Social Security was never intended to be a retirement program. It was merely insurance against living too long.

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This month’s book review and notes are from The Power of Zero - How to Get To the 0% Tax Bracket and Transform Your Retirement. Learn more about David McKnight over davidmcknight.com and listen to his podcast via YouTube. Fitting since we are just about to close out tax season. Perhaps, the lessons in this book will change the way you manage your money to be more tax efficient now and always.

With a compelling title like that, why wouldn’t you reach for this book. I actually had to take this book out of the library twice because I had failed to read it the first time around and it was on short-term loan. Don’t you hate it when that happens? Lucky for me, it was available on a subsequent library visit.

The Power of Zero takes on taxes, an all important topic and one that I have been delving a bit into since it’s not my area of knowledge. There’s a whole lot of question and answers and guesses on the internet regarding the future of taxes. Of course it’s hard to predict and hard to guess what the rate will be given so many variables, but it’s good to be aware of the consequences of taxes on your potential take home today and down the line, but based on some historical data, we currently have the lowest tax rates to date. This is the best breakdown I could find “How Have the Top and Bottom Income Tax Brackets Changed Over Time?” from the National Taxpayer’s Union Foundation. If you’ll note, not only is income for the highest tax bracket higher, but the tax rate is fairly low when compared to all of the other years. So it seems like today is the day to pay taxes instead of tomorrow.

In The Power of Zero, the author David McKnight, goes through a few scenarios why and how to ensure the taxes at retirement are lowered. He first talks about the power of deductions and how they are the most powerful avenue during our working years, but when we get to retirement, many of us will no longer qualify for these deductions so while we may think our incomes won’t be as high because we aren’t working, we may be taxed more because we don’t have qualified deductions. He also talks about the taxation of Social Security benefits and how it can be prevented by ensuring your other retirement accounts don’t get counted as provisional income upon withdrawal. He also suggests LIRP, Life Insurance Retirement Plan, which I had never heard of and will try my best to summarize and explain below.

Why Deductions Won’t Help Lower Your Taxes in Retirement

Generally in our working years, there are more deductions that we can take advantage of, but in retirement all of these deductions will be phased out which will result in higher taxes. This is an important point that McKnight pointed out and frankly, I’ve never thought about. Last year was the first we ever had mortgage interest. We never donated enough to need to itemize and our employers offered retirement plans so these deductions really didn’t have a big effect on us.

• Mortgage interest - By far the number one source of deductions for those who itemize, but hopefully by the time you retire, you've paid off your home and therefore won't be able to take advantage of this deduction. It’s also important to note that through the latest tax reform, for tax years 2018 through 2025, the standard deduction will be $12,000 for single filers and $24,000 for married couples filing jointly. That's close to double the levels in 2017. Unless you live in a very expensive house and in a very expensive area, which we don’t, the standard deduction works for us. This also means that the clock is ticking for when the tax change could change in 2025.

• Children - Children are a tax credit and a credit is far more valuable than just a deduction since a credit is a dollar for dollar reduction in your tax bill. It will be very rare that children will be living with you in retirement and even if they are, they are likely pass the age to be counted as dependents. This tax credit is one of the simplest and most rewarding tax breaks, and it has doubled over the last two years, benefiting families even more than before. This year’s (2019) child tax credit amounts to $2000 per child.

• Retirement plan contributions - By the time you are retirement, you hopefully are no longer contributing because you are withdrawing instead.

• Charity - While charitable contributions are a big source for deductions during working years, in retirement, because the income is lower or the prospect of income declines, more people opt instead to donate their time instead of their money which means lack of charitable contributions for a deduction.

The Idea of Provisional Income

I learned something new in this book and it is called “provisional income.” Provisional income, according to Investopedia, is “an IRS threshold above which Social Security income is taxable. The base, from §86 of the Internal Revenue Code (IRC), triggers taxability Social Security benefits requiring its inclusion in gross income tax payment on excess amounts.”

The most common sources of provisional income:

• One-half of your Social Security income

• Any distributions taken out of your tax-deferred bucket (Traditional IRAs, 401(k)s, etc.)

• Any 1099 or interest generated from your taxable-bucket investments

• Any employment income

• Any rental income

• Any interest from municipal bonds

So as long as you have these buckets, your Social Security benefits will be taxable. Part of the reason being that Social Security is essentially insurance for you living longer, not necessarily a contribution from you. If we all did contribute what we take out from Social Security, we would all be contributing more. Right now, given our trajectory, majority of our distributions would come from a 401K unless we do something about it.

The Roth IRA

The Roth IRA is the most favorable tax-free investment because as long as you are 59 1/2, all distributions from the Roth IRA are free from federal, state and capital gains taxes and the distributions do not count as provisional income and won't cause any of Social Security to be taxed. I guess this is part of the reason the IRS has restrictions on the Roth. The annual contribution limit for 2019 is $6,000, or $7,000 if you're age 50 or older. The Roth IRA also has an income limit of $189,000 for married filing jointly and $120,000 for singles.

