TVL_E209_joshua_sheats_interview_part_1
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00:00:29.960 | You're listening to The Voluntary Life, where you can hear ideas for finding freedom in an unfree world.
00:00:39.680 | Visit thevoluntarylife.com to connect with the show and hear all past episodes.
00:00:45.120 | Here's your host, Jake.
00:00:47.080 | Hi, it's Jake here. Welcome to The Voluntary Life.
00:00:51.160 | This is an episode about tax and I think it's relevant for anyone who's interested in entrepreneurship,
00:00:57.160 | but also just for anyone who's interested in financial independence and working towards more financial freedom.
00:01:03.640 | Tax is a really important topic.
00:01:06.440 | I want to talk about this issue strategically and I'm really pleased to have a special guest to talk this through with me.
00:01:13.320 | It is Joshua Sheets, the host of the Radical Personal Finance podcast.
00:01:17.760 | Hi, Joshua.
00:01:19.360 | Good morning, Jake. I'm glad to be here.
00:01:20.920 | Yeah, really pleased to have you on the show.
00:01:23.040 | You're currently in Florida, is that right?
00:01:25.520 | West Palm Beach, Florida.
00:01:27.200 | Awesome. Well, I really appreciated your invitation to appear on your show a while back
00:01:32.400 | and we had some great chats about the permanent portfolio and entrepreneurship.
00:01:36.240 | I wanted to bring you on to talk to you about your area of expertise in finance, in particular in terms of tax.
00:01:43.120 | But for those people who didn't hear those previous episodes,
00:01:46.640 | can you just give a little bit of a background to your background in finance and what your podcast is about?
00:01:52.880 | I come from a mixture of backgrounds, which is how I wound up doing a podcast.
00:01:58.000 | I was a long time, I call it personal finance junkie.
00:02:01.360 | From an early age, even before when I was a boy, I wanted to be rich.
00:02:06.000 | That was one of my major life goals and so I started studying everything I could learn about how to actually be rich.
00:02:12.320 | That led me deep into the personal finance world.
00:02:15.520 | Through a series of circumstances, I wound up working in the financial advice industry after college,
00:02:20.560 | working as a professional financial advisor and spent six years in that business.
00:02:24.960 | And on both sides of the aisle, I call it the personal finance world versus the professional financial advice world.
00:02:30.880 | I became frustrated with the opposite side.
00:02:33.040 | As a personal finance junkie, I was annoyed with the financial advice industry
00:02:36.880 | and how many things that I thought they were doing wrong.
00:02:39.040 | And then I got over in the financial advice industry and I got annoyed with all the stuff on the personal finance side
00:02:44.160 | that I found to be inaccurate and many people very well-meaning,
00:02:47.200 | but just simply ignorant and inaccurate in what they were saying.
00:02:51.040 | And so that led to my desire to see somebody put together kind of a combination of those worlds,
00:02:58.720 | bringing together everything from the world of personal finance,
00:03:01.760 | whether it's the big picture stuff like goal setting, life planning, a comprehensive view of life,
00:03:07.200 | or whether it's just the simple things like budgeting or how to actually manage the technical day-to-day details
00:03:12.480 | and the professional financial advice world.
00:03:14.960 | So technical details on how the tax code works in the United States of America,
00:03:18.960 | creative ways to use some of the benefits that most people don't think about,
00:03:22.960 | the in-depth nature of different financial products and how each of them has advantages and disadvantages.
00:03:28.240 | And all of that stuff came together to be personal finance and essentially radical personal finance.
00:03:33.040 | Essentially, the goal is to create the kind of show that I wish I'd had to go from no knowledge whatsoever of finance
00:03:39.760 | to the equivalent of a master's degree in financial planning.
00:03:44.000 | I actually have a master's degree in financial planning.
00:03:46.240 | And so I'm trying to give away everything I know on the podcast for free
00:03:49.280 | and support the independent media space by putting my content out there and helping others.
00:03:53.280 | I think it's awesome and you are prolific.
00:03:55.680 | You're putting out, I think, on average, it's like an episode a day, isn't it, that you're doing?
00:03:59.680 | Just about. We're on average over four a week.
00:04:02.800 | I shoot for five, but I'm not necessarily every day committed to that.
00:04:07.200 | But I do try to put out a lot of content.
00:04:10.000 | And the content, I try to keep it extremely varied.
00:04:12.480 | So I do interviews, my basic schedule, I do about two interviews a week.
00:04:18.240 | And I try to interview people from interesting perspectives, some of them rich, some of them not.
00:04:23.040 | Some of them have set up interesting, unique lifestyles and some of them haven't.
00:04:27.040 | I try to do a big picture show on things like goal setting, life planning, alternative ways of approaching life.
00:04:33.760 | I try to do a technical financial planning show where I go through some of the details of the US finance law.
00:04:41.360 | And then I answer questions and listen to Q&A.
00:04:44.560 | And I try to basically just create the kind of show that I wish I had had ten years ago to listen to every day on my commute.
00:04:50.480 | Awesome. Well, I'm really pleased to have you on the show to talk about this subject.
00:04:55.200 | And I thought I would start off by giving you my perspective on why I wanted you to talk this through with me.
00:05:01.360 | So as you know, we tackle issues to do with entrepreneurship and achieving financial independence on the voluntary life in lots of different ways.
00:05:08.880 | And when you look at the question of tax and look at the books that are out there on financial independence,
00:05:14.560 | a lot of books like, for example, the classic Your Money or Your Life have almost nothing to say about tax.
00:05:21.680 | They focus on opportunities for saving and investing through saving money on what is typically referred to as three big areas of spending,
00:05:31.120 | your housing, your transportation and your food.
00:05:33.520 | And yet other books like, for example, The Millionaire Next Door talk about tax and especially income tax as the number one expense in life.
00:05:43.120 | So it seems to me tax, if you're interested in financial independence, it's a really key issue.
