The Tax Code Helps You Retire! Find Out How - Part 2 with Kyle Gabhart

TRANSCRIPT

Kevin Schneider: [00:00:00] It's hard to talk to a financial advisor without mentioning retirement, and now, legends don't retire, but there is a sense of retirement in the way that you could be financially free,

so, stewarding your money today to help free yourself in the future is a very wise thing to do. What we see a lot is people who are W2 employees, they want to max out their 401(k). If there's a magic component, definitely do that. That's basically just added bonus to your retirement account,

but sometimes, people get into a situation where they have such a large nest egg and they can't touch it. Maybe they're 40 or 50, and they got a million dollars sitting there, or half a million, and they want to take some of that money out, are there options in a 401(k) to take that money out without getting just hammered with tax and penalty?

Kyle Gabhart: Yeah. It's a super question, and you're right. Whether or not you ascribed the notion of classic retirement or not, the [00:01:00] tax code is going to lead you down the path of thinking critically about pre-tax and post-tax and various retirement account vehicles, because regardless of when, or if, retirement is part of the picture for you, there are tranches of money you're going to want to create,

and so, what we tend to advise people on, is needing to have a portion of your liquid net worth in post-tax accounts, and a portion in pre-tax accounts, and a portion in tax-free accounts. Now, I realize that tax-free is going to raise an eyebrow on behalf of the tax efficiency autos in the room,

and really, I should probably put that in quotations, but what I mean is that there are accounts out there where it's possible to avoid a portion of the tax, and so I'll boil it down like this. All things being equal, you've got dollars that are going to come into an account and they [00:02:00] either get taxed on the way in, or they get taxed on the way out, and sometimes they also get taxed in the middle while they're there, and this is everything from a brokerage account to a 401, to a Roth IRA, to an HSA, to a 529. There's all these different kinds of accounts, and although they all have their own little different rules, it basically comes down to- Do I get taxed on the front, or not?

Do I get taxed while it's growing in the middle, or not? Do I get taxed when I pull it out, or not? And so, part of good tax diversification is to make sure that you don't find yourself with all of your dollars piled up in one giant pre-tax account like a traditional 401(k), because then you've lost flexibility.

Your hands are tied. Your only option for tapping those dollars is maybe alone or pulling the money out, and at a minimum, getting income tax, [00:03:00] if not at the same time, also getting a penalty on top of it, if you happen to be too young when you tap..

Kevin Schneider: So yeah, there's also ways that we've seen in the tax world to where you could be creative about maybe being strategic in absorbing some of that tax for a specific purpose. Meaning, if your retirement account's not doing well, you can cash out, which would basically get you a capital loss, but also, when you take hold of those.. or not a capital loss, I guess this is all going to be in a retirement account.. but once you take hold of the funds from a distribution, it's going to generate tax, but if we can use that cash that you take out of your retirement account and go into a tax advantageous asset, such as, possibly, real estate, if you meet certain requirements.. or oil and gas, like you mentioned earlier, there's opportunities out there to where you can actually transition out of your retirement account and get it as a different type of asset outside of there, and maybe not incur tax if you're smart with it.

But [00:04:00] those penalties are always going to be there whenever you take that money out, so you can always tax plan around the taxable income piece, but those penalties will always remain there- that 10% punitive penalty they get you on, but I think with the 401(k), Kyle, you're a little bit more flexible with actually tapping into funds.

So, for people out there who have a 401(k), how can they get to that money, potentially a little bit more creatively, without generating tax or anything like that?

Mike Pine: Really good question. So it does depend on the capabilities of the 401(k). If you are in a small business, sometimes the 401(k) will have a more limited set of features because it helps keep the cost down, and typically, a larger employer is going to have a lot of bells and whistles woven in. So some of the things I'll talk about may be available and others may not.

Kyle Gabhart: It's something that listeners would want to check on, but one example would be just a simple loan. There's a lot of misconceptions around taking a loan out of your 401(k). First off, there is a limit by [00:05:00] law. You can take up to $50,000 or half of the balance, whichever number is smaller, so you're capped at that, first off.

Secondly, although there is an interest on the loan and you have to pay that back over a period of time, not greater than five years, one of the slick things about it is you pay it back to yourself. So even though there's 3% or 4% or 5% interest, or whatever it happens to be, at least it's interest you're paying back into your account.

Kevin Schneider: Yeah.