The IRS allows you to access whatever you've put into our Roth IRA without penalty. (This is what my husband and I did for a house down payment as part of the first-time home buyer exception.) But to access the growth on your contributions tax-free and penalty-free, your Roth IRA account has to have been open for at least 5 years and you have to be at least 59 1/2.

McKnight recommends to strive to have an IRA balance large enough so that RMDs (required minimum distribution) at 70 1/2 are equal to your standard deduction. This of course requires a bit of planning and calculation since for me I won’t know what that standard deduction is when and if we retire at 65. I hope sooner.

LIRP - Life Insurance Retirement Plan

This is another financial product that I had never heard of. And a part of the reason I haven’t heard of it apparently is because I am not rich enough. A LIRP is essentially a “life insurance policy that is specifically designed to maximize the accumulation of cash within the policy's growth account. The goal of LIRP is to buy as little life insurance as required by the IRS while maximizing contributions. It has no contribution limits, no income limits (unlike the Roth IRA)) and has little legislative risk based on past law changes.” LIRPs are commonly used by those in the highest tax brackets which make sense as I would expect them to want to protect more of their assets from going to the tax man.

From an article in US News titled “How Ordinary Investors Can Use LIRPs,” here’s the breakdown and explanation of LIRP:

LIRPs use whole or universal-type life insurance policies that provide minimal death benefits and instead emphasize growth in cash value. While people with life insurance policies typically pay only the required premium, those with LIRPs shovel in extra money to build a cash value that is invested for growth to maximize withdrawals in retirement, which are tax free.

Among the key features of LIRPs:

• There is no income limit for opening one of these accounts. That makes them available to people who earn too much to open a Roth IRA.

• There is no limit on annual contributions. This is a major departure from rules on 401(k)s and IRAs, Keoghs, SIMPLE and SEP plans. Contributions, however, are not tax deductible.

• As with Roth accounts, there is no annual tax on investment gains and withdrawals of premiums paid to that point are tax free, as are additional withdrawals of investment gains if taken as loans. In contrast, withdrawals from the more common types of plans like traditional 401(k)s and IRAs are added to taxable income.

• LIRPs have flexible investing options, typically a choice between a fixed return guaranteed by the insurer, or a market-based return from a selection of mutual funds, actively managed and indexed.

• Unlike many retirement accounts, LIRPs have no penalty on withdrawals before 59.5. Policyholders can withdraw at any time so long as the policy stays in force

"The best candidates for this strategy are young, high-income individuals who aren't able to meet their retirement needs with standard retirement plans due to government-regulated contribution limits," Gendein says.

LIRPs are not designed for do-it-yourself'ers. Though you can shop for simple term life policies online, all insurance is sold through agents, and buying a complex whole or universal life policymeant for a LIRP requires the help of a professional, Fort says.

"Most insurance agents are not competent when it comes to the complexity of LIRPs, but would be more than happy to try to sell you one," he say. "Once you find an insurance professional claiming to be a LIRP specialist, you should ask about their ongoing management services, compensation structure, experience, designations and education. Make sure they are willing to provide multiple quotes or illustrations for your LIRP from multiple highly rated insurance companies."

So that is the gist of LIRPs. I’m going to read more about it to fully understand what it means. David McKnight has a book on LIRPs that I will try to pick-up from the library titled “Look Before You LIRP.”

Tax-Free Income Streams

The tax-free income streams that McKnight lays out are the following:

1. Roth IRA

2. LIRP, Life Insurance Retirement Plan

3. Traditional IRA via 72t conversion (The Mad Fientist does an exception job explaining how to access retirement funds early so read this too)

4. Social Security (as long as provisional income penalty does not get triggered)

He recommends taking advantage of today‘s historically low tax rates and today’s deductions to pay taxes today.

Final Thoughts

So admittedly, I was a little lost in some of the chapters, but I am now even more keen to ensure we are setting money aside in our post-tax accounts like our Roth IRA. There’s a lot more I personally want to read about as some of the information in the book would be very helpful for my parents who just retired. I don’t think it’s too late to try to save some taxes for them.

On another note, people will also say that taxes are a fact of life and it is and it is a duty for all of us as citizens to rightly pay for the taxes that we owe, but it also doesn’t mean that we can’t read the rules set forth by the IRS in this case and figure out a way to minimize tax implications today and tomorrow.

Below you’ll find links to David McKnight’s podcast where he further dives into the Power of Zero. I think it’s worth a listen to as he explains all the whys, hows, etc. similar to what’s in the book. I’m glad I picked up the book because it gave me a new perspective on taxes in the future.

Have you read the book? What are your thoughts? Have you taken an action item from it?