Basically if all we did was not spend any money as a government for the next 10 years and just use every little bit of money that we bring in from tax revenue to pay down the national debt, it wouldn’t even put a dent in it.” So, it’s just amazing, breathtaking amounts of money. There’s videos on YouTube that will show you what it looks like if you stack $100 bills up. It’s basically unfathomable. There’s all sorts of analogies that you can use to show how big, but the average American can’t even fathom how much money that is.
Casey Weade: And a lot of politicians see here, this discussion about outgrowing the debt. And I’m not sure that we really have a good understanding as a general public what it means to outgrow that debt and the reason why that’s ludicrous.
David McKnight: Right. The debt is growing so fast. Ben Bernanke, he talks about this in the movie. He says, “Look, it was irresponsible to do the tax cuts.” Now, keep in mind, I love low taxes just like anybody else but there’s got to be this commensurate reduction in spending, which we did not do. In fact, to finance the debt cuts, we actually borrowed $1.5 trillion over the next 10 years to be able to pull it off.
Casey Weade: Can you talk about that as well? Just talk about the difference, because I think a lot of people say, well, this is Reaganomics all over again. Yeah, well, we haven’t done it the same way. This is different than it’s been in the past when we’ve dramatically lowered taxes. We’ve also coupled that with something else.
David McKnight: Yeah. Reagan always said that if you’re going to lower taxes, you got to lower spending commensurately to be able to pay for those tax cuts. So, David Walker, former Comptroller General of the federal government, I paid a lot of attention to Dave Walker, because he was basically the CPA of the USA for 10 years under Bush and Clinton. He’s a centrist. He tells it like it is. He’s in the CPA Hall of Fame. He really knows his stuff. He basically said, “Look, when we did these tax cuts, we had the dessert before the spinach. We ate our dessert before the spinach.” What do we do? We dramatically lower taxes and we increase expenses to be able to pull it off. We did exactly the opposite of what most economists are telling us we need to do, which is either raise more revenue, double revenue, reduce spending by half or some combination of the two. We did just the opposite. We increased spending. We reduced revenue.
And people will confront me, and they’ll say, “Dave, you’ve been preaching the tax rates got to go up for the last 10 years,” and I’ll say, “Yeah, I have.” They say, “Well, what happened? Tax rates went down. You were predicting they were going to go up. They actually went down.” And I said, “Guess what, all Congress really did is kick the can further down the road,” which means that the fix on the back end is going to be all the more severe, all the more draconian, all the more aggressive. So, we just made problems much worse. All this really means is that 10 years from now, tax rates will have to go even higher to fix the mess that we’ve gotten ourselves in.
Casey Weade: Which furthers that point, we can’t outgrow this, because we have to reduce spending, we have to increase taxes. If we do either one or both of those things, we hurt the growth of the economy and we can’t outgrow it. It just seems like we’re in a bit of a pickle.
David McKnight: Yes. If you were to look at a graph, and if you were to consider a 5% growth in the economy, which is incredibly robust, there’s very few periods in the history of our country where we’ve sustained 5% growth for more than just a couple years. But if we were the guy from Vanguard, the chief economist from Vanguard in the movie, he says, “If we were to have some massive sort of economic boom, due to artificial intelligence, or what have you, and sustain 5% growth, 5% growth looks like this. It’s sort of this sort of flat curve. When you look at the growth of what we owe for all these programs, it’s going like this.” So, even a robust 5% growth is not going to help us pay for all of the things that we promised. There’s a massive delta between what, you know, the tax revenue the way it would be coming in as a result of 5% growth, and the actual curve, that is our spending. And there’s a really scary graph that we show in the movie, which literally shows the geometrical curve of the of the debt, and it goes up like that. And there’s no way that we’re ever going to raise enough revenue to be able to liquidate all that debt unless we can dramatically reduce spending.
And by the way, every year that we fail to cut Social Security, Medicare by one-third means the fix on the back end is going to be all the more dramatic. I mean, we have to do massive, massive cuts starting yesterday. And Donald Trump has made the promise that he’s not going to touch Social Security, Medicare during his administration. That’s potentially eight years of letting this thing snowball out of control.
Casey Weade: And we can talk about all these problems without growing the debt, but I think the biggest problem and I talked about this all the time, when it comes to the economy, when it comes to social security or Medicare, it’s a demographic issue that we have. Can you just speak to the change in demographics? Because when I have that discussion, many times people say, “Yeah, but all these baby boomers are going to be traveling. They’re going to have all this free time. They’re going to be spending money. They’re going to be taking money out of their IRAs. They’re going to be spending all this money on health care.” But I don’t think that quite cuts it.
David McKnight: It doesn’t cut it because they are not putting money into social security Medicare anymore. They’re starting to take the money out. People don’t realize it when Social Security first started out in 1935, you had 42 workers putting money into the program for every one person that took money out. So, you have all of these people putting money in, hardly anybody taking money out. When they took it out for two years starting at 65 and they typically died a couple years later. So, this program was set up to last forever. And by the way, when they started out, they guaranteed that taxes would never be more than 1%. So, payroll tax, FICA tax, whatever you want to call it, they guaranteed in writing. I’ve seen the actual code, the IRS tax code back then. It said it will never be more than 1%. And as we move forward in time, these numbers were working great and then all of a sudden, soldiers came home from World War II, and they started to do something that array to which they’ve never done before. What they started doing they started to have children. So, you may be thinking, “Great. More children equals more taxpayers equals more money going into Social Security, and eventually into Medicare, which came around as part of the Great Society in the mid-60s.”
Well, that’s not what happened because the baby boomers, remember, they didn’t have nearly as many children as their parents did. They had 30 million fewer children. So, now we have this Generation X. I’m a Generation X. We didn’t have nearly as many children as our, sorry, we had quite a few children, but we don’t have very many peers. So, we’re now in the situation where you have 30 million fewer Generation Xers. They’re trying to support 75 million to 78 million baby boomers by way of Social Security, Medicare, Medicaid, and it’s just not possible. We just can’t pull it off. 60 Minutes calls it a demographic glitch. Generation X is a demographic glitch. There’s not enough of us to be able to pay for all of these baby boomers. And by the way, it’s not just the US. It’s happening in Japan. Japan sells more adult diapers than they do baby diapers. Recently in Finland, they tried to reform their universal health care, because they’re collapsing under the weight of the programs and they shut it down. Nobody wanted to reform it. So, they’re now spiraling into bankruptcy. So, this is going to, this is all portending what’s going to happen to the United States 10 years from now.