00:05:49.600 | But some people don't even tackle it at all.
00:05:51.440 | So how important do you think it is for people who are interested in financial independence to really address this question of tax?
00:05:58.320 | Depending on the jurisdiction and tax authority under which somebody lives, and that will vary across the world and even within countries,
00:06:07.520 | it will vary from county to county.
00:06:08.960 | But for most people, I think it's their number one biggest expense.
00:06:12.800 | Usually it's not seen that way because we only see taxes one at a time.
00:06:18.080 | So for example, you might have a certain amount of income tax that you owe.
00:06:21.680 | But even within the United States, we have different types of tax that are levied against our income.
00:06:27.120 | And most people are only familiar with one of them and they don't see it.
00:06:29.680 | And so what I teach people to do is to calculate all of your tax.
00:06:35.120 | And I'll give you a simple example that I believe would have some parallels in the U.S.
00:06:38.480 | But it's a simple example from the U.S. tax code.
00:06:41.440 | In the United States, we have what we call employment taxes.
00:06:45.920 | And this is what funds our systems of socialized benefits, Medicare, Medicaid and Social Security.
00:06:52.240 | And for employees, this is levied against their income before their actual paycheck is received
00:06:58.000 | at a rate of 7.65 percent.
00:07:00.800 | The employee pays 7.65 percent and the employer pays 7.65 percent.
00:07:05.520 | So it comes out to about 15 percent, just over 15 percent when you add that up.
00:07:10.480 | Then on top of that, by the way, just to let you know and to interrupt,
00:07:15.360 | and we have exactly the same kind of thing.
00:07:16.880 | It's called national insurance contributions here.
00:07:19.280 | Very, very similar.
00:07:20.320 | So, yeah, I know exactly what you're talking about.
00:07:22.240 | So, yes, do carry on.
00:07:24.000 | OK, so most people are completely ignorant of that in terms of they don't factor that
00:07:28.240 | into their budget because they only sit down after the fact and actually run their budget
00:07:34.160 | much later.
00:07:34.880 | And they only run it based upon what they actually, the money that shows up in their
00:07:37.920 | checking account after their check is direct deposited.
00:07:40.320 | Well, that's 7.65 percent of your income.
00:07:42.800 | And in reality, it's 15 percent of your income, because if you weren't paying that tax,
00:07:46.400 | your employer would go ahead and send that money to you.
00:07:48.640 | From the employer's perspective, it's just a cost of doing business.
00:07:51.040 | And whether it goes to you or to the government, they don't have a choice in that.
00:07:53.840 | So that's essentially equivalent to 15 percent of their income missing.
00:07:57.600 | But most people don't ever calculate that, even when you get to the more straightforward
00:08:01.520 | number, which is income tax.
00:08:03.120 | So in the U.S., we run through and you calculate all of your income and then you pay a certain
00:08:07.120 | level of income tax.
00:08:08.480 | I have a little experiment that I play with folks, and I always ask them, "How much did
00:08:12.320 | you pay last year in income tax?"
00:08:13.920 | And then I wait for the answer.
00:08:16.480 | And I would guess about 90 percent of the time, the answer is, "Oh, I didn't pay anything.
00:08:21.440 | I got back $2,000."
00:08:22.560 | And because the way it works in the U.S. is some amount of money is automatically deducted
00:08:28.080 | from your paycheck, and then people at the end of the year will file a tax return and
00:08:31.520 | many people will do a refund from the federal government.
00:08:34.160 | But nobody actually understands how to sit down and read the tax forms and look and see,
00:08:38.240 | "Oh, I actually paid $9,000 of federal income tax.
00:08:41.440 | And even though I got $1,000 back, that was simply because I'd overpaid $1,000 through
00:08:45.840 | the course of the year."
00:08:46.640 | So when you start listing them out, and what I teach people to do the very first step is
00:08:51.520 | make a comprehensive list of all of your expenses and all of your income, and you start fundamentally
00:08:56.960 | individually identifying, "I'm paying this amount in employment tax," or for you, national
00:09:00.960 | insurance contribution, "I'm paying this amount in income tax.
00:09:04.000 | I'm paying this amount in property tax.
00:09:06.000 | I'm paying this amount in sales tax."
00:09:08.080 | And it goes on and on.
00:09:09.360 | And actually identify where each dollar goes.
00:09:11.280 | It can lead to substantial savings.
00:09:12.960 | And I'll give one story that might provide a little bit of incentive to actually do it.
00:09:17.120 | I had one listener called in and wrote me an email to my show and his letter to me said,
00:09:22.960 | "I want to thank you for the content that you've created on your show.
00:09:26.000 | Because of you, today is my wife's last day at work."
00:09:28.480 | And the story he told me was that by listening to my show, they had found in their family
00:09:34.960 | $30,000 of savings that could be had by his wife staying at home with their kids.
00:09:42.720 | Meaning, she was probably earning something like $50,000 per year.
00:09:47.120 | But the tax level was so high at that incremental amount, and they were able to find some other
00:09:51.760 | savings that in effect, if she stayed home, they'd only be out about $20,000 of income.
00:09:57.280 | And the net effect on their lifestyle of the amount of work that she was doing and the
00:10:03.200 | stressed existence of both people going out to salary jobs and fighting rush hour traffic
00:10:07.680 | and having to hurry through and put the kids in daycare and all of that wasn't worth it
00:10:11.920 | for $20,000 a year.
00:10:13.040 | But a major component of it was actually understanding the tax involved.
00:10:17.520 | And they could see that they actually saved $30,000 by her not working.
00:10:22.000 | That is really interesting.
00:10:24.080 | And so basically, what they were dealing with that couple, and we have a very similar system
00:10:27.840 | here is that if you have progressive income tax, where the more you work, effectively,
00:10:33.440 | the more tax you pay and also your tax rate goes up, then as a couple, you've got to
00:10:39.040 | sometimes reach the point where it's really questionable, is it really worth one of us
00:10:43.040 | working because of the amount that we're losing in taxes?
