225: How to Create Tax-Free Income for Life with David McKnight

Casey Weade: Dave, welcome back to the podcast.

David McKnight: Thanks, Casey. It's an honor to be back.

Casey Weade: Well, Dave, it's great to have you back. I don't know if you know this. I guess I never told you but you are our number one most downloaded podcast of all time. We have thousands of individuals that have been able to tune in and get this message about the tax train coming. And I wanted to kick it off first with talking just kind of reminding the audience what the Power of Zero is, what the tax train is, what's on the horizon. And then I want to kind of shift over to what's evolved since our last conversation.

David McKnight: Sure. You bet. Yeah. So, back in 2015, actually, 2014 now that I think about it, I wrote a book called The Power of Zero and we discussed that on your last podcast. And the basic premise of the Power of Zero is that because of unfunded obligations for Social Security, Medicare, Medicaid, the national debt is getting bigger and bigger and bigger. We don't have enough money to pay for all of these things and so the national debt grows hand-over-fist every year. We're now at 28 trillion. I would imagine that the last time we spoke, Casey, the debt was only 21 trillion. So, we've gone up about $7 trillion. That's a seven followed by 12 zeros, by the way, $7 trillion in just the intervening two years since when we last spoke. Here's the primary problem. The whole reason why we can afford to have so much debt is because interest rates are historically low. What's going to happen, though, as the debt gets bigger and bigger and bigger, other countries are not going to really believe that we're going to have the ability to pay that money back and so they're going to say, "Yeah. We'll continue to loan you money but with the proviso that we get to charge you more interest." Okay. So, what's going to happen is we're going to get to the point where we have so much debt, interest rates are going to return to historically normal levels that the cost of servicing all of that national debt is going to consume the entire federal budget.

Forget about Social Security, forget about Medicare, Medicaid, forget about the Smithsonian in Washington, D.C. All of these things are going to be above and beyond what we can currently pay for under today's current tax rates. And so, a lot of experts have come out and said, "Look, even in the next 10 years, tax rates will have to increase dramatically or we go broke as a country." In fact, some of them have even said that tax rates will have to double within the next 10 years to keep our country, sort of keep our ship of state afloat. And so, the real question becomes, and I address this in Power of Zero is how do people who are preparing for retirement best protect themselves against the impact of dramatically higher taxes even 10 years from now? And so, we sort of turn convention on its ear. We say, "Look, everybody's been saving the lion's share of the retirement 401(k)s and IRAs and other tax-deferred vehicles. In doing so, you are literally entering into a business partnership with the IRS, and every year the IRS gets to vote on what percentage of your profits that they get to keep. Is that really a smart strategy when it comes to maximizing after-tax income in retirement? So, really the premise of the book is if you can get to the 0% tax bracket by the time you retire and then tax rates double, well, two times zero is still zero so that really is the best way to insulate yourself from the impact of higher taxes.

Casey Weade: Dave, you've put out more than one book in the tax world and the tax planning world, and with things evolving so quickly when it comes to taxes, I'm going, "How does Dave even keep up with tax changes?" You have to put out a book almost every single year in order to keep up with how quickly taxes are evolving. Last time we spoke was the end of 2019, released in March of 2020 on Retire With Purpose, and since then things have continued to evolve. How do you keep up? Last time, we were expecting taxes to go up in 2026. Now, it looks like taxes may be going up next year.

David McKnight: Yeah. And so, I just have to sort of resign myself to having to revise the Power of Zero and my other books every time there are major tax changes. And so, the Joe Biden tax plan is going to be a major, major overhaul on the US tax system and so we have to approach retirement with a sense of flexibility and the willingness to be nimble and to anticipate potentially what's coming down the road. I know that a lot of people think that tax rates are going to go up. In my book, the updated revised version of the Power of Zero, I talked about how tax rates for Main Street America are going to go up in 2026. Well, for people who are in the highest marginal tax bracket, their tax rates are almost certainly going to go up next year but what about everybody else? What about people in the 22% tax bracket? What about people in the 24% tax bracket? Joe Biden has made, he campaigned on this idea that he wasn't going to raise taxes on people making less than $400,000. So, if he honors that promise, what does that look like for everyday Americans? And my personal belief is that, hey, if you do make more than $400,000, you're going to pay through the nose but if you make less than $400,000 as a married couple or less than $200,000 as a single person, I believe that Joe Biden under budget reconciliation is going to extend those Trump tax cuts for another eight years.

Now, Ed Slott disagrees with me on this. I think there's room there for disagreement but I believe that if you're trying to insulate yourself from the impact of higher taxes down the road, you're now going to have eight years starting in 2022 through 2029 to be able to take advantage of these historically low tax rates. Come 2030, we will have kicked the can down the road so much that the federal government's going to be forced to raise taxes. So, what my message would be to everyday Americans, people who find themselves in those middle-income tax brackets, 22%, 24%, take advantage of these low tax rates. Stretch that tax obligation out over the next eight or nine years. Of course, let's wait to see what Joe Biden officially has to say. Stretch that tax obligation out over the next eight or nine years. Keep yourself in a low tax bracket, get those dollars systematically, reposition the tax-free so that by the time tax rates do go up for good, you've done all the heavy lifting and then you can take those dollars out tax-free.

Casey Weade: Well, last time we spoke, you shared how those highest marginal tax brackets. I think a lot of the proposals that were on the table at that time said we're only going to tax the rich, which is what we continue to hear out of Washington. We're only going to tax the rich, those with incomes over 400,000. We don't know if that's single individual, single filers, or joint filers. However, we might regard those individuals as the rich. And you said that those highest marginal tax brackets act as a bellwether for all of the other marginal tax rates. And are you saying now, yes, that's true but that won't come to fruition for years into the future?