Tom McClintock talked about in the movie how eight years from now we’re going to be Venezuela. Ten years from now I’m predicting a massive, massive increase in tax rates, if not sooner. So, the long and the short of it is you people ten years from now will look back on 2019 and say, “Why did we not take advantage of historically low tax rates?” Those were good deals of historic proportions. Nobody likes paying tax. I give them permission to not enjoy it but when compared to what it’s likely to be even 10 years from now, we just don’t even have any clue what’s about to hit us.
Casey Weade: Well, I got to say I got done watching the movie and I have followed this for so long and have felt very negative about the future of tax rates for a long time. However, I’ve still been guilty of throwing money in that tax-deferred retirement account, taking that tax deduction and I always diversified. I would throw half of it in Roth and half of it in 401(k) because I don’t really know the future. I just have this idea of what it’s going to be. I get done watching that movie. I emailed their HR director and said, “Hey, move everything to Roth. I’m going to pay all the taxes today because they are guaranteed going to be significantly higher taxes in the future.” We could beat this drum all day, but I think most people recognize and believe that to be the case. Taxes will be higher in the future than they are today. But I’ve asked thousands of people. I’ve had rooms of 100 people at a time where I’ve said, “Who in here things taxes will be lower in the future?” I’ve never once had a single person raise their hand to that question.
So, I think we can pretty much admit that everybody has this pretty good understanding. Taxes will be higher in the future. I think then we go, “Well, what do we do about it? Just we know that taxes will be higher in the future but what do we do about it?” I’ve seen statistics from Vanguard that 74% of individuals are concerned about rising taxes. However, only about 20% are actually doing anything about it. So, what can we do?
David McKnight: Well, you make a good point. If you look at the cumulative 401(k)s and IRAs in our country, if you were to add all of them up, they add up to about $21 trillion, $22 trillion which is interesting, because that’s basically what the national debt is. All you’d have to do is raise taxes to 100% on all those retirement programs and you can liquidate the debt tomorrow. But if you look at how much money is in the cumulative Roth IRAs, Roth 401(k)s, Roth conversions in our country, it’s only about 800 billion so it’s like a 22, 23:1 ratio. So, if you think of the train analogy, if you have money in an IRA or 401(k), you have your money sitting on the train tracks, and a huge freight train is bearing down and you know it’s come in in the form of higher taxes. We know roughly when it’s going to good here, we know what it’s going to feel like, but we also know what we need to do to get our money shifted off the tracks and that’s really, there’s a couple of different ways to do it. It’s how we’re funding our retirement accounts. Are we putting money into after-tax types of accounts like Roth 401(k)s, Roth IRAs? Are we doing Roth conversions where we’re preemptively and proactively paying the tax on these accounts, really trying to stretch that tax liability out over as many years as possible?
I tell people to try to get it done before 2026. Because it used to be that people say, “Dave, when are tax rates going to go up?” I say, “Well, in some distant, unknowable future, perhaps 10 years from now, tax rates are likely to go up.” Well, guess what, we now know the year and the day when tax rates will go up, January 1, 2026. We’re going to go automatically go back to the pre-2018 tax rates. We know it’s going to happen unless something, you know, unless democrats, for example, gets control of the House, the Senate, and the presidency before then, we know that we’ve got seven years to be able to systematically shift that money to tax-free. So, stretch that tax liability out over seven years. Don’t rise into a tax bracket that gives you heartburn as you make those shifts from tax-deferred to tax-free, but at the same time recognize that you do have to get all the heavy lifting done before 2026. So, in my mind, there is an ideal amount of money to shift every year. It’s the amount that keeps you in the tax bracket that doesn’t give you heartburn, but that allows you to get all the shifting done before tax rates fall for good.
Casey Weade: From my experience, and we know from the statistics, I mean, most people aren’t doing tax planning. They have this concern about rising taxes. They’re just not even doing anything about it. What are some of the top reasons you think that individuals aren’t doing their tax planning that needs to be done?
David McKnight: The number one reason why people are loath to do tax planning to preemptively and proactively do Roth converting is nobody wants to pay a tax before the IRS requires it of them. Nobody wants to pay a tax today and think that the tax rate down the road could be lower than what they’re paying today. Nobody wants to pay a higher tax rate today and get out of potentially being able to pay a lower tax somewhere down the road. So, it all comes down to uncertainty, uncertainty over the future of tax rates. People don’t want to pay a higher tax today and miss out on a lower tax rate down the road because that’s the line that we’ve been fed our whole lives. What’s the reality? The reality is that tax rates are probably going to be higher than they are today. We’ve never had more certainty around that subject than we do today. We’ve never had more certainty around the tax code. The current tax code sunsets in 2026. So, like I say, in Chapter 6 of my book, The Power of Zero, we have this window of opportunity during which to take advantage of historically low tax rates. We finally have some certainty dispelling the doubt around the future of tax rate, so why not take advantage of it?
Casey Weade: Well, I totally agree, and I still think that there’s this feeling that people have that, well, my CPA didn’t tell me to do that. My financial advisor hasn’t had this discussion with me yet. I mean, just the other day, I had a client who said my CPA wants me to set up a simple IRA for the business and the 22% tax bracket today, he’s only going to make more money in the future than he has currently. He’s in his mid-40s. And why would we put anything in tax-deferred retirement accounts at this point? Why do I see that most CPAs are not recommending Roth or not recommending tax-free strategies? And financial advisors alike aren’t having those types of discussions really encouraging people to do things like Roth conversions?
David McKnight: Yeah. CPAs are sort of a peculiar breed. There’s a couple of very proactive ones, but by and large ones, I have CPAs that are some of my best friends. I’ve got a brother-in-law that’s a CPA. Some of them get it. A lot of them, however, recognize that the key to keeping their job is to give their clients as many tax savings today. CPAs don’t get brownie points for saving you money 20 years from now, when they’re dead, right? CPAs get brownie points for saving you money today. If you get a big tax refund at the end of the year, then their clients are absolutely doing backflips. If you end up owing more money than you did last year, then all of a sudden, they’re looking for a new CPA. This is sort of the harsh reality of it. You can pay tax now or you can pay tax later. CPAs love giving you tax savings today because it makes them look like the hero. However, if the tax that they save you today is lower than the tax that you could potentially pay later on, if you postpone the paying of those taxes so some point much further down the road, they’re not the hero. They’re the goat.
So, like I said, there’s a lot of proactive CPAs that get it. They understand that there are strategies that can be brought to bear in a client’s portfolio today that can really maximize retirement income and retirement by minimizing taxes. But the vast majority of them don’t buy it. They have not adopted that strategy. They’re like the medic at the end of the battle who walks across the battlefield and say, “This is how many are dead, and this is how many are injured,” right? They’re very reactive. They’re very historical. What CPAs need to learn how to do is to be more proactive and more futuristic by saying what is your tax bracket today? What is your tax bracket likely to be 10 to 20 years from now, when you take this money out? And let’s opt for the bucket that will maximize your retirement income. If tax rates are going to be lower in the future, let’s put as much money into tax-deferred as we can today. If tax rates are going to be higher in the future, then let’s put as much money into tax-free as we possibly can.