00:10:46.000 | And so that's what I get from what you're saying is, in their case, it actually was
00:10:50.800 | better off having the opportunity for them not to.
00:10:53.040 | Exactly.
00:10:54.260 | Right.
00:10:56.000 | Now, that's really helpful.
00:10:58.160 | And that brings me on to the question, the next question that I have for you, which is
00:11:01.840 | the comparison between being an employee and being an entrepreneur, because I come at this
00:11:07.520 | question from an entrepreneur's background, and looking at taxes, and in particular, income
00:11:12.480 | tax, because we were just talking about that example of that couple with income tax.
00:11:15.840 | It seems to me that there is a much bigger scope for reducing your tax liability relative,
00:11:22.480 | especially to the amount of value that you're creating and your potential for reaching financial
00:11:26.880 | independence in the future from becoming an entrepreneur relative to being an employee.
00:11:32.080 | Is that your view as well?
00:11:33.760 | What do you have to say about the comparison of employee versus entrepreneur when it comes
00:11:38.320 | to tax?
00:11:38.880 | In the US, there's a big debate among different political parties about, you know, do we,
00:11:43.840 | should we tax the rich or should we tax the poor?
00:11:45.920 | And people talk about having different tax loopholes for people at different income levels.
00:11:50.880 | There might be some of those things that exist.
00:11:53.120 | I haven't been able to specifically identify them, but I am convinced there are two tax
00:11:57.840 | codes in the US.
00:11:58.640 | There's a business owner tax code and there's an employee tax code.
00:12:01.360 | And it's exactly like you say, the individual employee has almost no flexibility with their
00:12:07.440 | tax planning.
00:12:08.480 | But the employer, the entrepreneur, even at the smallest, simplest level has an incredible
00:12:14.400 | amount of flexibility in their tax planning.
00:12:16.240 | And I often get questions from people.
00:12:19.520 | I was working with a couple recently and just talking and this couple is high income earners.
00:12:23.600 | One spouse is a pharmacist.
00:12:26.560 | The other spouse is a physical therapist.
00:12:28.640 | And both of them are employees earning an excellent amount of income.
00:12:32.000 | And we're looking at their tax bill and they're like, we paid so much in tax.
00:12:35.440 | What can we do?
00:12:36.160 | Well, unfortunately, as an employee, there were a few little tricks, but none of them
00:12:41.520 | that make nearly as big of a difference as if we could take $100,000 of income and have
00:12:47.600 | one of the spouses stop working as an employee pharmacist and start running a pharmacy of
00:12:53.360 | their own or moving to their own independent company.
00:12:58.080 | And I could go into details, but essentially, it's a huge difference.
00:13:03.280 | Right.
00:13:04.960 | Well, I do want to go into more details on the entrepreneur side.
00:13:07.760 | I'm definitely interested in that.
00:13:09.120 | But let's stick with the employees for just for a moment, because that is an interesting
00:13:13.520 | one, because I know that a lot of people who are pursuing the kind of extreme saving approach
00:13:19.040 | to trying to reach financial independence, they're doing it as employees.
00:13:22.400 | They have full time jobs and they're maxing out their savings within tax deferred or tax
00:13:29.200 | exempt savings accounts and retirement accounts.
00:13:33.440 | But it seems to me that if you are an employee, that's one of the kind of main ways that you
00:13:39.200 | can try and save tax is by using tax deferred accounts.
00:13:43.600 | Is that the way that you see it as for employees?
00:13:46.640 | Absolutely.
00:13:47.760 | That's about that's about the only big one.
00:13:50.480 | The ability to defer, you know, depending on the type of account, something like 17,
00:13:54.480 | 18 thousand dollars of your own money into the account and and, you know, delay the income
00:13:59.120 | tax on it in the US, that would be 401ks, IRAs.
00:14:02.160 | And every country has a similar system.
00:14:03.760 | That's that's the biggest savings.
00:14:07.280 | To answer the question, let me give you a quick bit of background.
00:14:10.240 | And there's a little bit of a framework that I use.
00:14:12.480 | And for years, I would read these little books and these personal finance things.
00:14:16.400 | And they would talk about putting money into IRAs or putting money into retirement accounts,
00:14:20.080 | things like that.
00:14:20.640 | And I would read them and I didn't have a framework to fit them into.
00:14:23.440 | And then one time I was reading a financial planning textbook and it was going through
00:14:28.640 | and giving the framework.
00:14:29.600 | And once I found this, it helped me to understand everything.
00:14:33.200 | And it's a framework that any person in any tax jurisdiction can apply to any tax.
00:14:39.200 | There are only three basic things that you can do to to change the level of taxation
00:14:46.080 | that you're the only three basic strategies that you can apply to tax planning.
00:14:49.440 | The first strategy is timing.
00:14:52.240 | The second strategy is income shifting.
00:14:55.680 | And the third strategy is conversion.
00:14:58.720 | Let me give some examples so you understand.
00:15:01.920 | Cool.
00:15:02.400 | With regard to timing, the only thing that you can do under a timing strategy is to either
00:15:07.760 | defer income to the future.
00:15:09.440 | When hopefully you'll be paying tax at a lower rate or accelerate income today to where you're
00:15:18.000 | going to be paying tax at a lower rate or deferring tax deductions to the future or
00:15:23.920 | accelerating a tax deduction to today.
00:15:26.240 | Those are all going to be income timing strategies.
00:15:29.520 | So the simple example of a retirement account, the way that most of the retirement accounts
00:15:33.600 | work in most of our countries is you put money into the retirement account and you don't
00:15:38.880 | pay any income tax today, but rather you defer the income to the future and you're going
00:15:44.960 | to pay income tax in the future under whatever rate you're paying at that point in time.