Kyle Gabhart: And so particularly depending where we're at in the market cycle, it could be really advantageous if the new dollars plus the interests that are going in are while we're in a recovery cycle, then you've got that opportunity to pick up some additional growth and leverage while you're doing that,

And if we were in a market decline at the time, let's say the real estate market was down, and that $50,000 you pulled out helped you get into picking up, maybe, your first [00:06:00] rental property, then suddenly, you're picking up real estate at an opportune time. The dollars that you were pulling out were while the account was down anyway,

and as you're plowing dollars back in, it's during the recovery from a dollar cost averaging perspective that can work out really handsomely for you.

There's other options as well. So again, in some of the larger plans, you might find opportunities where you could select from the get-go to have Roth be the designation rather than pre-tax.

Now, that does have tax implications for you in that you're not going to be writing off the contributions you're making, but now, you're building up dollars that never get taxed again, and earnings that never get taxed. Some of the larger plans will even let you make additional contributions above and beyond your initial limit

that are going into a post-tax account similar to a Roth, but really, almost more like a brokerage account, and so these begin to create opportunities for you, and then

depending on your age, [00:07:00] there's another option that could be available, which is - you could take advantage of building a bridge between your 401(k) and your typical retirement years, 59 and a half age, 60, what have you, and you can get payments out of your 401 on a set schedule over a period of five years,

and not get penalized, so it's only income. In that case, there's no penalty, and a lot of folks end up using that as a bridge until they unlock those dollars that are tied up north of 59 and a half.

Kevin Schneider: Yeah, that's great, and one thing that we need to be cautious of is on those 401(k) loans, if they allow for it, that if you do change employers, that loan becomes due. So, you don't want to just- Okay, I'm going to tap into my money, I'll pay it back over time.. and then you get fired in a month. You better pay it back, or else now, it's going to be taxed and it's going to be penalized.

So, there's a lot of hurdles. If you're going to be looking at getting into any type of [00:08:00] retirement funds, and you want to best strategize the tax side, but also the financial side, like Kyle was going into, please reach out to us or reach out to your CPA and financial advisor because there's so many traps, and one little hurdle you don't clear can cause devastating effects.

Mike Pine: And make sure you understand what your CPA and financial advisor is explaining, like really walk through it. I know Kevin had a very short, like a 10 minute initial consult with a new client this past year, and he said, 'Hey, I want to take out my down payment on my 401(k). We're going to buy a vacation rental.'

Kevin walked him through how to materially participate, and Kevin said, 'Yeah, that should work if you do the down payment.' Well, he missed that down payment portion, this client. He went and he took the entire cash purchase price out, didn't leverage at all. So he took 100% out and he got 30% bonus depreciation.

Well, guess what? He still owed tax and he was surprised! And we said, 'Do you remember the down payment part?' He was like, 'Yeah, but I thought I could just do more.' So it's important to [00:09:00] truly understand what your tax advisors are explaining and sharing with you.

Kevin Schneider: So, I never invest into something. I don't know really what I'm getting into. I don't invest into stuff that I don't understand. I don't take tax positions I don't understand. I just don't do that, and you shouldn't either. You should really take control of ownership of where your money is going,

and now it's good to have advisors, CPAs, and financial advisors, and attorneys to guide you and teach you, but if they're going to chalk something up on a chalkboard, and there's this flow chart with 20 diagrams, and money's going here, money's going here, money's... if you don't understand it, just don't do it.

There is some value in simplicity, but there's also value in getting that education and taking ownership of your own finances, because I see a lot of people who blindly follow them as well, and that could be dangerous, especially if your financial advisor isn't really plugged into your specific situation all the time, and you just follow them.

I mean, they may be serving 300 clients. They They may not have the finger on the pulse [00:10:00] of what's going on and what's best for you. So you need to understand these concepts and listening to a podcast like this, or other podcasts, or reading books- just get that education, and because it's important.

Mike Pine: I have another example I want to ask you, Kyle. Let's say I'm in my early forties. I've had a great W2 job now for 20 years. My 401(k) is looking pretty good, but I hate my job. I've decided, I don't know how I did it, but I've been an employee for the last 20 years. I found a business, I want to buy it. I have plenty of my 401(k), but I don't want to pay all the tax to pull it out.

Isn't there a pretty cool way that you and I have worked with before to use that 401(k) money to basically buy a business that I can spend the second half of my career in?