Casey Weade: Well, and financial advisors I think when I’ve sat down with families, I was discussing this with our team of advisors the other day, we have these discussions about doing Roth conversions. So, you need to fill up that 22% tax bracket or you need to fill up that 24% tax bracket. Let’s do these conversions. We get this sense that sometimes they feel like we’re doing it for our own benefit. And it’s just the opposite but I think it’s because they haven’t heard this from another financial advisor or their own advisor.
David McKnight: Yeah. And let me just take two seconds, Casey, to talk about the 24% tax bracket. My favorite and I asked rooms full of financial advisors, what do they think is my second favorite tax bracket? They all know my favorite tax bracket is zero because if tax rates double two times zero is still zero, but they hardly ever guessed that my second favorite tax bracket is 24. And let me tell you why. Let’s say that I’m talking to my client, and they’re in the 12% tax bracket. Currently, if I were to persuade them to bump up into the 22% tax bracket, in an attempt to get them to tax-free in retirement, they’re not going to be all that invested in that recommendation. Why? Because I essentially doubled their tax rate in an attempt to get them to the 0% tax bracket. I sort of got them to pay a lot more in taxes and then attempt to save them taxes. That doesn’t make a lot of sense. However, if they’re currently in a 22% tax bracket, and they’re probably always going to be in the 22% tax bracket, why not bump up into the 24% tax bracket? That’s only 2% more. It allows you to converge an extra $150,000 to tax-free for only 2% more. We’re not talking doubling your tax rate. We’re talking increasing it ever so slightly on the margin from 22 to 24 and you can protect an extra $150,000. Why let a single year ago by where you’re not maxing out the 24% tax bracket?
So, there’s so much opportunity in this existing tax code. Most people don’t realize that if you go to the top of the 24% tax bracket today, it’s in the area of 326,000. I think that’s the top of the 24% tax bracket. If you wanted to convert up to $326,000 after 2026, that would put you in the 33% tax bracket. What an incredible savings. What an incredible tax sale that we’re right in the midst of and most people don’t even realize it.
Casey Weade: I love that. And that is why I talked about it all of our events. This is a big deal going from 15% to 12% is exciting but you go, “Well, it’s only 3%.” It’s 20% less taxes. I mean, that’s the reality. It’s a big deal. But taking away that 25%, not leaving the 24% until you get over to $315,000, $325,000 and you have a doubled standard deduction, that is just huge because now we can make more sense at Roth conversions than ever before. And I think this is an important point you made in your book when it comes from financial advisors and I think this is important for people to understand. Financial Advisors don’t benefit when you do a Roth conversion. It doesn’t matter if they are commissionable advisors or fee-only advisors if they’re doing a Roth conversion as a commercial advisor, but they’re going to be potentially having 25% less earning a commission on. If they are doing Roth conversions and they’re a fee-only advisor, they’re going to have 25% less in fees. They’re going to be able to collect over the life of that account. So, it’s important to have these conversations with your advisor and recognize that they’re doing this solely for your benefit.
David McKnight: Yeah. And that’s something I talk about in all of my workshops as well. Why do most major financial institutions not want to talk about this? It’s because how do they get paid? They charge you a fee. If they’re managing a million of your dollars, and you’re charging 1%? They’re making $10,000 per year off it. If you were to shift that million dollars to tax-free because you think that tax rates are going to go up, you might pay 25% tax along the way. So, now you’ve got 750,000 sitting into your tax-free bucket. If they’re still charging you 1%, now they’re only making $7,500 per year off you. They just experienced a pay cut for persuading you. The tax rates in the future going to be higher than they are today. And for that reason alone, the major money management institutions, the Merrill Lynchs, the UBSs of the world, they don’t even want to touch this conversation with a 10-foot pole. Casey, you and I, we don’t care how much money we’re managing. What matters to us is how much people get to spend after tax. That’s the only number that matters. And if we can pay a tax today at a lower rate than what it would otherwise be 10 years down the road, then that’s good for everybody.
Casey Weade: Well, it’s funny. I hired an advisor, hired a couple of advisors from one of the largest national brokerage firms in the world, and when he came to work for me, he said, “We weren’t allowed to talk about taxes.” Why would a financial advisor not be able to talk about tax planning? But I think you hit the nail on the head. It’s because that wouldn’t benefit their shareholders. It wouldn’t benefit the board of directors. It wouldn’t benefit the company they were working for, even though it would benefit their clients. There was something you said in the book. I just want to make sure we get it out. I think you said it in the movie as well and it just hit me like a ton of bricks. You talked about the purpose of traditional retirement accounts. Can you speak to what the purpose of those retirement accounts really is?
David McKnight: Yeah. So, we’ve been weaned on this notion that one of the primary purposes of a retirement account is to save us taxes. We put money into a 401(k) so we can save taxes. Our CPA says, “Hey, do a SEP IRA, so you can save money in taxes.” Well, guess what? The true purpose of a retirement account is not to save you money in taxes. It’s to increase. It’s to maximize your retirement income at a period in your life, when you can least afford to pay the taxes. That’s the true purpose of retirement income. And to the extent that we start fixating on that, as opposed to how can I save the most money today, that’s when we’re going to start to solve this retirement crisis.
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Casey Weade: Yeah, I love that. Maximize after-tax income at a point in your life you can least afford to pay the taxes. I think that just drives all the sense in the world and it really hit me strongly. I think one of the things as we get into what we can do specifically, in order to get these tax-deferred dollars and to tax-free dollars, let’s just give the audience a quick overview of the tax buckets and the three tax buckets that you talked about.
David McKnight: Yeah. We’ve been told that there’s millions of different types of investments out there. There are millions of different types of investments but I’m here to tell you that all of those investments basically fit into only three types of accounts. I refer to these accounts as buckets of money. The first bucket is what we call a taxable bucket. These are going to be investments where you pay a tax every year, rain or shine. You’re going to pay tax on the growth of that money. These are CDs, money markets, brokerage accounts, mutual funds, stocks, bonds, anything that produces a 1099 is going to cause a taxable event every year. It doesn’t seem like a big deal. But every year you’re paying tax, that’s eroding the growth of your money over time. You amortize that. That inefficiency, that taxation, you amortize it out over 30 years, it could cost you a million dollars. How can you tell where the government wants you to put money? Well, what account Do they have no limit on how much you can put in? Like a brokerage account. Yeah. If you won the Powerball lottery, you can put every last dime of those savings, every last dime of those winnings into a mutual fund and the government would just love it. They would just take it to the bank because they’re making taxes each and every year.