00:15:49.680 | And so the idea is I'm deferring it toward retirement years and I'm going to be paying
00:15:54.800 | tax at a lower rate then.
00:15:56.240 | So therefore, I'm going to pay a lower aggregate rate by deferring the income.
00:16:00.240 | Now, on the flip side, you can also accelerate income.
00:16:03.440 | And sometimes you might find yourself in a very low tax bracket.
00:16:06.400 | And some of the hardcore savers in the US, they apply this strategy.
00:16:10.480 | They save, save, save for five or six years and then they quit earning money and that
00:16:15.360 | drops them down into an extremely low tax bracket.
00:16:18.080 | And so now they go ahead and accelerate some of the income out of those retirement accounts
00:16:22.640 | and they keep it in at the zero percent tax brackets and they go ahead and bring it into
00:16:27.280 | today when they're paying tax at a low rate.
00:16:29.600 | So those are deferring income or accelerating income.
00:16:32.800 | And the key variable is what's the total rate that we're going to be paying on each dollar
00:16:36.880 | of income.
00:16:37.360 | That's all going to come into a timing strategy.
00:16:39.280 | - Okay, okay.
00:16:40.160 | Now, that sounds great.
00:16:41.440 | Now, I definitely want to hear about the other two, but let me just interject there just
00:16:45.360 | to give an example of what you're talking about to kind of make this more concrete.
00:16:49.200 | So for example, I sold my business to a much larger company.
00:16:54.480 | And when I did that, I went from being an entrepreneur to being an employee.
00:16:58.000 | I became a director in this larger company.
00:16:59.600 | I had to go and work in this company.
00:17:01.360 | So I found myself for the first time in many, many years actually being an employee.
00:17:05.840 | And during that period of time, it was three years that I worked for this company,
00:17:08.880 | I put the absolute maximum amount that I could into the UK equivalent of a retirement account.
00:17:15.200 | We call it a pension here, but I don't think you use quite the same terminology.
00:17:18.400 | But so I was putting the maximum amount that I could from my income into this retirement
00:17:24.320 | account so that I wouldn't get taxed on the income.
00:17:27.200 | And if I'd just taken that as income, I would have had income tax.
00:17:30.160 | And so I would have lost that money in tax.
00:17:32.000 | So I've done exactly what you're saying, which is to defer tax on that money, which is now
00:17:37.200 | sitting in a retirement account, and I won't be able to access that until I think it's,
00:17:42.560 | I think maybe when you're 55 in the UK is the first time you can access some of it.
00:17:46.240 | And then, and then you'll start, you get some tax free, and some of it you have to
00:17:51.360 | pay income tax on.
00:17:53.520 | But in the meantime, it also, it can accumulate interest and grow tax free as well inside
00:18:00.400 | this sort of shelter.
00:18:01.840 | So that strategy is very, very clear to me.
00:18:05.040 | But the other thing that you said about, you know, the extreme savers who then accelerate
00:18:09.760 | that income, I don't know if that works in the UK, because you see our pensions, the
00:18:14.160 | way that it works here is once you, if you do put that money aside, in our equivalent
00:18:18.800 | of retirement accounts, you can't access that until you're aged 55 or whatever.
00:18:23.520 | But it sounds to me like that's not the case in the US.
00:18:26.560 | Is it different for you there?
00:18:28.080 | Do you have any exceptions that you're aware of?
00:18:31.200 | For example, in the UK, if you put money into a pension account, and you decide to buy a
00:18:35.280 | home for the first time, can you take money out for that?
00:18:37.440 | Or if you have a you go through bankruptcy, can you take money out for that without paying
00:18:40.800 | penalties?
00:18:41.520 | I think there is there are some I'm definitely not the expert on this.
00:18:44.720 | There are some exceptions that you like you we have something called self invested pension,
00:18:48.560 | where you can also use their pension to, to buy property or various other things.
00:18:54.080 | So there is some there is a certain amount of flexibility, but essentially, the money's
00:18:58.320 | kind of locked up until until you're able to get to it.
00:19:01.120 | Again, I'm not an expert.
00:19:02.240 | So maybe I'm just missing a huge chunk of opportunities.
00:19:05.520 | But it sounds like there's quite a lot more flexibility in the States.
00:19:08.320 | There's been a there have been a few changes in the last few years that have added some
00:19:12.960 | of the flexibility.
00:19:13.760 | And these are unintended loopholes, intended or unintended doesn't really matter.
00:19:18.160 | What happens is nobody in the US country in the world, probably nobody actually understands
00:19:23.600 | the tax code.
00:19:24.480 | And the politicians are the worst.
00:19:25.920 | They don't understand it either.
00:19:26.960 | So they pass things and then later we find out what's in it and then they they add a
00:19:31.840 | patch to it and they change something and adjust it.
00:19:34.320 | So what I was referring to as far as the change, there's a little strategy in the US that
00:19:38.160 | they call the Roth conversion ladder.
00:19:41.680 | And so fundamentally, there are two major different types of pension accounts.
00:19:44.560 | We do call them pensions, although most people don't, but the technical financial planner
00:19:48.480 | would usually call them a pension account.
00:19:50.320 | There are two types of pension there.
00:19:52.240 | When you use the and both of them are pensions, there's what's called a defined contribution
00:19:56.000 | pension, which is where you're just putting in a same defined amount, a contribution each
00:20:00.960 | time.
00:20:01.520 | And then there's a defined benefit pension.
00:20:03.920 | And that's where you're guaranteed a certain amount out of it.
00:20:06.320 | But they're both pensions.
00:20:07.440 | And so the accounts that we use in the US, things like IRAs and 401ks, those are still
00:20:12.880 | pension accounts.
00:20:13.600 | But most people don't think of them as that.
00:20:15.840 | They usually think of the US pensions as defined benefits.
00:20:19.440 | I'm going to get 3000 a month when I retire.
