It’s only a matter of time before tax rates begin skyrocketing and David McKnight wants you to be prepared. He recently joined Financial Sense’s Lifetime Income program to discuss his best-selling book The Power of Zero. He posits where tax rates are likely headed and shares tips on how you can prepare to protect your assets.
See How to Capitalize on Lower Taxes Before It’s Too Late for audio.
Debt Trap Ahead
Your taxes are likely headed higher, and it won’t matter who is president or controlling Congress. The fact is, the U.S. has $22 trillion of debt and the federal government keeps insisting this figure is not a problem.
The way they run the numbers, our debt-to-GDP ratio is only about 106 percent, which is not historically terrible. What politicians aren’t considering, McKnight stated, are promises to fund various entitlements, such as Social Security, Medicare and Medicaid. Our debt-to-GDP ratio is not 106 percent, McKnight added, but rather is closer to 1,000 percent. Most of the debt to be incurred is going to be spent in the future, he stated.
“If we did our accounting like every other country in the world, and like 22 Nobel Laureates within the borders of our own country wish we did it, we would actually have $239 trillion in national debt,” McKnight said. “It's not what we've incurred today. So that's not really what we have to worry about. We have to worry about what's coming down the pike. And it's massive, massive bills for entitlement programs like Social Security and Medicare.”
Day of Reckoning
Demographics are not favorable either. As baby boomers retire, they stop contributing taxes, and start drawing down entitlements. Each retiree requires more workers to support these entitlements. Eventually, there are only so many ways to deal with the projected shortfalls in these programs, McKnight stated. We either need to double our tax rates, reduce spending by half, or do some combination of the two.
This is why tax rates currently represent a bargain, McKnight explained. During World War II, the upper tax bracket was as high as 94 percent on every dollar of income above $200,000. As recently as 1960 to 1963, the highest marginal tax rate was 89 percent. The lowest marginal tax bracket was 23 percent.
Compare that with the 10 percent bracket today. These rates are unlikely to remain this low in the future, McKnight stated, simply because 78 million baby boomers are unlikely to accept lower Social Security benefits or pay more of their medical expenses in retirement.
“Today, we have a historically good deal,” McKnight said. “It's a tax sale of a lifetime. Congress is talking about raising the highest marginal tax bracket to 70 percent. If history serves as a model, all of those other tax brackets are going to ratchet up right along with it.”
Reducing Taxes to Zero
The current low rates offer an opportunity for savers, McKnight stated. The current tax rates came out of the tax bill President Trump introduced and are set to expire on January 1, 2026 – which means we know the exact date taxes are heading higher. Come 2026, we’ll be back to the rates prior to 2018, which means the highest marginal tax rate will be 39.6, and all other tax brackets increase accordingly.
This means it is a good time to preemptively pay taxes on your 401k or IRA at the current low rates. McKnight shared several instruments you can use to achieve a tax-free status.
The first is a Roth IRA, which allows you to pay taxes now at the current rates as you make contributions and withdraw capital tax-free later. The other option is tax-free bonds. Both have their restrictions and advantages, McKnight stated.
Another option is a life insurance retirement plan, or LIRP, which has several advantages of its own. Money in a LIRP is treated differently by the IRS. For example, you can touch the money before you turn 59 and a half without penalty, which you can't do with a 401k or IRA. As money in the LIRP grows, you don’t receive 1099s and don’t pay taxes on it.
Additionally, it does not count as provisional income, which is used to determine if your Social Security is going to be taxed. Withdrawals from IRAs and 401ks often count for this purpose, making LIRP withdrawals even more attractive. There are no income limitations or contributions limits with LIRPs. You must pay for these perks, however, in the form of monthly premiums toward the cost of term life insurance. There is an advantage to this setup, because most LIRPs allow you to withdraw death benefits in the event you need long-term care.
“The LIRP can be very, very powerful when used in concert with a lot of these other tax-free streams of income that we talked about,” McKnight said. “If you think that the taxes you're going to pay today are lower than what you would pay in retirement, this is really an excellent window of opportunity to take advantage of low tax rates. Every year that goes by where you failed to take advantage of these low tax rates is potentially a year beyond 2026 where you could be forced to pay the highest tax rates that you've experienced in your lifetime.”