So, the taxable bucket, we want to be careful because it’s the least efficient of all the buckets. We pay taxes every year that erodes the growth over time. So, really, most financial experts can agree upon this, that you want to have no more than six months where the basic living expenses in that bucket. You want to have not too much money so that it’s growing tax efficiently, but you want to have not so little that you’re not prepared for an emergency. So, that’s a taxable bucket. Pretty straightforward. A tax-deferred bucket is the one that most people are familiar with because they’ve been saving it most of their lives, 401(k)s, IRAs, 403(b)s, 457s, annuities, pensions, those types of things. They have two things in common. First thing they have in common is, generally speaking, when you put money in, you get a tax deduction. So, for example, if you’re making 100,000 per year, you put 10,000 in your 401(k), your new taxable income is 90. But the second thing they have in common is how they’re taxed upon distribution. And the IRS has a special word that they use to characterize that income when it comes out. They call it ordinary income. What does that mean?
That means when you put money in, all you really did was defer the receipt of that income until some point much further down the road when you take the money out, what rate are your tax? Well, whatever tax rates happen to be in the year you take that out and based on the fiscal landscape of our country that promises to be probably substantially higher than it is today. So, we have to be very, very thoughtful about how much money we can have in our tax-deferred bucket. It’s okay to have some money in our tax-deferred bucket because some of those required minimum distributions at 70.5 are going to be offset by our standard deduction. But we don’t want to have so much money that it overwhelms the standard deduction and any distributions coming out of the tax-deferred bucket also count as what we call provisional income, which causes your social security to be taxed, which causes you to spend down all your other assets to be able to compensate. So, really, we want to have only so much money in that tax-deferred bucket enough to be able to be offset by the standard deduction, but also keep our provisional income low enough that our Social Security is not taxed. And then the third bucket is…
Casey Weade: Before you get to the tax-free bucket, there’s an important point you made on the tax-deferred bucket, which is that’s like a loan, right? You basically loaned money, and the IRS is eventually going to want that money back. You get a loan, a personal loan from a banking institution or an individual. You have a set interest rate. You know what it’s going to be, but with the government, they can change that interest rate only at some point in the future.
David McKnight: Yeah. The analogy that I use is almost as good as the analogy that Don Blanton uses in the movie. I’ll do both analogies and you’ll see that Don Blanton’s is much better. The analogy I typically use is when you put money into an IRA or 401(k) it’s like going into a business partnership with the IRS. Every year, the IRS gets a vote on what percentage of your profits they get to keep. It doesn’t sound like a very good business partnership. The way Don Blanton describes it, and I haven’t mastered his ability to tell the story but it’s an amazing and compelling comparison. He basically says, “What if the federal government came up to you and said, ‘Hey, look, I’m going to loan you some money. I’m not going to tell you what the interest rate is. I’m going to let you spend that money. And then at some point much further down the road, I’m going to come back and ask that you repay that money. I’m not going to tell you what the loan interest is until the year in which I need you to repay it. And by the way, currently, I have $22 trillion of debt. By the time I want you to repay it, I may have posted a $40 trillion of debt. Would you take that check from the federal government?’ And the answer is not in a million years, you wouldn’t.” Don Blanton explains that incredibly well. It sends chills down my spine just thinking about this but how apt an analogy is that?
Casey Weade: Well, if we don’t want that kind of partnership, which we don’t, let’s get to the tax-free bucket.
David McKnight: That’s right. So, the tax-free bucket basically says we proactively and we preemptively pay taxes on these accounts, because we think that tax rates there are going to be lower than they will in the future. Once that money gets into tax-free, no matter how much it grows from that point forward, no matter how high tax rates go from that point forward, it doesn’t matter. We’ve insulated and protected ourselves from the impact of higher taxes. I tell people, “Hey, let’s try to get to the 0% tax bracket. Why? Because of tax rates double two times zero is still zero.” So, the only way to truly insulate yourself from the threat of rising tax rates is to get to a tax-free scenario in retirement.
Casey Weade: Well, what falls into that bucket? One, I mean, we know Roths. We pay the taxes today, grows tax-free in the future. We can pull the money on tax-free. There aren’t required minimum distributions. But then there’s another, I mean, there’s hardly anything in that bucket and municipal bonds don’t even fall into that bucket. Municipal bonds don’t fall into that bucket because they affect your provisional income and affect the taxes you pay on Social Security. There’s only two things. There’s Roth and then there’s this thing you call LIRP. Well, what is LIRP?
David McKnight: Yes. So, LIRP is what I call, and people can call whatever they want. In Chapter 5 of my book, I call it a life insurance retirement plan. Basically, it’s a bucket of money that gets treated differently for tax purposes than any of the other buckets that we’re customarily familiar with. What happens with this bucket is you put money in, you make contributions. As your money grows, your bucket begins to fill. Only the IRS is going to treat the growth on the money in that bucket under a different section of the IRS tax code than any of the other plans that we’re familiar with. What does that section of the IRS tax code say? It says, you can touch the money pre-59.5 without penalty. You can’t do that in your IRAs or 401(k)s. As your money grows, you receive no 1099 so no tax as it grows. When you take the money out, does not show up as reportable income on your tax return. What does that mean? That means it’s tax-free and does not count as provisional income, which means it does not cause your Social Security to be taxed. They’re also going to tell you that there are no contribution limits. They got clients to do $50 a month. I got clients that do 200,000 per year and everywhere in between.
They’re going to tell you that there are no contribution, sorry, no income limitations. And the question I like to ask people is can Bill Gates to a Roth IRA? And the answer is no, Bill Gates cannot do a Roth IRA. He makes too much money. You start making north of about $203,000 of modified adjusted gross income, you can no longer do a Roth IRA. Those income limitations do not apply to this bucket. You can make a million dollars a year and still put money into this bucket. They’re also going to tell you that if history serves as a model, there is no legislative risk. What does that mean? That means that they’ve changed the rules on this bucket three different times ‘82, ‘84, and ‘88. And every single time they change the rule, they simply said, “Whoever has the bucket before the rule changes gets to keep it and continue to put money into it under the old rule for the rest of their lives.” We call that a grandfather clause. So, we have this bucket that has a lot of very attractive attributes. And usually, at this point, people say, “Well, Dave, that sounds like the perfect bucket. Let’s put all my money into there.” Well, I tell people all the time, it’s never a good idea to put all your eggs in one basket. And not only that, but the IRS says that, in order to do this bucket, there’s a cost of admission. They’re going to require that there’ll be a spigot attached to the side of that bucket through which flows on a monthly basis some expenses. What do those expenses go towards? They go towards the cost of term life insurance. So, long and the short of it is you got to be willing to pay for some term life insurance or some other administrative expenses in there, but you got to have a need for life insurance.