00:20:22.000 | But the little loophole that came out was that we have two different types of defined
00:20:27.440 | contribution pensions.
00:20:29.040 | And these are known as IRAs, individual retirement accounts, or Roth IRAs.
00:20:33.920 | And they're also known as traditional 401ks and Roth 401ks.
00:20:38.720 | And basically, one of the accounts, you go ahead and pay the tax now and you put the
00:20:44.480 | money into the account and then you leave the money alone.
00:20:47.520 | And when you take it out at retirement, you never pay income tax on the gain.
00:20:51.600 | And the other type of account, you defer the money now.
00:20:54.640 | You don't pay any tax on it now.
00:20:56.320 | But you pay all the tax in the future on the gain.
00:20:58.640 | And the rule of taxes, income tax specifically, you're always going to pay tax.
00:21:02.240 | You're either going to pay it now or you're going to pay it later.
00:21:04.560 | And so that's the whole calculation you're running.
00:21:06.880 | Is it better to pay it now or is it better to pay it later?
00:21:08.960 | So the difference between these is that in the US, they passed a law where you can actually
00:21:14.640 | convert your account from one type of account into another type of account.
00:21:19.280 | And there used to be an income limitation on this.
00:21:22.240 | But now that income limitation has gone away.
00:21:24.320 | And my theory is that the US government is broke and they need more tax revenue.
00:21:28.320 | And that was why they passed it.
00:21:29.440 | I don't know if it's true or not, but that's what it seems to me.
00:21:31.600 | They're trying to encourage people to go ahead and pay income tax now instead of deferring
00:21:35.440 | it for the future.
00:21:36.160 | But what has happened is many people have the opportunity to put money into a traditional
00:21:42.000 | 401k, which is the same thing you have at jobs, or an IRA, these deferred contribution
00:21:47.920 | plans and pay no tax on it now while they're working.
00:21:50.800 | So they're working, say, earning $100,000 a year as an engineer.
00:21:54.160 | Then they're putting $20,000 a year into the account.
00:21:57.200 | And then they leave their engineering job.
00:21:59.200 | And they've set aside a little bit of money in an external account.
00:22:01.600 | They move to Mexico or they go travel the world full time.
00:22:04.480 | And they don't need that much money.
00:22:06.240 | Well, now their income has dropped to zero.
00:22:08.720 | And in the United States, you can pick up a certain amount of income and still stay
00:22:12.240 | in the 0% tax bracket.
00:22:14.080 | So then little by little, they start converting over some of the money from the traditional
00:22:18.960 | account, which is where the tax is deferred, into the Roth account.
00:22:22.960 | And by only doing that in, say, $10,000 increments, they can stay under the 0% tax limit.
00:22:31.040 | Because when you convert it, you have to pay the income tax in the year of conversion.
00:22:34.800 | But because they're not making any money, they're keeping it at a 0% rate.
00:22:39.040 | Then by putting it over into the Roth account, they'll be able to use it in the future.
00:22:43.760 | And this is compounded with a little rule, a little trick that the early retirees in
00:22:48.000 | the US system are using, where in a Roth IRA, you can always take out what's called your
00:22:54.160 | tax basis, the actual contributions into it, without paying any tax and without paying
00:22:59.040 | any penalties.
00:22:59.760 | So even though it's a retirement account, you put in $5,000 this year and $5,000 next
00:23:04.560 | year, you've contributed $10,000.
00:23:06.720 | That's what we call your basis in the account.
00:23:09.040 | And the account's grown to be $12,000.
00:23:11.520 | You can take out the $10,000 for any reason without paying penalties or tax.
00:23:16.880 | But if you take out the $2,000 additional, you'd pay penalties and tax on that.
00:23:20.640 | So what they do is that once you put the money into the Roth IRA and once you leave it alone
00:23:25.840 | for five years, then you can go ahead and take out the contributions without paying
00:23:30.560 | any tax or penalty.
00:23:32.320 | And so people are putting money into their 401(k) during their working years.
00:23:36.400 | They're pursuing early retirement.
00:23:38.000 | Then they quit.
00:23:38.560 | They go travel.
00:23:39.520 | They start incrementally converting the money over into a Roth IRA, leaving it alone for
00:23:44.560 | five years, and then start taking out their basis at the age of, say, 48, 49 and taking
00:23:50.240 | that money income tax-free.
00:23:52.160 | And then at 55 or 59, when they go ahead and start taking the distributions out, they can
00:23:56.960 | go ahead and take the gains out tax-free.
00:23:58.880 | So that's the strategy that is available under the U.S. tax code.
00:24:02.400 | And the two best resources, if listeners are interested in reading about that, there is
00:24:06.240 | a site called MADFientist, M-A-D-F as in Foxtrot, I-E-N-T-I-S-T.
00:24:13.120 | That's written by a guy named Brandon.
00:24:14.560 | He does a great job explaining this for U.S.-based people.
00:24:17.440 | And there's also an excellent travel site by an author named Jeremy and his wife Winnie,
00:24:23.520 | and they have a site called GoCurryCracker.com, GoCurryC-U-R-R-Y-Cracker.com.
00:24:30.080 | And on that site, they go through details and actually show with their tax returns how
00:24:34.800 | they've employed this strategy for their early retirement perpetual travel lifestyle.
00:24:38.800 | That's cool.
00:24:39.280 | I actually interviewed them.
00:24:40.480 | And so, yeah, that's a nice example.
00:24:43.280 | And that makes it's really helpful you explaining it because that makes a lot more sense to me
00:24:47.280 | how people in the U.S. can pursue that approach.
00:24:50.640 | I may be wrong on this, but I don't think that you can do quite the same thing in the
00:24:55.040 | U.K. because we do have the same basic structure in that you can either pay the tax now and
00:25:01.040 | then put your after-tax income in a tax-exempt savings account, which can grow without having
00:25:09.120 | tax on the interest, or you can defer the tax by putting your money into a retirement
00:25:15.840 | account or pension.