David McKnight: Historically, that has been the case. And I've quoted Maya MacGuineas, who is the President of the Committee for a Responsible Federal Budget. She'll be on my podcast this week. And she did a study where she said, "Look, if you wanted to prevent the national debt from simply growing more than a trillion dollars per year, in other words, keep it at a trillion dollars of growth per year, you would have to raise taxes on people making more than $400,000 up to 103%." Well, people lose all incentive to work once they get to the point where they're giving away 100% of their income. So, she said, "That's obviously not viable," so she lowered the threshold to 250,000 and she concluded that people making more than $250,000 would have to pay 80% tax on every dollar above $250,000. She says, "That's probably not going to work either," so basically what she concluded was that they would have to lower the threshold to about $40,000. In other words, anybody making more than $40,000 would have to pay 40% tax on every single dollar that they made above that $40,000 threshold, and that's just to prevent the national debt from growing by more than $1 trillion per year. That's not eliminating the growth of the debt. It's not even paying down the debt. It's just preventing the debt from growing by more than $1 trillion per year.

So, even though Joe Biden has made the promise that he's not going to raise taxes on the middle class, mathematically speaking, it's just not tenable. If he refuses to broaden the tax base for eight full years, come 2030, we're going to be in a position where tax rates are going to have to be raised much higher on everyone than if he had just put a reasonable plan in place that sort of spreads the tax obligation over a lot more people. And so, my fear is that by kicking the can down the road, the fix on the back end is going to be much more aggressive. It's going to be much more draconian, which gives us all the more motivation and incentive to take advantage of these tax rates while they're historically low because come 2030, I think they're going to rise and they're going to rise precipitously.

Casey Weade: Before we transition into your latest book, I do want to ask the question, though, because I think about this. I think others do as well. Isn't it a catch-22, though? If they're going to raise taxes that much into the future, they're stifling economic growth, which reduces overall tax revenues. So, can they still overcome the deficit by raising taxes if that's stifling economic growth?

David McKnight: Yeah. So, what you do is you sort of paint yourself into a corner. You say, "Okay. We will put ourselves in the position where we absolutely have to have more revenue." So, you have two choices at that point. You can either raise taxes on everyone. There aren't enough rich people out there to just tax the rich. You could confiscate all of the wealth of the 1,000 billionaires in the United States and there wouldn't be enough to really run the federal government for more than a couple of years. So, you can either do that or you can print money. And the problem with printing money is that all of the programs that are driving the national debt, Social Security, Medicare, Medicaid, they're all tied to inflation. So, if you print more money to try to solve these problems, then you drive up the cost of these programs because they're all tied to inflation. You print money, inflation goes up, the cost of these programs go up. So, it's like a dog chasing its tail. You never really have enough money to pay for this non-discretionary spending that the Congress is required to pay for by law. So, there aren't a lot of good choices, which is why every year that goes by where Congress fails to act and to put a permanent solution into place that's viable, that's tenable, that is not just a patch, the more draconian the fix on the back end. So, this is why I like talking about this stuff because we have to sort of raise the warning cry to our politicians. We need leadership in Congress to say, "Look, enough is enough." If we don't do something now, then the fix down the road is going to be even more difficult and trying for Americans in every tax bracket.

Casey Weade: Well, I don't want to sit here and debate politics for an hour. I'm sure we could. And what the government should do is we should reduce spending and increase taxes. What should we do? However, I think the moral of your story is that we're trying to eliminate that risk. We're trying to make that risk of rising taxes irrelevant so we can focus our efforts somewhere else. And I think that's what you get to in your new book, Tax-Free Income for Life, which we're going to give away to our audience here in a little bit. First of all, what was really missing from the Power of Zero that led you to write Tax-Free Income for Life?

David McKnight: Well, I'll tell you a quick story. I actually start off the book with the story and it's a study done by Harvard Business School and they basically went to people that had a million dollars and they said, "Do you feel like you have enough money?" And they said, "No, we don't feel like we have enough money to last through retirement," and then they asked a second follow-up question, "How much money do you think you would need to feel comfortable like you'd have enough money to last through life expectancy?" And they said, "Well, I think if we had 2 million, we would feel pretty comfortable so roughly double." So, they said, "That's interesting." They take note of it. They then went to people that had $2 million and said, "Hey, do you think you have enough money? You think you have enough money to last through life expectancy?" And they said, "No, we don't have enough money. We wish we had 4 million." So, they went to people that had 4 million. They wished they had 8 million. Those who had 8 million wished they had 15 million. Once people had about $15 million, they no longer fear running out of money. And so, of course, the study begs the question, do you need to have enough? Do you need to have $15 million in your investment portfolio to feel like you won't ever run out of money before you die? Or is there a different way to sort of mitigate this risk of running out of money or what we call longevity risk?

So, that is the sort of the premise of the book and what I realized at the end of the Power of Zero is we do a pretty good job of showing readers how to mitigate tax rate risk. You get to the 0% tax bracket but as much as I hate to admit it when people get interviewed and they complete these surveys all across the country, they ask some of the simple question, what is your greatest fear in retirement? You know what, Casey, it's not taxes. It's actually longevity risk. It's the fear of running out of money before they run out of life. And so, I thought that to really complete the circle, I had to show my readers how to mitigate tax rate risk and longevity risk within the very same financial plan. It turns out in today's financial planning world, there's not a lot of people that talk about doing that. It's a lot harder than it looks. And so, the book is basically a roadmap on how to mitigate both longevity risk, the risk of running out of money before you run out of life, and tax rate risk within the very same financial plan.

Casey Weade: What is it between individuals that I meet that have $500,000 and they feel like they have enough money to last the rest of their life? Not concerned at all about running out of money. Then I've got clients that have $10 million and they are terrified of running out of money from a high level. You know, what is your assessment? Why do you think that there is this dichotomy?

David McKnight: Yeah. I don't know. I think a lot of it comes down to what are the guaranteed streams of income that you have in your life. So, you may have someone who has $500,000 but they also have Social Security, which is a guaranteed stream of income. It's adjusted for inflation. You might also have a company pension from a company you worked for. That is also a guaranteed stream of income adjusted for inflation. And the combination of those two things might be plenty to meet all of your basic living expenses. And so, people may say, "Hey, look, I may only have $500,000 but I have my main nut covered. You know, I'm going to be able to always have food on the table. I'm always going to be able to have electricity. I'm always going to have a roof over my head." But at the very same breath, you may have someone who has $10 million that doesn't have those same streams of guaranteed income. They feel much more insecure about how long their money is going to last.