Now, a lot of people that are approaching retirement, say, “Hey, look, my house is paid off. My kids have moved out. I’m rapidly approaching retirement. I don’t really need life insurance,” and a lot of the companies that sponsor these programs, they recognize that so they’ve done something to sweeten the pot. They simply say that in the event that somewhere down the road, you should need long term care or have what we call a chronic illness, they will give you your death benefit while you’re alive, for the purpose of paying for long term care. So, that can be a very, very attractive way to pay for long term care insurance. People don’t like traditional long-term care insurance, because it’s a use it or lose it proposition. In this scenario, if you die peaceful in your sleep 30 years from now, never having used the long-term care portion of it, someone’s still getting a death benefit. So, there is the sensation of having paid for something you hope you never have to use.
So, some people say, “Well, this sounds like a silver bullet.” It’s a panacea. Let’s put all our money into there. It’s not a perfect investment. But it does something that none of the other tax-free investments is able to do. So, what I say is let’s take a complementary approach where we couple the LIRP with our Roth IRAs and our Roth 401(k)s and our Roth conversions, and taking money out of our IRAs up to standard deductions. And then if we do it all in the right way, our Social Security is tax-free. Let’s have multiple streams of income. But the LIRP can be a very attractive complement to all of those other streams of tax-free income.
Casey Weade: We’re talking about an overfunded life insurance policy meaning we put more in it than we needed in order to support that death benefit. So, we end up getting this side account that’s growing tax-free. And this is something that I’ve used for the last 10 years. It’s something that my dad uses, my mom uses, the majority of my family’s life savings or annual income savings goes to these vehicles. Dan Sullivan, who I’m a big fan of, he talks about how this is one of the best things that he has in his investment portfolio and so I’m a big fan. And I think one of the reasons is I am still putting money in Roth. I’m still maxing out my Roth. I think there’s this natural sequence of where we go with those dollars, whether it goes from HSA, then we go to our Roth 401(k), then we go to other options, we have to go to life insurance, because we run out of options, especially as our income goes up. And there’s a reason for this diversification from these two different tax-free options. We don’t just go straight to the life insurance policy. We’re going to have some Roth. We’re going to have some cash value life. We’re going to have our HSA. Can you speak to the difference in legislative risk between a Roth IRA and a LIRP?
David McKnight: Sure. What we would likely see with a Roth IRA is if they were to ever change the rules somewhere down the road, and say, “Okay. Roth IRAs are off-limits. You can no longer contribute to a tax-free account.” I don’t know why they would ever do that, because Roth IRA is almost certainly ensured that they’re going to get more tax revenue today than they do in the future, because we’re using after-tax dollars, but if they were to ever to make those accounts go away, they would likely say, you get to keep whatever’s in your Roth IRA. You just don’t get to contribute anything more to it. The thing that makes these life insurance policies unique is that to make them function properly, you have to have the ability, the option to continue to put money into them over time. So, every single time they change the rules on these things, they simply said, “Whoever has the bucket gets to keep it and continues to support and continue to put money into it under the old rule for the rest of their lives.” I talked to people occasionally who say I’ve got a life insurance policy from 1978. And they start to describe these crazy rules, like I can put $100,000 in it per year, no problem. And that was what the rule was back in 1978.
Casey Weade: And they still do it.
David McKnight: Yeah. It doesn’t exist anymore, but they can still do it because they got grandfathered under the old rule. And so, that’s typically how these things are treated. So, that’s a pretty major difference between the traditional life insurance grandfathering and what would likely happen to a Roth IRA.
Casey Weade: So, we start feeling like this is a great idea. We need to set up this other legislative diversification for our investments, not just investments between stocks and bonds, but we want to have some tax diversification as well to protect us against legislative risk. We want to add this LIRP to our toolbox. And so, we hop online, we hop on Google, and we start googling life insurance as tax-free income. We look at be-your-own banker concepts or family banking concepts. And I think about half of those articles that you read out there talk about the agent receives this big commission that comes directly out of your pocket. You’re going to pay exorbitant expenses and fees. It’s a horrible investment vehicle. What do you say? And what do you say to those individuals? What do you say to those articles that are out there talking about excessive fees and expenses?
David McKnight: Well, I think that the Dave Ramsey’s of the world and some of those online financial gurus, they love to beat up on these approaches, because the fees for these programs tend to be somewhat front-loaded. This is how I described the fees in life insurance retirement plan. Say look, they’re a little bit higher in the early years, but they’re much lower in the later years but when you average out the expenses over the life of the program, it ends up being about 1% to 1.5% of your bucket per year, which if you think about it is about what most Americans are paying in their 401(k). The thing with the 401(k) is that the fees on 401(k)s are more backloaded. What do I mean by that? Well, if you’re paying 1.5% on a 401(k), you put in $10,000, you’re paying $150 that first year. But guess what, if your 401(k) grows to a million dollars, you’re still paying 1.5% 30 years later. Now, you’re paying $15,000 per year. So, the fees really are sort of inverse what they are with the life insurance. With life insurance, the longer you keep it, the better it gets. The lower the internal expenses, the higher the internal rate of return.
So, it’s not really fair to judge life insurance policies or life insurance retirement plans based on what the fees are in the first year, because there’s a lot of expenses to get the program up and running. You’ve got to pay for the medical exam. You’ve got to pay for the underwriting. You’ve got to pay for the advisor that’s helping you to get the plan implemented. There’s a lot of expenses that happened in the early years but as time wears on, those expenses dropped dramatically. And it’s like a pie, you got to let it bake, you got to let it marinate, you got to let it build up a head of steam. And if you do, what you’ll find is that the expenses, on average per year over the life of the program are incredibly low. I would even make the claim that they’re lower than most 401(k)s. You just have to have some patience, and let the thing marinate over time.
Casey Weade: Well, I also want to say I think there’s some truth to some of those articles out there because it has to do with how the policy is structured. We have to keep the death benefit as low as possible, and how do advisors make more money? The bigger the death benefit, the higher the cost, the more they make. And so, can you just speak to how to properly structure a policy in order to keep those costs as low as possible and get to that 1%, 1.5% average cost?