00:25:17.040 | But then you can't switch them between the two, if you see what I mean, at least not
00:25:21.680 | that I know of.
00:25:22.320 | But that actually means that for the employee who's pursuing early retirement in the States,
00:25:29.120 | that's a pretty important strategy to be able to use because otherwise a lot of your
00:25:33.440 | money gets locked up and it becomes a lot less flexible as to how and when you can access
00:25:40.400 | your money, which I believe is the case in the U.K.
00:25:42.480 | Right.
00:25:43.680 | It's extremely important.
00:25:44.800 | Now, it does have downsides.
00:25:46.400 | Every strategy has downsides.
00:25:48.640 | And it's up to the individual to look at their individual strategy and just look at
00:25:53.200 | their individual investments and understand what are the risks and benefits, what are
00:25:58.400 | the upsides and downsides of this strategy in my life, and is this one going to be right
00:26:03.360 | for me.
00:26:03.760 | But if somebody is an employee, because there are many benefits to being an employee, I
00:26:09.200 | often think what it would be like to just go and work a 40-hour-a-week job and leave
00:26:13.040 | my work there on Thursday night.
00:26:15.360 | There are many benefits to it.
00:26:16.720 | And the key is to understand what are the strategies that I can apply within my context
00:26:22.640 | that will help me get closer to my goals.
00:26:24.640 | Yeah, absolutely.
00:26:26.640 | Well, I have another question about those deferred accounts, because as well as the
00:26:32.160 | question of how flexible they are, and it does sound like they're more flexible in the
00:26:35.920 | States, there is also the question of whether or not you have other risks using – putting
00:26:42.480 | a lot of your money into tax-deferred accounts.
00:26:44.720 | And one of the risks that people talk about is the question of sovereign risk and the
00:26:49.680 | question of pension funds essentially being expropriated, which does happen.
00:26:55.200 | It hasn't happened in the U.S. or the U.K. for a long time, or maybe I'm not even sure
00:27:01.520 | if it has happened in the past.
00:27:02.960 | But it happens all over the world in places like Argentina and so forth.
00:27:07.520 | And this is one of those risks that you either dismiss or you think is maybe a possibility
00:27:13.440 | or some people are very concerned about it.
00:27:16.880 | What is your thought about that question?
00:27:18.880 | In my mind, the best answer is going to be a balance.
00:27:24.080 | To me, to assume that tax law doesn't change and that governments don't change the law
00:27:31.360 | in order to suit their own purposes is simply naive.
00:27:33.920 | On the other hand, to think that it's all a vast conspiracy of trying to strip each
00:27:42.240 | and every individual of all of their wealth, I haven't seen the evidence for that.
00:27:46.240 | And even though I usually am drawn towards those kinds of theories, I want them – I
00:27:51.440 | want to see a little bit of evidence.
00:27:53.440 | I am very concerned about this risk and I'm especially concerned about it in many of the
00:27:58.160 | large Western countries.
00:27:59.680 | I do not see personally any possible way for the U.S. government specifically to be able
00:28:07.040 | to handle all of their obligations.
00:28:10.800 | And in the U.S., in the financial structure, the problems that the U.S. faces, it's not
00:28:16.800 | so much a current debt problem.
00:28:18.480 | The U.S. government owes, depending on where you go, something like $18 trillion of
00:28:23.360 | direct debt.
00:28:24.560 | But the problem is not the direct debt but rather what we call the unfunded liabilities
00:28:29.440 | of the social programs.
00:28:30.880 | And this number, depending on whose number you go with, can be anywhere from $100 trillion
00:28:36.160 | to one professor that I think makes a lot of sense, a guy named Lawrence Kotlikoff at
00:28:40.720 | Boston University.
00:28:41.920 | He estimates it to be over $220 trillion of total debt.
00:28:45.200 | And so you look at that and the big problem in the U.S. is not actually the social security
00:28:50.880 | system, although that is a problem.
00:28:52.640 | It's primarily the medical systems, Medicare and Medicaid, which are woefully underfunded.
00:28:57.040 | And I look at it almost as from a perspective of political reality.
00:29:01.760 | The political reality is that in general, politicians will usually promise as many benefits
00:29:06.320 | as they can and pay for as few as possible.
00:29:09.200 | And this is why in the U.S. we have an epidemic of local municipalities, pension programs
00:29:15.680 | going completely kaput.
00:29:17.440 | Because if you come in and you're working as a firefighter, it's very easy for the
00:29:20.880 | mayor and the town council to say, "We don't have a lot of money right now, so we're
00:29:24.480 | not going to pay you a high current salary.
00:29:26.960 | But what we will do is we will fund this pension plan for you, and we'll pay you a
00:29:31.440 | very generous pension."
00:29:32.400 | And most firefighters that I had as clients and that were friends of mine primarily were
00:29:36.400 | working in order to gain their pension benefits.
00:29:39.040 | And it's a great early retirement plan.
00:29:40.640 | You go and you work for 20 years, then you retire and you get 80 percent of your take
00:29:44.640 | home pay from then on for the rest of your life.
00:29:47.040 | And I worked with guys that were 44, 45 years old coming out of a 20-year career and getting
00:29:51.680 | paid almost $100,000 U.S. per year every year for the rest of their life.
00:29:57.280 | And you look at that and say, "Wow, that's fantastic."
00:30:00.000 | But the problem is, is that going to be paid?
00:30:02.320 | Now it varies among municipalities, and this is the risk that we face in different countries.
00:30:07.320 | The U.S. is different than Great Britain, and Great Britain is going to be different
00:30:10.080 | than Greece.
00:30:11.080 | And there's no comparison between the Greek economy and the U.S. economy in the sense
00:30:15.160 | of they're not the same in almost any way except that there's a country and there's
00:30:19.600 | a national economy and politicians are politicians.