Kyle Gabhart: There absolutely is. It is certainly one of the more complicated mechanisms out there when it's all said and done, but it's absolutely viable. [00:11:00] It's what's known as ROBS - Rollover for Business Startups, and as long as you have a really careful coordination between the financial advisor, between the legal professionals that are helping you get the entity structured properly and between the tax and accounting team, then it is absolutely possible to roll the dollars out of your 401, effectively roll them into the businesses 401, this new business entity you set up, buy your own stock, and in effect, transfer the dollars all the way into a business checking account so that you can then go and bootstrap the business yourself by leveraging those retirement dollars that would otherwise be tied up,

and if you check all the boxes and you follow the script, there's actually not a tax liability on that particular transaction.

Mike Pine: Beautiful. And it works. It really does. You can even pay yourself a reasonable wage [00:12:00] as the president or CEO of this business. You've just got to make sure you do it right.

Kyle Gabhart: There are a few pitfalls to watch out for, no doubt.

Kevin Schneider:

So with all the different retirement accounts available, you talked about the 401(k), and the IRAs are very unique. They're not as high in limits as the 401(k) with the contribution, but there's some great tax strategies revolving the Roth, and the biggest hurdle that our clients are going to see, and the listeners out here, is that they're small income limits, and they really don't adjust those income limits as well over time.

They're not keeping up with pay raises and inflation as well as we'd like them to, so there's limits to contributing to a Roth. So could you explain the tax first, the benefits- the tax benefits, the investment benefits, of a Roth, and if you're over those, the income limits- is there a way to still take part in a Roth IRA?

Mike Pine: [00:13:00] And put more than $6,000 a year away. Is there a way?

Kyle Gabhart: Really good question. So first thing is, why is a Roth important? It's about getting post-tax dollars into an account that grow over time, and the growth completely avoids tax, and sometimes people think- Oh, then I've got to know what my tax rate is in the future..

and that would only be true if you were doing it for just a few years. If you get in on it early enough, and you've got this thing growing for 10, 15, 20, 25 years, it's a no-brainer because you're getting all of these dollars that never get taxed, and down the road you've got the flexibility to choose.

When you tap into the Roth, you are now receiving income that's not going to be a part of your tax equation, so it gives you flexibility. It allows you to be nimble from a tax perspective, whereas if all of your dollars are pre-taxed, you've got no flexibility- [00:14:00] every dollar you pull out in your golden years is going to be fully taxed,

and we don't know where the tax brackets are going to go, but I do know that if all of your dollars are pre-taxed, everything's going to get taxed, versus being nimble, and being able to navigate above and below and around where those tax brackets are, which having a pool of tax-free dollars through the Roth, allows you to do that.

Now, I'll address the second piece, which is, how do we do so? The first thing to realize is a lot of people have access to the Roth and don't even know it, because they say, 'I make too much money. I can't utilize a Roth,' and don't realize that there is a special side door, and that side door is- if you are in a 401(k) and it makes a Roth option available, it does not matter what you earn.

You can literally click the box inside your 401. There is no income check. The front door, the Roth IRA, has an [00:15:00] income check. The Roth 401 does not. You could put every available dollar of contribution a year through a Roth 401(k), and now you're in the Roth game and you didn't matter what your income was. So that's the first one.

Secondly, there's a back door, so you've got to go past the side door over to the back door, and the back door happens in the realm of IRAs rather than 401s. The back door is that the IRS allows you to do a conversion. A conversion is where you take dollars sitting in a traditional IRA, and shift them over to a Roth IRA.

The conversion has no income check at all, and so dollars that are sitting there can just be moved wholesale over to the Roth, and there's no limit to how many you can move. Now, once you've moved all of it, then you're into the realm of each year you can make a contribution to your traditional, and then [00:16:00] immediately convert it over into the Roth,

and so, that is, in effect, the backdoor Roth. Now, there are some gotchas, there are some asterisks and some footnotes to read, but in a nutshell, that's how you get money into a Roth.

Mike Pine: So, I can take unlimited amounts of money in an IRA and convert it into a Roth?

Kyle Gabhart: The answer is yes, but you might not want to. So I'll take an example of a client that we share that we were working with at the end of last year together, and you guys were crunching the numbers and all the things in their accounts, and we were aiming to take a traditional IRA bucket, which, if I recall, it was somewhere in the ballpark of three quarters of a million,

and we wanted all of that to go Roth. As we were looking at the other pieces of what was happening in their tax situation, It really didn't make sense to do that because a pretty healthy chunk of it was going to end up in [00:17:00] the highest bracket, and so what we ended up doing was dialing it in to go- Okay, if we take this portion of it and convert it, since that portion had previously avoided tax, then the conversion is a taxable event, and so since they already had some pre-tax dollars sitting there, we had to be savvy about how much we were going to convert, and you guys did the calculation. Your team told us how much to convert, we did the conversion, we're going to do that again this year for them, and likely next year. I think over those three years, we'll finally have them completely out of pre-tax dollars in their account,