David McKnight: Most people when it comes to life insurance, they get as much death benefit as they can for as little money as possible. Here, we’re trying to do just the opposite. We’re getting as little death benefit as the Irish requires of us. And we’re stuffing as much money into it as the IRS allows in an attempt to mimic all of the tax-free benefits of the Roth IRA, without any of the limitations thrown a death benefit that doubles as long-term care. And we’ve got a pretty compelling financial tool that serves as a very, very attractive complement to our other tax-free streams of income.
Casey Weade: Well, I think that’s an important point. I mean, you say, “Well, I’ve got this $50,000 annual premium. I’m only getting a $2 million death benefit.” And you say, “Well, that’s a pretty bad deal because traditionally I would be paying, say $10,000 or $5,000 for that $2 million death benefit, and now I’m paying way more than that. But that’s okay because we’re not trying to dump that $5,000 or $10,000 in there and never see it again. We want to get some return on this. We’re going to overfund it and keep those costs down over time. Then the next decision is what kind of policy do we use? And historically, and I think still today, one of the top tools out there, people are using whole life insurance as a strategy. But then you’ve also got the strategy. It’s been around for say, 20 to 25 years or so indexed universal life, then there’s variable universal life that’s been around a little bit longer than indexed. And that’s where it starts to get a little confusing. What’s the difference between whole life, indexed, and variable? Which one’s the right tool for me?
David McKnight: Yeah. And you talk to a different advisor, you’ll get a different answer. I personally have written a whole book on why I believe that index universal life is the appropriate life insurance type to be able to use in this type of scenario. And the reason is that when you put money into an index universal life policy, the money in that growth account is the core, at least the growth of the money in that growth account is linked to the upward movement of a stock market index. You get to keep whatever that stock market index does, say the S&P 500, up to a certain cap. That cap might be 12%. If the stock market ever goes down in any given year, they simply credit you as zero, so you’re always going to be between 0 and 12, or whatever the cap happens to be. So, if you look at historical rates of return, we’re talking 7%, 7.5%. You subtract that 1% to 1.5% fee off of there, and then we’re talking a net rate of return of say 6% over time. Guess what? If you can get 6% in your LIRP without taking any more risk than what you’re accustomed to take into your savings account, that’s a pretty safe and productive way to grow at least a portion of your portfolio. And that’s why I’m a big fan of IUL.
Some of these life insurance policies out there, I think whole life, there’s a place, there’s a time and a place for whole life. It’s not my favorite approach with this type of worldview. It could still work. It’s just tougher. The thing that you don’t want to have happen is have the rate of return in your life insurance retirement plan to be so low, that when you take money out of an account that maybe was earning 6% or 7%, and you stick it in a life insurance policy that’s only grown at 3%, then that reduction in rate of return can neutralize a lot of the tax benefits, which were the justification for doing the policy to begin with. So, if we can keep the rate of return within the life insurance retirement plan similar to the rate of return that you were growing in that investment that you liquidated in order to fund the life insurance policy, that’s an ideal scenario.
Casey Weade: Well, I think that also has to do with how you get the money out tax-free in the first place, which gets into wash loans and participating loans. Can you just kind of talk through how we get money out of these in a tax-free manner, and maybe even share with us the difference between whole life and index universal life when it comes to those participating loans, or loan caps and zero wash loans?
David McKnight: So, there’s a way that you have to distribute the money from these policies. I always tell people, if you take the money out of it, take it out the right way, it’s tax-free. It does not show up on your tax return. And the way you do that is you take a loan from the life insurance company, and you use the cash value inside your policy as collateral for that loan. So, I’ll give you an example. Let’s say I got a million dollars in my IUL. I wake up one day, I want to take a loan of $100,000. I call it my life insurance company, I say, “Hey, send me $100,000.” They say, “Okay.” They then cut me a check from their own coffers for $100,000. That’s the check I get in the mail three to five business days later. They have to attach a real rate of interest to that loan, let’s call it 3%. It’s got to be an arm’s length transaction. They’re telling the IRS it’s a loan. They’ve got to have an arm’s length transaction, a real rate of interest that they’re attaching to that loan. It’s called 3%. Well, in the very same breath, the life insurance company will take $100,000 out of your growth account inside your life insurance policy and they’ll put it in what we call a loan collateral account which is also if it’s the right company also growing at a guaranteed 3%.
So, even though your loan interest is accumulating on the one hand, your loan collateral account is mirroring it step-for-step. So, if your loan account grew to a billion dollars, then you would be guaranteed to have a loan collateral account that matches it, which will pay off that loan at death. All you know is that you asked for $100,000, your growth account went down by $100,000, you didn’t have to pay tax on it, and you know, it’s all good. And if you die with at least $1 in your bucket, then it’s all tax-free to you. So, it’s very, very interesting. It’s very, very compelling. All you know is that you didn’t have to pay tax. It felt like a distribution from Roth IRA over time. It’s not a Roth IRA, but the tax-free nature of it made it feel like a Roth IRA.
Casey Weade: And I think one of the risks is and I think you kind of alluded to this, interest rates go up, right? So, interest rates skyrocket. That may not improve the profitability of a whole life carrier and actually pay you a higher dividend to match that higher loan rate but when you look at IULs, they act differently and can be more beneficial in a rising interest rate environment.
David McKnight: Right. So, cap rates are typically associated with rising interest rates. So, rising interest rates simply mean that insurance companies, they have more money to be able to pay for these options that I don’t want to get too complicated here, these options that they’re using to make the whole IUL work. So, as interest rates go up, the cap rates go up, which means you are allowed to capture more of the upward movement of the stock market index. You talk about participating loans. Basically, what a participating loan says is instead of charging you a 3% interest in your loan collateral account, maybe they’ll charge you a little bit of a higher rate of 5%. But then they’ll say in your growth account, they’re not going to take the money out and put it in a loan collateral account. They’re just going to leave it in, in the index, and whatever the index does, then that offsets whatever the cost of the loan is in your loan account with the life insurance. To give a quick example, if they’re charging you 5% for the loan, but your index grows at 10%, guess what? They just paid you 5% for taking that loan. And granted, you’re not going to get 5% every year but if you could just net 1% on average per year over the life of your retirement, that 1% what we call arbitrage and literally double the amount of money that you can take out of these programs which, boy, I’ve seen the numbers, and when you look at the numbers, and you compare them to every other investment out there, it looks very, very attractive.
Casey Weade: Yeah. And I think one of the things that’s unique about IULs that is one of the big benefits as long as you get with the right carriers, a lot of these carriers will guarantee they’re going to credit you the same amount of interest as your loan rate is ever going to be. So, you never have to worry about policy collapsing due to that particular factor. But I think maybe we’re getting too far down the rabbit hole here. I think one of the things as people are listening to this they go, “I’ve never heard of IUL. I’ve never heard of LIRP. I’ve never heard some of these terms. Why isn’t my financial advisor having this conversation with me? I think that we’re seeing more advisors have these conversations. We’re seeing more than mainstream brokerage houses start to utilize these types of vehicles, these types of products, for the clients they’re working with but why do you think it’s taken so long for this to catch hold? And why are most financial advisors not talking about these tools?