Casey Weade: That's a really interesting assessment. And as I think about those clients that I have that are maybe in that half-million-dollar range, those over the $10 million range, those that are super-wealthy, they don't feel they have a need for guarantees. So, they tend to lean more towards higher-risk investment strategies, whereas those individuals that have less than net worth, they lean more towards those guarantees. And this could be a lesson for those super-wealthy out there and I think that's a good lead-in to you share the two greatest retirement risks. You say it's tax-rate risk and then longevity risk and you said in there, saving more money won't solve the longevity risk issue. And I think some will be taken back by that. They said, "Well, doesn't more money solve everything?"

David McKnight: Yeah. It's not about your assets and retirements. It's about your income. And so, I think what that Harvard study really shows is that even people of substantial means when they're sort of dependent upon the ebbs and flows of the stock market over time to ensure that they're going to have enough income coming in year-over-year, that can be a bit of an emotional roller coaster ride versus the people that have guaranteed streams of income that are guaranteed to last as long as they do. Those are the people that tend to have the much softer pillow at night. They tend to have happier retirements. In fact, Stephen Dubner from Freakonomics has studied this for a while. He even said, "People live longer lives. Not only are they happier but they have longer lives when they have guaranteed sources of income that last as long as they do, as opposed to relying on positive returns from the stock market to meet all of their income needs in retirement."

Casey Weade: You know, I wonder what goes on psychologically with individuals that have those guaranteed income streams. I'm thinking about those high net worth individuals or even lower net worth individuals with big pensions and Social Security. They say, "I have enough income. I don't need any guaranteed income because I already have more income than I need." What if they still had a guaranteed income strategy when they don't need the income? What are your thoughts on that? What would that do psychologically for those individuals who don't even need the income?

David McKnight: Yeah. I mean, that's a good question. I think that it would be excessive. I think that if you have, me personally if I had more guaranteed income than I really need, I would wonder if there would be some opportunity costs on that income. I personally feel like if I can guarantee my nut, I can guarantee my living expenses, that gives me a permission slip, if you will, to take much more risk in my stock market investments. Why? Because if the stock market goes down in any given year, I'm not constrained to take money out of that stock market portfolio to meet my lifestyle needs. I have the luxury of allowing the stock market to recover before I tap into that portfolio to pay for various discretionary expenses. I call them in my book shock expenses, which is, "Hey, there's a hole in the roof," or aspirational expenses, "I want to take all my grandkids to Disney World." You're not going to feel constrained to tap into your stock market portfolio during a down year to pay for those discretionary expenses. You'll say, "Hey, I can wait until the next year to pay for that trip to Disney World and in the meantime, I'm going to get my stock market portfolio a chance to recover." So, I think that it would be a hard sell for some people to say you're going to have even more guaranteed income than you need because in the back of their mind, they're saying, "Hey, could I be growing this money in a more productive way since I don't necessarily have to tap into it on a yearly basis?"

Casey Weade: Well, I agree. And the reason I say this is just a client popped into my mind that doesn't need the guaranteed income but wanted a guaranteed income strategy. They don't draw on that income every year but they know they have this fallback to do so and every year we're taking those distributions that were to be income, reallocating them to the market. And their portfolio overall is growing better than those that didn't want any guarantees because of what you just said. They're willing to take more risks. They have something to fall back on in case we have a bad year. It gives them more confidence. And in return, the overall portfolio is growing at a higher rate than if they had a 50/50 stock-bond portfolio, for instance. But great insights. Next, I want to talk about the four risks lurking in your investment portfolio from your book. You talk about sequence of returns risk, withdrawal rate risk, long-term care risk, inflation risk. Can you hit on each of these individually?

David McKnight: Sure. Sequence of return risk references the order in which you experience returns in your stock market portfolio in retirement. And what all of the studies seem to show is that a sequence of negative returns later on in your retirement is not really a deal-breaker because you only have so many more years to live at that point. And even if you have a couple of down years in a row, it's not going to really be a deal-breaker for you. What they really found, though, through all of these different Monte Carlo simulations is that if you have a sequence of negative returns in the first 10 years of retirement, you can send your stock market portfolio into a death spiral from which it never recovers, and I give an example of that in the book. So, for example, let's say you retired right after the tech bubble burst, like in the year 2000, and they experienced three years of negative stock market returns in a row and I actually wrote a book on this called The Volatility Shield. Then your portfolio can go bankrupt 15 years earlier than the person that experienced a negative sequence of returns much later in retirement. So, the whole point with sequence of return risk is that if by the off chance you were to experience that negative stream of returns early on in retirement, then you could run out of money 15, even 20 years in advance of life expectancy.

Now, at that point, you're sort of trying to get by on Social Security alone. You're sort of limping through the rest of your retirement. So, what was turning out to be a very rosy retirement turns into sort of bare-bones subsistence type living. And so, sequence of return risk is devastating. If you retire at the wrong time and experience that negative sequence of returns in the first 10 years of retirement, it can be absolutely devastating to a retirement plan. You make it past those first 10 years, it's a different story but if it happens in the first 10 years, it really changes the trajectory of your retirement.

Casey Weade: We know that begs the question if it's really the first 10 years. Some say, Kitces says it's the first 15 years of retirement, Michael Kitces. Some say it's 10, some say it's five. Let's say it's 10 years that we really need to be concerned about. Why do we need a guaranteed lifetime income? Why wouldn't we just secure the first 10 years' worth of income needs?