and that is a magical point in time, because once you have no pre-tax dollars in the account, and that could be because you've never had pre-tax dollars in an account, or it could be because you've converted all of it - once you have none, you now open the ability to not just go through the back door, but to go through the back door [00:18:00] and not pay a cover charge, because from the IRS's perspective, if you put dollars in there that have never been taxed, and if I put it in in 2023 and do the conversion in 2023, I never had an opportunity to claim a deduction, and so it is a non-deductible contribution I made to that IRA. Once I'm in that realm, then I can do that every single year and convert it into the Roth with no tax obligation at all.

I can do that for myself. I can do that for my spouse, even if my spouse doesn't have income, and then, the really fun one is - let's say you're a small business owner.

Let's say that it makes sense and there's a lot of nuances to consider, but let's say that a SEP IRA makes sense, even though a SEP is an employer plan.

It has the magical words 'IRA' on the back end. So what that means is it looks, talks, smells, acts just like a traditional, but with a [00:19:00] dramatically higher limit. Like we're talking 10X the limit that you would have on an individual retirement account, and so a SEP IRA, since I'm a business owner, would enable me to fully fund for me, and again, maybe even for my spouse, if we have enough income to justify it through the business, $50,000-$60,000 a year each, that we then funnel through that back door into the Roth, and that's what's often regarded as a mega backdoor Roth contribution.

Mike Pine: That is hot. That is awesome. So 60- 66,000 I think this year for SEPs. That's pretty

Kyle Gabhart: That is correct. 2023- $66,000.

Mike Pine: Let's say I have spent all of my retirement accounts building a business. I've got a good business..

Kyle Gabhart: And that happens a lot with business owners. That is a really common scenario. I just want to give all the entrepreneurs out there [00:20:00] a little bit of grace, that if you find yourself in that situation, you are in good company. That is a common, common scenario.

Mike Pine: Takes capital to get a business up and running, but we see a lot of clients, or new clients, come in and they're in that position- they're in their mid forties or so, they've don't have anything put away for retirement, but they've got a good business now, and they finally have some really good income.

They probably have 10 or 15 years of really good income, or maybe only 5 in their fifties, but they're getting good cash flow now. They want to put money in a retirement account. Is there a vehicle where they can put more than $66,000 a year away?

Kyle Gabhart: There is. So there are additional mechanisms in the tax code that allow you to set up, for lack of a better term, almost your own pension plan, but it's for your private enterprise, and that comes into play of bolting on additional buckets on your existing 401(k) [00:21:00] chassis, that allow you to sock away even more dollars than you could in a normal 401.

The first bucket you add is a profit sharing bucket that's going to let you get to that magical $66,000, but on a 401(k) chassis. The next thing you can add beyond that is a cash balance. A cash balance plan is a little bit more nuanced. It involves actuaries, it involves a lot of math and number crunching, and if you've got employees, that's all got to be factored into it,

but once the dust settles, it creates the capability to set aside on the low end, $100,000 a year pre-tax, as a business expense, and on the high end, you could be putting aside $300,000-$400,000 pre-tax, as a business expense into this plan, and you could be doing that year after year. If your spouse is a part of the business,

[00:22:00] double the numbers that I just gave you, and that can allow you to stockpile money while dramatically reducing your tax liability during those building years, and now, you've got, effectively, that pension, that bucket of dollars that you've built up for your future, and you can use that to now siphon off pieces at a time, as you need to, each and every year in your golden years to give you the income you need at that point.

Mike Pine: So we get those big jumps in deductible contributions. You call it Cash Balance Plan. I also heard it referred to as Defined Benefit Plan, but it's a real thing. It's legit. We've had clients put away over $300,000, reduce their taxable income by $300,000, funding their DB planner, their Cash Balance Plan,

and then, there's even cool stuff you can do with that, because we had this one client did that for a few years, sold the business, great windfall, paid some tax that year, but then [00:23:00] he wasn't making any money. As a matter of fact, he was- became a real estate professional, was buying real estate and had big net operating losses from the power of depreciation,

and guess what? He had this huge retirement account that he could do things with, and maybe pay some tax or not pay taxes, get a big NOL. I love your world, Kyle. It is sexy.

Kyle Gabhart: You know what, Mike? I'm going to adjust a statement I made earlier. The tax code is beautiful.

You've convinced me.

Mike Pine: It is one, one big, beautiful thing out there.

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