00:30:22.000 | So I'm very concerned about that risk.
00:30:24.680 | I personally see an even bigger risk to retirement accounts, and I'll tell you that one because
00:30:29.720 | to me that's the more applicable one that has me steering away from them in my own personal
00:30:34.240 | financial planning.
00:30:35.660 | But I think it's an important risk and to just simply discard it is naive.
00:30:39.960 | I would be uncomfortable planning on those accounts never changing their laws for the
00:30:46.040 | coming 50 to 75 years.
00:30:48.640 | I wouldn't recommend to somebody, if I were coaching a client and this client is 50 years
00:30:52.460 | old and they have a lot of their wealth in 401(k)s, I wouldn't recommend that in the
00:30:56.720 | U.S. current situation that they freak out, sell everything, and move everything into
00:31:01.260 | gold coins.
00:31:02.680 | But I wouldn't recommend that a 15-year-old put all of their faith and all of their plans
00:31:06.840 | into those types of accounts.
00:31:08.680 | So in my mind it's a balance.
00:31:11.960 | If you don't mind, let me just share the bigger risk that I see about these accounts.
00:31:14.720 | Yeah, I was going to ask you what you think that is.
00:31:16.040 | I think sovereign risk matters.
00:31:18.120 | But to me, I think the bigger risk is lack of control of money.
00:31:22.840 | And this was a major thing that I learned as a professional financial advisor.
00:31:27.800 | When I was a personal finance junkie, every personal finance book I read, the path to
00:31:32.200 | wealth was simply this.
00:31:33.880 | Go to college, get a job, and fully fund your retirement accounts and buy good mutual funds
00:31:38.120 | in those retirement accounts.
00:31:39.480 | And I did that.
00:31:40.920 | The problem was I got to the point even a few years ago when I started Radical Personal
00:31:44.920 | Finance where the majority of my savings was in retirement accounts and other tax-deferred
00:31:51.920 | accounts that I couldn't access immediately, funds that weren't fully liquid.
00:31:55.960 | And I had other savings but then I made the mistake of buying a house and heavily putting
00:32:01.720 | much of my liquid savings into that house.
00:32:04.000 | Now I thought it was a good decision at the time because I thought I was in a very stable
00:32:07.400 | situation.
00:32:08.800 | And anybody who had known my financial plan at that time would have encouraged me to make
00:32:12.120 | the decision that I made.
00:32:13.680 | But then all of a sudden, I found myself in a desire to start a business and I didn't
00:32:17.400 | have a lot of liquid cash.
00:32:19.400 | Now when you combine my experience with my observation doing financial planning and I
00:32:24.040 | challenge each and every listener to go and look in their town and ask themselves this
00:32:27.640 | question, "Do you know anybody who became very wealthy and the foundation of their wealth
00:32:35.240 | was the fact that they fully funded their retirement plans from the age of 20 to the
00:32:40.880 | age of 60?"
00:32:43.280 | I know only one person like that.
00:32:45.760 | And what I found was that it's very unusual.
00:32:49.280 | Now many people have a lot of money in their retirement accounts.
00:32:52.600 | Most of those people have a lot of money in their retirement accounts simply because they
00:32:55.440 | have a very high income.
00:32:57.360 | And when you compare say somebody making $40,000 a year and how much money they can contribute
00:33:02.120 | to their account putting $400 a month aside versus somebody making $300,000 a year and
00:33:07.880 | setting aside $20,000 a year, the $300,000 a year earner is going to have a massive retirement
00:33:14.120 | account balance.
00:33:15.360 | But it's not necessarily because of the account.
00:33:17.200 | It's because they put $20,000 a year in savings.
00:33:19.760 | And what I noticed is that if you go around my town and just about every town I've been
00:33:22.960 | in, the people who are wealthy are always the people who own the businesses of the town.
00:33:28.440 | You know, the Joshua Sheets car dealership or the Joshua Sheets gas stations or the Jake
00:33:33.560 | DeSilis engineering company or insert whatever business it is here.
00:33:38.600 | And I learned that business was the primary driver of wealth.
00:33:42.880 | And if I put all my money into retirement accounts, that can work if I'm going to be
00:33:47.120 | an employee over a long period of time.
00:33:48.840 | But it's a much faster path to financial independence to simply be an entrepreneur.
00:33:53.060 | I live right now almost exactly the same lifestyle that I would be living if I were purely living
00:33:59.100 | on dividends.
00:34:00.100 | I'm working more than I would be working if I were just living on dividends from an investment
00:34:04.620 | portfolio.
00:34:05.620 | That is true.
00:34:06.620 | But I would still be doing the same work that I'm doing now and I'd be living the same lifestyle.
00:34:12.340 | I didn't need to wait 10 or 15 or 20 years and become a multimillionaire to build a lifestyle
00:34:17.700 | of financial independence.
00:34:19.340 | I've built a business that funds my lifestyle, but in order to build a business, I need investment
00:34:24.900 | capital.
00:34:25.900 | And if it's all locked up in a retirement account and I don't have the money to go out
00:34:29.060 | and buy a microphone for my podcast or I don't have the money to go out and pay a web designer
00:34:33.980 | to design my website, etc., then I don't have my business and I'm stuck in the system.
00:34:39.080 | And you go back to this question of intent and frankly, I don't know.
00:34:42.740 | I could talk on, I've talked a lot about the history of retirement on my show.
00:34:46.900 | I don't know what the intent was, but I will say this.
00:34:49.740 | If I were trying to design a system in which the primary wealth was going to be accrued
00:34:59.140 | and accreted by the companies that are involved in the investment business and I were trying
00:35:04.680 | to design a system where people bought investments for as long as possible, thus allowing me
00:35:11.020 | to make money and yet never used those investments, I would design a system that looks very much
00:35:17.300 | like the retirement account system.