David McKnight: Well, I think it's a pretty expensive proposition to - it goes back to what I discussed in my book called the 4% Rule. So, the 4% Rule is a rule that was come up by Bill Bengen, who was a financial planner back in 1992. He said, "Hey, my clients are taking these really crazy, willy-nilly, haphazard approaches to taking distributions from retirement." Back before 1992, the prevailing wisdom was that whatever the historical rate of return was on the stock market, that was sort of the distribution rate you could take from your portfolio. So, for example, if you had a million dollars in your IRA and the history of the stock market showed an average rate of return of 7%, people thought, "Well, I can take 7% of my million dollar portfolio out each and every year." So, they were taking $70,000 per year out of their portfolio. As recently as 2008, they did a MetLife study and they asked a bunch of different respondees, what do you think is a realistic distribution rate to take from your portfolio? And a full 45% of respondees said they thought they could take 10% out. So, William Bengen basically said, "This is craziness. We don't have any parameters surrounding what is a reasonable, viable, long-term distribution rate from a retirement portfolio."

And basically, he did Monte Carlo simulations, he did hundreds of thousands of them, and he basically concluded that you could only take out 4%. So, if you have $1 million, you could take out $40,000 per year adjusted for inflation. Well, as recently as 2010, a lot of economists have said, "Hey, look, the 4% Rule is outdated." He was basing his projections on a stock market outlook that was far rosier than it is today. Bonds back then 5.5% were much higher than they are today. So, they said, basically, the 4% Rule is a little bit too optimistic. They said, "If you really want to be sure that you're not going to run out of money, then you're much better off using a 3% rule." So, if you have a million dollars in retirement, by day one of retirement, the most you could hope to take out in any given year is 3% or $30,000 adjusted for inflation. So, the problem with this approach, Casey, is it's an awfully expensive way to pay for retirement. So, for example, if you need $100,000 in retirement per year, you divide 3% into $100,000. That tells you that you would have to have $3.333 million accumulated by day one of retirement to be able to pay for your lifestyle throughout a 30-year retirement. And so, using distribution rates can be very, very as a guide to determine how much income you can take and be very, very expensive, and there's lots of other different issues that I talk about in the book when you adopt that sort of approach. In terms of your question, what would happen if you did a guaranteed income for the first 10 years and then you let the stock market portfolio sort of ride, and then in the 11th year, you start taking money out then? I mean, that's a good question. I'm not sure if you know Jason Smith. He's adopted a model called the bucket's approach that does precisely that. And I think that the Monte Carlo simulations show that the results are very, very similar. The point is, if you can avoid sequence of return risk in the first 10 years, it completely changes the trajectory of your retirement.

Casey Weade: Yeah. I think that's the bottom line. And isn't that somewhat of the strategy that you outlined in the book for, say, funding the Roth conversions from the taxable funds? You have this bucket approach. It's outlined in the book for those after-tax funds that are going to be left in the market.

David McKnight: Yeah. That's right. So, we talk about, hey, look, if you want to mitigate longevity risk and tax rate risk, one way to mitigate longevity risk is by way of an annuity. The problem is if you drop that annuity into your tax-deferred bucket, which 97% of the people do, you're exposing yourself, number one, to tax rate risk. You're exposing yourself, number two, to the risk of Social Security taxation. Both of those things can cause you to run out of money 10 to 12 years faster than you otherwise would. And so, I talk about using the type of annuity that mitigates longevity risk but also allows you to mitigate tax rate risk. And that's by doing what I call a Piecemeal Internal Roth Conversion, which basically says you've got a million dollars in your annuity and you want to step it over to the tax-free account so that you're not exposed to a rise in tax rates over time. A lot of companies require you to convert it all in one year. And, Casey, could you imagine converting a million-dollar IRA all in one year? I mean, the taxes you'd be taxed at your highest marginal tax rate on most of that money. And so, some companies have what I like to call a Piecemeal Internal Roth Conversion, PIRC, which allows you to convert that money to tax-free in any amount that you like over whatever time period your financial plan calls for.

So, what that allows you to do is to start taking that guaranteed lifetime income out of your tax-free bucket. You're insulated from the impact of rising taxes and when you take money out of a Roth IRA, it does not count as provisional income. It does not count against the thresholds which cause Social Security taxation. So, the problem is you can't do that Roth conversion all at once. You typically have to spread that Roth conversion out over five or six years, which means you can't really touch that income until the sixth or seventh year. So, that begs the question, how do you pay for lifestyle expenses during the first six or seven years of retirement when you're waiting for that Roth conversion to mature so that you can then take that guaranteed lifetime stream of income out of your annuity? And so, I talk about a time segmented approach, which basically says that you can have various segments of investments, various portfolios that mature, that are invested in primarily conservative instruments that mature when you need the money. So, for example, if you needed money in the sixth year, you would invest primarily in bonds that mature in the sixth year. If you needed money in the fourth and fifth year, you would invest your money in a segmented account that has bonds that mature in the fourth and fifth year. So, by investing in a safe and productive way and in such a way where you're not likely to lose money, then you can really mitigate sequence of return risk and really eliminate it from your portfolio. So, it's something that really is relevant for people who want to participate in that Piecemeal Internal Roth Conversion. They want to eliminate tax rate risk and longevity risk from their portfolio and do it within the very same financial plan.

Casey Weade: I think it would be important. Looks like we're going to transition into the strategy from a high level here. And then I want to dive in a little bit deeper to some of the nuances of the strategy that you outlined in your book. Can you give us a high-level overview of what the strategy looks like and how it addresses these four major investment risks?

David McKnight: So, essentially what we're saying is that the 3% rule, which is if you have a million dollars by day one of retirement, the most you could ever take out of that portfolio is $30,000 per year adjusted for inflation. So, if you want $100,000 per year, you have to save $3.33 million by the time you reach day one of retirement. That's not realistic for a lot of Americans. There's a less expensive way of doing it. If you can offload longevity risk to a company that can manage it much better than you can personally, then you can actually do so much less expensively. So, for example, I know interest rates ebb and flow so you'd have to look at what an annuity company could give you these days but let's say you gave an annuity company a million dollars of your liquid portfolio. So, you're handing a chunk of your liquid retirement savings over to an insurance company and they, in turn, will give you a guaranteed stream of income designed to last as long as you do. And let's say that the distribution rate that they would allow you to take off of that annuity is 6%. So, what you did was you said, "Okay. I'm going to hand a million dollars over to an annuity company and it's going to allow me to take 6% or $60,000 per year every year until I die." Contrast that with the 3% rule that says that you really should not take more than 3% of your retirement portfolio out in any given year, adjusted for inflation.