David McKnight: I think that, historically, these life insurance retirement plans have been loaded down with expenses. They’ve been very expensive. They’ve been not very efficient. They sort of just trundle along getting people 3% to 4% growth. Well, guess what. Life insurance companies recognize that there’s a section of the tax code that allows for – Ed Slott, he’s done six PBS specials. Ed Slott, USA Today calls him America’s CPA. Ed Slott says the single greatest benefit in the IRS tax code is life insurance. Why would a guy of Ed Slott’s repute say on PBS, no less, over and over and over again that life insurance is the single greatest benefit in the IRS tax code? Well, guess what? Companies have engineered these programs. They’ve evolved these programs over time such that the expenses are so low that like I said, when we average that over life, the program that they’re less expensive than the average 401(k). So, they’ve been able to re-engineer these policies so that they’re very, very low expense, they’re very efficient, they accumulate money very, very quickly and safely and productively. And some of these evolutions and these reengineering of these programs that happened only in the last 10 years, I have been studying these types of programs for the last 20 years of my life. I’ve seen these things evolve over time. I’ve seen all of the reduction and expenses and the addition of variable participating loans versus just the standard wash loan.
There’s all these different things that have made these programs so much better, the addition of the long-term care or chronic illness rider that allows you to get the death benefit before you die from perhaps long-term care. These programs are so good and so compelling, that I think that some advisors are just behind the curve whereas guys like you and me, Casey, who have been studying this for so many years, we understand it. I’ve written books on how to understand these things better. They’re not something that you can pick up overnight. So, I think that more and more financial advisors are going to start to embrace these as they start to recognize how an unlimited bucket of tax-free dollars can really be a boon to the average American in a rising tax rate environment.
Casey Weade: Well, we’ve covered so many topics from the future of tax rates, tax planning, talked about Roth conversion, and then we got the LIRPs. I’ve just got a handful of miscellaneous questions that I’d like to get out there that I think can be really beneficial to individuals, even advisors for that matter. I think, typically, as a financial advisor, we’re coached to help people through our clients’ emotional roller coasters. They might go on, “Don’t panic when the market tanks.” But I think there’s also an element of emotional coaching that we can do, behavioral coaching we can do around taxes at the same time. What do you have to say about tax-based emotional decisions?
David McKnight: In terms of do we sort of have a hair-trigger response to…
Casey Weade: Well, let me say this. I’ve got a couple that I worked with recently where a couple of years out from retirement, and I’ve gone, “You know, let’s just fill up this 24% tax bracket. You’ll be tax-free for the rest of your life.” I show them the analysis that proves that it’s going to be better to pay the taxes today. They can see it with their own eyes, but they just won’t pull the trigger. And you need to do this, but they just don’t want to pay the taxes. They don’t want to pay the taxes, and it’s all emotional because they have the facts. What should I do in that situation?
David McKnight: That’s a good question. We see that a lot. And I tell people all the time, “I give you permission to not enjoy paying the taxes, but you have to consider the alternative.” You know, the number one question I get when I do my workshops is am I too old to get to the zero percent tax bracket? And I simply tell people that we barnstorm across the country filming The Tax Train Is Coming, interviewing George Shultz. We interviewed David Walker. We interviewed Ed Slott, Tom Hegna, Don Blanton. We interviewed the Governor of Utah. We interviewed every major professor in academia from the most prestigious schools across the country, and they’re all saying in ten years, tax rates are going to be dramatically higher than they are today. Some of them even said tax rates are going to have to double. Tom McClintock said, “We’re going to be a Venezuela in eight years.” So, if people don’t want to pull the trigger, it’s because we haven’t convinced them I guess, of the urgency of the situation. If they knew what was coming around the bend, they would get that money, shipped it out of there, and they’d say 24% is a good deal of historic proportions. I’m going to not let a year go by where I’m not maxed out on my 24% tax bracket.
So, we’re not saying don’t pay taxes. We’re saying, “Look, when given the choice between paying taxes at today’s historically low tax rates or postponing the payment of those taxes to some point further down the road, you’ll probably be better off paying them today.” So, it’s just, yeah, you don’t have to enjoy it but consider the alternative. That’s really what it comes down to.
Casey Weade: Well, that brings us to that 24%. Again, I just love that 24% tax bracket. I say fill it up. Once you factor in social security taxes, potential Medicare premium penalties, and the future of tax rates, you can pretty well be assured you’re probably going to pay higher than 24% in the future. In my mind, our advisors have attended Ed Slott’s event. They attended right after we saw TCJA go through, the Tax Cuts and Jobs Act, also known as the Trump Tax Plan. That went through, we went and updated our IRA knowledge. Ed Slott is like the premier IRA expert in the country. And at that event, he said, “I would convert all the way to the highest tax brackets that we currently have. There is no perfect tax bracket.” And I wonder, first of all, that seems pretty darn aggressive. But I wonder what you think. How high should we be going? Should we go just to the 22, 24? How do we find the right balance for ourselves?
David McKnight: Yet going from 24 to 33 is a pretty big leap. So, I don’t know if I’m quite as aggressive as Ed, although I love Ed, and he’s a friend of mine, I would probably say, “Hey, look, if you’re currently in the 22, that means you’re the line 10 on your tax return, which is your taxable income, that means that you probably have $100,000 of taxable income. That means that you can I think the top of the 30, top of the 24 is like 326,000 in change, something like that, that means that you have, what is that, $226,000 per year that you could convert without bumping out of the 24% tax bracket. That is a lot of money. And if you can do $224,000 per year over the next seven years, that’s $1.5 million that you could get shifted. Now, if you have more than $1.5 million that you need to shift, then you could certainly entertain bumping up into the 30 to 35 or the 37. But I would say at the very least make sure that if you’re okay with the 22, then you’re almost certainly going to be okay with the 24. And why not max that thing out as well?
Casey Weade: You seem pretty confident that we’re going to see these tax rates last until the end of 2025 resetting in 2020. I have interviewed other people that have said they’re definitely not going to last that long. Why this confidence that you’ve got this set period?