Well, by utilizing an annuity, and again, this depends on interest rates, you could potentially accomplish the very same thing with half the amount of money. So, it's just much more economical. It's much more feasible for the everyday American to have a guaranteed stream of income or to have a high likelihood of not running out of money before they die if they do so by way of an annuity. So, that's the overall premise is that you can have a guaranteed lifetime income that mitigates a lot of these risks, particularly sequence of return risk. We also talk about how it mitigates withdrawal rate risk. If you have your income guaranteed in retirement by an insurance company and you know that that is going to come to you, rain or shine, you're not relying on your stock market portfolio to be able to meet your lifestyle needs. So, you're much less likely to take out 10% or 7% or 5% in such a way that it would bankrupt your portfolio far in advance of life expectancy. And so, we also talk about inflation risk and long-term care risk. I really think that long-term care risk is one of the most pernicious risks facing Americans these days. I'll share with you a quick dialog, Casey, that I like to use with my clients. I'll be sitting across from Mr. and Mrs. Jones and I'll say, "Mr. Jones, you know I love you, right?" And he'll say, "Yeah. Dave, I know you love me." I'll say, "I do love you but you're better off dying than needing long-term care." And they look a little bit shocked and they'll say, "Why is that?"

And I'll say, "Well, at least if you died, Mrs. Jones here would be a beneficiary in all of your accounts. She would get your 401(k) and your IRA, so on and so forth. And while we would all miss you terribly, life for Mrs. Jones is going to carry along relatively unchanged. However, if you didn't die, if you almost died, then all of the money that Mrs. Jones is planning on receiving over the course of her life now gets earmarked for the long-term care facility. What does she get to keep? She gets to keep one house, one car, a minimum monthly maintenance needs allowance of about $2,500 a month, and about $130,000 of cash. So, what was shaping up to be a perfectly rosy retirement for Mrs. Jones turns into bare-bones subsistence type living." And of course, the converse is true if Mrs. Jones ended up needing long-term care. So, the problem is, how do you mitigate this? People don't love paying for traditional long-term care insurance. Why? Because it's expensive. It could be hard to qualify for. You may live to be 120 but if you have a bad back or a bad knee or bad hip, you may not even get accepted. And what happens if you pay, pay, pay, pay for 30 years, and die peaceful in your sleep and never having needed the long-term care insurance? Guess what? They don't send you all your money back at the end. It goes to pay for someone else's benefit. So, that can be a source of heartburn for a lot of different people. So, in the book, we talk about ways to mitigate long-term care risk without all of the heartburn that traditionally goes into mitigating long-term care.

Casey Weade: So, it sounds like we're carving out a portion of our portfolio to create a guaranteed income stream, cover our expenses in retirement as long as we live. We're doing so with some type of annuity. And then we have other after-tax dollars that we've set aside to cover inflation, long-term growth, and we're also going to be converting the IRA to a Roth IRA to mitigate tax risks in the future. So, we've got the annuity being converted to a tax-free income strategy. We have after-tax assets to guard us against inflation in the future. And then we have additional assets that we're setting aside that will be leveraged for long-term care risk.

David McKnight: That's right. You did a much better job of summarizing what's in my book than I just did so well done.

Casey Weade: Well, I'm glad we outlined it from a high level but I think some of the nuances are what's going to catch people off. And the first piece I want to go into is probably just hitting on guarantees and annuities, the A-word in the financial world. I mean, guarantee is said and I think antennas go up to say, "Well, nothing is really guaranteed but death and taxes." You're pretty big on the tax piece. What is really guaranteed? What does guaranteed mean when you talk about guaranteed lifetime income?

David McKnight: Yeah. I mean, guarantees are based upon the claims-paying ability of the insurance company but it basically says, "Look, if the insurance company, if you give an insurance company a liquid chunk of your retirement savings, they will in return give you a stream of income that's guaranteed to last as long as you do." So, what they're essentially doing is they're taking your assets and they're pulling them with the assets of thousands of other people and they know that some people are going to be living much longer. They have that Methuselah gene, right? They're going to be living much longer. Some people are going to walk off the curb and get hit by a Mack truck. So, they're going to live a much shorter life. But when you average it all out, it's what Tom Hegna calls mortality credits. The people who live much longer than they anticipated are going to have their guaranteed stream of income funded by the person that stepped off the curb and got hit by the Mack truck. So, all in all, everybody gets a guarantee that their income is going to last as long as they do and, of course, like I said, based on the claims-paying ability of the insurance company.

Casey Weade: So, you talk about different types of annuities in there. Most of the research that's out there today seems to focus on SPIAs or immediate annuities. What type of annuity do you think best fits in this guaranteed income portion of the portfolio?

David McKnight: Well, I think that mathematically speaking, the SPIA is going to give you the most bang for your buck, okay, if you look at all the insurance companies and it's a pure mathematical decision. So, I can give you a million dollars. Which company is going to guarantee me the highest income month-over-month every year until I die? I mean, you could even spreadsheet it. It's pretty straightforward and some companies give you more income than others. What I noticed, however, is that there are basically three things that really give people heartburn over the single premium, immediate annuity, and there's no getting around the fact that when you give a big chunk of your liquid savings to an insurance company in exchange for that guaranteed lifetime stream of income, you are giving up liquidity on that money, and that is a reality that prevents a lot of people from ever entering into the contract, entering into the proposition, and that's one thing. The other thing is most SPIAs don't adjust for inflation. So, people say, "Hey, look, you're giving me $5,000 a month. That's perfectly adequate to cover all of my expenses in the here and now but because of the inexorable effects of inflation over time even 12 years from now, that's going to have half the spending power at a reasonable rate of inflation." So, is not having any inflation protection giving the rate at which the federal government is printing greenbacks, is that really smart?