David McKnight: Well, because people got to remember that in order for this to change that you need control of the House, you need control of the Congress, and you need the presidency. You need all three of those things. Now. I happen to think that these things go and go in cycles, the pendulum swings one way, then it swings the other. I think that in this period of relative economic prosperity, Trump’s going to be very, very hard to beat. Remember Clinton said, “It’s the economy, stupid.” Most of the prognosticators say that if this economy continues to do really well through the election, that Trump will be almost impossible to unseat. And then you say, “Okay. Can the Democrats win back? They’ve already won back the House, but can they win back the Senate as well?” That might be a trick as well. So, those stars really have to align for the democrats for us to see a change to this before 2026.
Casey Weade: Okay. Yeah, that’s good insight. And now I just have one more maybe tactical question for you before we move on to those higher-level philosophical questions. And that is some people, I think we’ve all been told put your money in your 401(k). If you’re getting the match, put as much in there as you can get that match and then put that money somewhere else. Maybe get your match and then put it into a Roth IRA or a LIRP, look for another tax-free alternative. If all we have is a tax-deferred 401(k) and a tax-deferred match, are there reasons in your mind that we shouldn’t even put money in there for the match?
David McKnight: I’m a big fan of the match. I like the match. Not everybody agrees with me. But I think that if you can say get $1 for $1 match up to 6% of your income, you’re doubling the return on your investment that first year. And remember, you need to have some money in your tax-deferred bucket. What better way to get money into your tax-deferred bucket than by putting up to the match in your 401(k)? Because remember, when you retire, you’re going to have a standard deduction and that standard deductions got to offset something. And if you have all your money in tax-free, then your standard deduction is going to sit there languishing, and it’s not offsetting anything. So, you’ve got to have some money in your tax-deferred bucket. Why not put money up to your match, to be able to get money accumulating and growing in that account so that by the time you retire, you have the standard deduction, which if you’re married today is 24,400 that you can use to offset distributions from that bucket. So, I think it’s okay to have money into a match. I sort of draw the line that putting money above and beyond the match.
Casey Weade: Now, if you have a pension along with that 401(k) that you expect to receive in the future, does that change your mind on that fact? Because now maybe we don’t want anything in that tax-deferred bucket, because we already have a lot in that tax-deferred bucket in the form of a pension.
David McKnight: I still like the free money. I still think that once you get it in there, you’re still going to be able to shift the money out of there to tax-free and be able to do it in historically low rates at 22 or 24. Remember, this type of planning is especially compelling for people that have pensions. Why? Because your pension counts as provisional income. It’s going to cause your Social Security to be taxed. In retirement, the social security and taxable portion of your social security and your pension will fill up the 10% and 12% tax bracket or the equivalent, the future equivalent of those tax brackets. And any money you take out of your IRAs and 401(k)s is going to land right on top of that and be taxed at the 22% tax bracket or the future equivalent of the 22% tax bracket. So, guess what? If you’re currently in a 22% tax bracket, and your retirement tax bracket is going to be at least 22%, why let a single year go by where you’re not maxing out the 22% tax bracket? And by the way, 24% is only 2% worse so let’s max that out as well. So, I happen to think that people that have pensions, the Power of Zero worldview, the Power of Zero roadmap to retirement is even more compelling.
Casey Weade: Now, do you get a lot of and you’ve talked to, I mean, you wrote the book Power of Zero, get this book, Power of Zero, get the movie, Power of Zero. Do you have many people that are maybe a little skeptical and say, “Zero? Come on? I’m always going to pay taxes. There’s no way I ever get to 0%.”
David McKnight: Yeah. I’ve had people, especially really conservative, most libertarian people on Facebook, that will send me messages. They’ll just see. They don’t know what my book is about, but they’ll see the title, the Power of Zero and they’ll say, “Everybody should be paying taxes. You’re getting stuff from the government. You should be paying taxes and you’re a freeloader if you think you’re going to not pay tax.” Listen, we’re not suggesting people not pay tax. We’re just suggested that when given the choice between paying taxes at historically low tax rates or postponing the payment of those taxes until some point much further down the road, mathematically, you’re better off paying them today. So, that’s really all we’re saying. We have other people that say, “Dave, there’s no such thing as a 0% tax bracket.” And I say, “True. There technically is no such thing as a 0% tax bracket. But if you’re living on a lifestyle of say, 200,000 per year in retirement, and you’re not paying a single dime to the IRS, what better way to call it than 0% tax bracket?” Tax-free, 0% tax bracket. I mean, I just really love the way that falls off my lips, 0% tax bracket. There’s power in the zero because of tax rates doubled two times a year is still zero. So, I call it the zero even though there’s no such thing. You know, if you look at the IRS tax table, it’s 10, 12, 22, 24, 32, 35, 37. There’s no such thing as a zero. But if you’re tax-free, you and I, Casey, we can call it zero.
Casey Weade: Yeah. We’re not talking about violating the law here. We’re doing tax planning. We’re still paying our taxes. We’re just not paying more than then we’re legally required to pay. There’s no benefit to your morality or ethics by paying more than you’re legally required to. And I think that’s an important point. Now, I’ve got one last question as we wrap up here today. And this has to do with your thoughts on retirement. What does retirement mean to you?
David McKnight: Retirement and I think my thoughts on retirement near a lot of the rising Generation X and even some of the back end of the baby boomer generation. I don’t know that I love what I do so much that I don’t know what I would do, frankly, Casey, if I did retire. Retirement to me means doing what you really love doing. And for me, that means being in the in a position where I have the option of not working one day because I want to go on a vacation or I want to spend time with my grandkids or what have you, but just be in a position where I have the option of not working. If work is what brings people pleasure, and it gives them purpose and it gives them aim in life, I think that that’s what they should be doing. And what we’re seeing more and more, Casey, is that people aren’t retiring outright. They’re saying, “Let’s put ourselves in a position where we don’t have to work if we don’t want to, but we love the drive and the purpose behind having something that really engages us day in and day out.” And people are going to live longer lives when they have that purpose-driven retirement versus simply retiring and waking up, playing golf for two weeks, and then trying to figure out what you’re going to do after that, right?
Casey Weade: Well, that’s why I named the book Job Optional, because I see more and more people that I’m working with that love their careers. They want to keep working. They just want to do it on their own terms, on their own schedule. And it seemed like that’s what you’re doing. You’re living in Puerto Rico and kind of working when you went to work. You’re doing the dream job of your own and that’s pretty neat. And I think you’re sounding the horn, you’re warning people about raising taxes about something they need to be aware of, and sometimes that can be a little depressing. However, you’re also following that up with hope and putting together strategies and helping people put together plans to make sure that the retirement doesn’t get destroyed by higher taxes in the future. And for that I thank you. You’re doing the world a wonderful service. So, thanks for joining us here today.
David McKnight: It’s been my pleasure. Thanks for having me, Casey.