And then the final one is let's say you do enter into the transaction. Two years into it, you step off a curb and you get smashed by that Mack truck. What happens to all that money? Does it go to your kids? No. It goes to the risk pool and it goes to pay for someone else's income. And so, the combination of these three things and study after study after study have said that those three factors are the reason why single premium, immediate annuities are gaining very little currency among retirees. They have such positive benefits but they're gaining very little traction among retirees. And so, I talk about an alternative that seems to mitigate all of those concerns for most Americans. And that's what I call a fixed indexed annuity, which basically allows you to tie the growth of your income to basically a stock market index. As that stock market index grows over time, your income grows commensurately. And so, that can be a great way to sort of protect yourself against inflation over time, and it also has a death benefit feature which basically says that should you step off the truck and get hit by the Mack truck, your kids will get whatever money you didn't spend plus the growth over the course of your life up to that point where you died and they're the beneficiaries and all that. So, the fixed index annuity, and also gives you liquidity on your money during the deferral period, by the way.

And so, that really tends to mitigate the three concerns that most Americans have over instruments that provide guaranteed lifetime income. And I think that you and I have seen and we've seen this across the industry that fixed indexed annuities are far more popular than single premium immediate annuities because of their flexibility and their ability to speak to those three basic concerns that people tend to have with single premium immediate annuities.

Casey Weade: Well, and I'll say this kind of as a side note, I had a conversation with Dr. Wade Pfau a while back and I was saying why do we see that fixed indexed annuities often actually have better-guaranteed income rates than we see with SPIAs. And he said it's a certainty factor. The insurance company knows everyone's going to take the income from the immediate annuity. However, with the guaranteed income fixed indexed annuity, everyone has that. However, only a fraction of those are actually going to utilize the guaranteed income benefit because you have advisors that are selling guaranteed income benefits as if they are going to grow your real money over the rest of your life and the income benefit is never actually turned on for a lifetime. I think that's one of the really interesting things about guaranteed income benefits with fixed indexed annuities. And I also see for you in your strategy, when it comes to tax planning and playing defense against rising taxes, a SPIA doesn't work all that well because if you drop half a million dollars into a SPIA, you can't convert it systematically over the next, as you said, maybe eight years, five years. You can't just do 10% of that SPIA every year. You have to do it all at once on the front end before the income starts coming to you. But the fixed indexed annuity allows you to do that fractionally.

David McKnight: Right. That's exactly right. So, the SPIA, you drop an IRA into a SPIA and once that's set in motion there's no turning back the hands of time. I mean, what's been done is done. It's irrevocable. And so, what you've essentially done is you've cemented your exposure to tax rate risk over time. If tax rates double over the next 10 years, there's absolutely nothing you can do about it. So, let's say that taxes go for you from an effect of 20% tax rate to an effective 40% tax rate, that dramatic reduction in income - and one of the things that I like to tell people and this is sort of the culminating point in the book is that your income in retirement can be guaranteed but if you do it within the tax-deferred bucket, the after-tax amount is not guaranteed. And that's the rub because you're sort of beholden to the IRS. As tax rates go up, the amount of after-tax income that you get to keep goes down. And where do you think most Americans go to plug that hole in their guaranteed lifetime income? They go to their stock market portfolio and they spend down what's remaining in their stock market portfolio. What happens if by taking money out of that tax-deferred bucket that guarantees that SPIA income, that increases your provisional income to the point where you now have a $5,000 tax on your Social Security. How are people going to pay that tax on their Social Security? Well, they're going to take more money out of their stock market portfolio to plug the hole in their Social Security.

So, there are two holes that can be created and you're guaranteed lifetime income by situating your annuity within the tax-deferred bucket. And the combination of those two holes and the act of compensating for them can force you to spend down your stock market portfolio 10 to 12 years faster than you ever thought possible. And I think that a lot of advisors out there don't recognize the unintended consequences of positioning those SPIAs within the tax-deferred bucket. And so, part of the point of my book was just to educate not only advisors but members of the general public that you should be very, very thoughtful before you decide to drop a huge amount of money into a SPIA or into an FIA for that matter that doesn't have the ability to allow you to do that Piecemeal Internal Roth Conversion.

Casey Weade: So, we're mitigating some of this with the fixed indexed annuity. Where does the LIRP fit in? You've had books written all about LIRPs in the past. What's a Life Insurance Retirement Plan? How does it fit in? I have my guaranteed income. I have some after-tax funds set aside to fund the Roth conversions and to be there for long-term growth. What's the life insurance retirement plan exactly? Where does that come into play?

David McKnight: That's a good question. I think it really serves two purposes in retirement. So, the first one is your money is growing safely and productively within the LIRP. And so, after 10 years and I usually say you definitely need to wait 10 years because these programs need a chance to really gain ahead of steam. But after 10 years, there's going to come a time in your retirement where you need to pay for discretionary expenses, whether it's those aspirational expenses or those shock expenses. And your guaranteed lifetime income between your Social Security and your annuity income may not be enough to meet the cost of those discretionary expenses. And so, what I say is in the years where the stock market is down after the tenth year of retirement and you're reluctant to take money out of the stock market because you don't want to take money out while it's down, that's sort of a sequence of return risk in and of itself, I think this is a perfect time to start taking money out of your LIRP. So, the LIRP is you're guaranteed to not lose money. So, your money is growing safely and productively. So, you're not going to experience any negative consequences as a result of sequence of return risk. So, it's the perfect vehicle to fund discretionary needs when you need to plug the hole on your roof or you want to take the grandkids to Disney World but you don't want to draw upon your stock market portfolio because it's down. Take the money out of your LIRP. The money is growing safely and productively.

The other part, as I said earlier, I talked about the risk of long-term care. What most LIRP companies allow you to do these days is to receive your death benefit in advance of your death for the purpose of paying for long-term care. So, for example, you have a death benefit of $400,000. You wake up one day, you can no longer feed yourself, bathe yourself, transfer yourself, what have you. Find one doctor to write one letter to that effect. They will start sending you 2% of that death benefit or $8,000 a month every month for four years for the purpose of paying for long-term care.

And guess what? If you die peacefully in your sleep 30 years from now, never having needed long-term care, guess what? Someone's still getting a death benefit, probably your kids. So, there isn't that sensation of having paid for something that you hope you never have to use. And so, in my mind, the LIRP is very, very useful in the sense that you can draw tax-free income out to pay for those discretionary needs when your stock market portfolio is down, and the death benefit doubles as long-term care. And should you die peacefully in your sleep, never having to need long-term care, then your kids get a death benefit. I've noticed that 80% of my clients who enter into LIRPs do so because of that long-term care benefit.

Casey Weade: I think there's going to be this question from some regarding funding of this vehicle and funding the Roth conversion taxes as well. And some advisors would have you convert your IRA into a life insurance retirement plan, into a LIRP. Some would have you convert the IRA into a Roth IRA. Do you support both of those? And if so, what's the correct balance? Do we use after-tax funds to fund the LIRP? Do we use the IRA funds to fund the LIRP? What's the right balance?

David McKnight: Well, and the powers here, I talk about how the ideal amount of money to have in your taxable bucket, which is usually your emergency fund, is about six months' worth of basic living expenses. We come across people all the time who have far in excess of six months' worth of basic living expenses. So, if you find yourself in that position, that is the perfect account from which to fund your LIRP. There are occasions where people don't have any money in their taxable bucket at all, and you're sort of forced to peel off a portion of the Roth conversion, take money that would have otherwise gone into a Roth conversion, and put that into your LIRP to be able to get that long-term care benefit.

What I am opposed to are these sort of IRA rescue programs where they say, "Let's take your IRA, let's shift it into a life insurance policy over three years. Let's take a loan from a life insurance policy to be able to pay the taxes on the conversion or the distribution from the IRA into the life insurance retirement plan." That's something that I am sort of inherently opposed to, but I think it's okay if you have a surplus of money in your IRA and that's the only way that you can fund the LIRP to get that long-term care benefit that is so crucial to a balanced retirement plan. I think that there's nothing wrong with that.

Casey Weade: Well, individuals think about life insurance as something that is there to provide a death benefit. What is the type of life insurance that you are supporting when it comes to using it both for tax-free income and a long-term care death benefit?

David McKnight: Well, so I feel like it's absolutely crucial when it comes to life insurance that the money be growing safely and productively. There are problems with-- there's a product called a variable universal life policy, which your cash value ebbs and flows with the stock market. And part of the issue is that if you get into your 60s and 70s, and you experience a massive drop in your cash value due to a major downturn in the stock market, then the way these things work is as your cash value grows, the amount of life insurance you're required to pay for goes down, but if your cash value goes down, then all of a sudden you can be in a position where the amount of life insurance you're required to pay for rises dramatically.

And if that happens, when the mortality costs internal to the policy are most expensive, which could be in your late 60s, early 70s, so on and so forth, then all of a sudden it could send your policy into a death spiral from which it never recovers. And then you run out of money, you run out of death benefit, you no longer have long-term care. So, I like having the policies that have a guarantee that you'll never lose money, money's growing safe and productively. So, there are two approaches at that point. You can either have a whole life policy or what's known as an indexed universal life policy.

I tend to favor the indexed universal life policy because the money grows a little bit more productively than the whole life policy. And it tends to have better loan provisions, which are the means by which you take those dollars out tax-free. There's a lot of companies that offer guaranteed zero percent loans, which I think is a really big deal because you don't want the interest to snowball and once again, force you to run out of money before you run out of life. So, an indexed universal life tends to be what we propose, but there's a lot of people that tend to favor whole life that hands out my book, The Power of Zero all the time. And it's sort of just different strokes for different folks.

Casey Weade: Life insurance has evolved tremendously over the last year, 10 years, 20 years, just like our tax environment. And we had some recent legislation that changed the world of life insurance or it will start impacting life insurance here in the coming months, as we would expect. H.R. 133 had some regulations plugged into it. Can you just speak to what types of things are changing in the life insurance world? Is it favorable? Is it unfavorable? How does consumer leverage these things to their advantage if they want to go down the LIRP path?

David McKnight: Sure. So, when a lot of these life insurance programs got created, there is a section of the IRS tax code, Section 7702, which governs the amount of money that you can put into these life insurance policies. The IRS, believe it or not, does believe that there can be too much of a good thing. And so they limit, they have strict limits on how much money you can put into a life insurance policy. And those limits were premised on what interest rates were at the time. And so, what they basically said was given, say, a 4% interest rate environment, this is how much money you can expect to be able to put into a life insurance policy. And we're going to be limiting it because we believe that 4% will grow and compound your money over time. So, there's a reduced amount of money you can put in.

Well, we all know what has happened to interest rates in the interim. And so, what they basically did, and this was as a result of a successful lobby from organizations within the life insurance industry, they basically said, look, these policies aren't going to be able to have the same types of outcomes if in this low-interest-rate environment where we're only allowed to put in the amount of money that you previously allowed us to put in under the 4% interest rate environment. So, what they did was they said, okay, we're going to dramatically reduce the interest rate variable in this equation and what that effectively resulted in was consumers can now put almost twice as much money into these programs than they were previously for the same amount of death benefit.

And that's just good news for everybody because what it means is that you're going to be able to stuff even more money into these policies and grow your money even more productively over time because there's going to be less expense that's draining on that policy. So, united a podcast on this, we call it the LIRP Christmas Miracle because it happened over Christmas, and there's just that overall wonderful net benefit for clients that are going to be entering into these contracts.

Casey Weade: Now, these types of strategies, do they work for anyone regardless of their age or their health? If we are already in retirement, could we implement a strategy like this? Or do we need to be a number of years out from the time we're actually going to be stepping into retirement? I guess that's question number one. And then that kind of leads into number two, what if we aren't in the best health?

David McKnight: Yeah, so I'm not as much dissuaded by someone who's 60 or 62 who wants to enter into an LIRP because we aren't generally recommending that they take money out for 10 or 12 years, right? So, that's going to build a head of steam. As time wears on, the amount of insurance that the IRS requires them to purchase, it's smaller and smaller and smaller. So, they become more and more efficient as time goes on. So, generally, you get to the point where you're 65 and older, I tend not to love this as much for an accumulation type of objective.

The other thing that you have to consider, so it's not just age, the other thing that you have to consider is that think of the LIRP as a bucket of money with a spigot attached to the side of it. Okay, so you put your money in. As your money grows, your bucket begins to fill. The IRA says, hey, we're going to give you the benefit of an unlimited bucket of tax-free dollars. We're going to require that there be a spigot attached to the side of your bucket through which flows on a monthly basis, some expenses. What are those expenses going to go towards? They're going to go to pay for that death benefit, that's part and parcel of the overall product.

Part of the problem is insurance, I don't know if it's a problem since in reality, insurance companies are in the business of predicting how long you're going to live. They're like oddsmakers in Vegas, they're very, very good. I mean, If you go to your doctor, your doctor says, "Hey, I think you're going to live a nice, long, healthy life." What does that mean? It's meaningless. If an insurance company comes back and says, "We think you're going to live to be age 82." They don't tell you this, but if they said that, that means that they're willing to bet money. They're putting their money on the line, that's how long that they think that you're going to live.

And so, what these underwriters at insurance companies do is they assign you a rating, they send you through a pretty intense underwriting process. They look at your medical records, they take blood, they take urine, and they basically come back and say, we're going to give you a rating. And I like to sort of quantify it in a numerical way. Anywhere from 1 to 31 means you walk on water, you're going to live forever. 30 means you're on death's doorstep. They got to sort of hold out a mirror to see if you fog it, and then you get everywhere in between, okay. I think as long as you're a lot closer to a 1 than you are a 30, then the LIRP mathematically can make sense, but you do have to go through that underwriting process to see if it's a fit.

You don't have to do that for SPIA or for an FIA because there's no health component, but because life insurance does have a death benefit component, insurance companies want to make sure you're not going to die in the first 10 years because if you die in the first 10 years, it's a great deal for you but a horrible deal for them. They want to make sure you're going to live a certain amount of time so that's a worthwhile deal for them.

Casey Weade: It's almost a balance that you're creating in the portfolio, maybe somewhat of a time way to diversification approach. You have the annuity, you win. If you live a long time, you've got life insurance, you win if you don't live as long.

David McKnight: That's exactly right. In fact, there used to be strategies, you may remember this, where they had medically underwritten SPIAs, where they basically said, let's go see if we can medically underwrite this so that we can base that SPIA on how long you're actually going to live. And then let's find an insurance company that's going to give you as much death benefit as possible for that amount of SPIA, that income that you're getting. And there is a way to play insurance companies against each other. They no longer do that, but there is a way to sort of take advantage of that arbitrage that you're talking about.

Casey Weade: Yeah, I know we're coming to a close. And I just have one final technical question for you. And it had to do with something I found in the Q&A segment of your book. You had a question that said, should I elect guaranteed lifetime income in one of these vehicles as single or joint life? Should we have a single guaranteed lifetime income or a joint lifetime guaranteed income? You recommended single, and I think that'll catch a lot of individuals off, especially married couples of the same age or about the same health. Why would they choose a single lifetime payout? That seems like we're kind of taking a step back from the mitigation of risk.

David McKnight: Well, one of the caveats that I said in there is that if you can figure out which of the two spouses is going to live the longest, then that is the proper approach. So, for example, if you have the annuity that lasts, as long as both spouses and that's one thing, what I basically say, look, if you can go through the underwriting process and you can have the insurance company tell you which spouse is going to live longer and like I said, they're very, very good at predicting how long people are going to live, put the annuity on the spouse that's going to live the longest. That way, you're not ever going to be in a situation where one spouse dies and that income stops and that other spouse is sort of left twisting in the wind. And so, if you can figure out how long, and plus you have the death benefit that is there to cover you as well, so that was my approach, that's my philosophy, that if you can figure out who's going to live the longest and informs a lot of different decisions that you make vis a vis retirement plan.

Casey Weade: Unfortunately, it doesn't mitigate the Mack factory as you call that in your book, but first, I go, what's the Mack factory? Oh, yeah. Mack truck, that makes sense, but if you have the LIRP as part of the overall portfolio, especially if both spouses have the LIRP and you elect the single lifetime income, you have that piece to fall back on. So, you're maximizing your lifetime income. And then, if you get it wrong, the wrong person dies first, you have the death benefit to fund the surviving spouse.

David McKnight: Yeah, it's exactly the same concept behind the pension maximization. Take the single-life option and then buy a life insurance policy with the difference. And if the person happens to die, then the surviving spouse gets life insurance, but death benefit.

Casey Weade: Alright. Well, I think that brings us to a close with the time we have together, but I do want to say, I bet there's some that are out there going, boy, where's David's crystal ball right now? Do you have any thoughts on future legislation, pending legislation that's coming down the pike right now? Anything that you think maybe not everyone's completely aware of?

David McKnight: Well, you and I discussed this beforehand. I do believe that Joe Biden will honor his campaign promise, which is to not raise taxes on people that make less than $400,000. I believe that he will raise taxes on everybody else starting in 2022, but I think he's going to extend the tax cuts for everybody else that were instituted under Donald Trump which basically means if he follows through with that, that starting in 2022, you will see the same tax rates going in under budget reconciliation, you can only extend it temporarily for eight years at a time, which means that the tax rates that Middle America are enjoying right now will extend through 2029. That's what I think is going to happen. There's a lot of people that agree with me on that, but there are people that don't. And so that's my crystal ball. That's what I think is going to happen. And I think that means there's a lot of opportunities to take advantage of the tax sale of a lifetime before tax rates go up for good.

Casey Weade: Well, David, I don't know if there's another individual on this planet that's done as much research into the world of rising taxes or the risks thereof than yourself. It's always a pleasure to have you on the show. Thank you so much for joining us today.

David McKnight: Thank you for having me. Casey.

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