00:35:20.860 | Because what happens in reality is people put all their money into it, all they have
00:35:25.260 | is a limited number of investments in most plans, the investment companies gain a lot
00:35:30.500 | of money off the fees of managing those investments, it all goes into the generalized markets around
00:35:35.620 | the world and those people cannot touch it for 40 years.
00:35:41.300 | That's a pretty good system if your goal is to gain wealth.
00:35:43.820 | Now was that the intention?
00:35:45.740 | I don't know if it was the intention or not, but I guarantee that the people who were influential
00:35:50.500 | in getting those laws established and at least recognizing the opportunity, they saw the
00:35:55.880 | business potential because every business person that has an opportunity to rope in
00:35:59.920 | a consumer under some type of terms is going to keep that consumer a very long term customer
00:36:06.220 | with little ability to escape, every business person is going to see the benefit of that.
00:36:11.220 | That is so interesting.
00:36:12.220 | I really appreciate that perspective and I think that's a really important point because
00:36:18.180 | I was talking about locking your money up in a retirement account for a very long time
00:36:23.940 | being an issue just in terms of gaining access to your funds and you're talking about it
00:36:29.900 | even within the context of the states where there are some special ways that you may have
00:36:34.260 | a bit more flexibility than in the UK.
00:36:36.260 | You still have less flexibility and that's still going to limit your opportunity to pursue
00:36:40.940 | other great opportunities in life like entrepreneurship and like the chance to start a business.
00:36:46.180 | So I think that gives a really interesting perspective for people to think about the
00:36:51.060 | possible downsides and some of the things that you have to take into account.
00:36:54.840 | As you said Joshua, everyone is going to have to make their own decision about this, but
00:36:58.260 | I do think that there are negative sides to locking your money up in that way that limit
00:37:04.060 | your opportunities and that's something that people need to be aware of too.
00:37:09.500 | Having said that, I also had the advice – like I read the advice in Harry Brown's book about
00:37:14.700 | retirement accounts when he was talking about this sort of sovereign risk and the fact that
00:37:18.940 | some people are afraid of that.
00:37:21.500 | His point was look, you can't be sure what's going to happen in the future.
00:37:25.260 | Laws can change, but that doesn't mean that you shouldn't take advantage of the opportunities
00:37:28.980 | that are available to you to minimize your taxes in any way that you can.
00:37:33.180 | I personally consider that to be a good approach.
00:37:36.180 | I think why not use whatever opportunities for deductions that you have and opportunities
00:37:41.800 | for deferring taxes if you can.
00:37:44.060 | Yes, it's true in the future the laws might change and you may not be able to use them,
00:37:49.140 | but I think it's sensible to take advantage of things that you can take advantage of if
00:37:53.140 | they're available now.
00:37:54.860 | The best thing that I try to do on my show is to pull the emotion out of the decision
00:37:59.100 | because what happened for me was I spent so many years reading personal finance books
00:38:04.240 | and they said never cash out your retirement account, never touch your retirement account,
00:38:07.900 | never touch your retirement account.
00:38:09.340 | For me, it almost became almost a religious idea in the sense of you never touch your
00:38:14.060 | retirement account, but it was a religious idea without any actual fundamental basis
00:38:17.580 | and truth.
00:38:18.620 | It was just simply an emotional idea of don't touch your retirement account and the reality
00:38:23.260 | is if you simply pull back from the emotion of it and you look at it as opportunities
00:38:29.660 | and advantages and disadvantages, you can create a list of the benefits and the pros
00:38:34.860 | and the cons of actually of the contribution to the retirement account.
00:38:40.640 | One of the potential disadvantages is the sovereign risk, but one of the potential advantages
00:38:45.180 | is the deferral on tax and you can measure that risk.
00:38:48.260 | I perceive the current risk based upon the political reality under today's world in the
00:38:54.060 | US to be pretty low, but I'm not sure about that 30 years from now because political situations
00:38:59.220 | can change, but if you flip it around and recognize, okay, what's the alternative use
00:39:03.160 | of the dollar and this is what most people don't think about.
00:39:05.460 | The fundamental most important concept I think people need to grasp with financial planning
00:39:09.540 | is the concept of opportunity cost.
00:39:11.500 | I did a show on it.
00:39:12.500 | It's one of my most popular shows about how opportunity cost influences everything and
00:39:17.140 | some practical examples of this would be if you were trying to decide between the age
00:39:22.980 | at the age of say 18, you're trying to decide whether to put a thousand dollars into a retirement
00:39:28.700 | account or to take that thousand dollars and to pursue an educational opportunity which
00:39:32.900 | is actually going to result in a substantial increase in your earning ability.
00:39:37.820 | So whether that's a class, a certification, a university degree of some type that has
00:39:43.060 | a specific applicable financial outcome and you were trying to measure the benefit of
00:39:48.500 | investing the thousand dollars in the retirement account or investing the thousand dollars
00:39:51.860 | in your education, you would be able to come up with which one is better and I think almost
00:39:58.180 | every time it would be better to invest that thousand dollars into education and knowledge
00:40:03.100 | that's going to lead to higher earning potential.
00:40:05.540 | Now if you're comparing investing that thousand dollars in the retirement account versus consuming
00:40:11.160 | the thousand dollars which is the situation that most people are in, it's either I put
00:40:15.100 | the money in my retirement account or I spend all my money.
00:40:17.340 | Well, in that situation, you would be better off going ahead and investing the thousand
00:40:22.780 | dollars.
00:40:23.780 | If you, Jake DeSilis, were going to go back and you were going to recreate your financial
00:40:28.140 | life and you were going to compare the amount of money and the amount of sweat equity that
00:40:32.140 | you put into building your business and you were going to put the same amount of money
00:40:35.700 | into a retirement account, you came out far ahead with building the business.
00:40:40.860 | And so for you, it was better to build the business than to put the money into the retirement
00:40:44.540 | account.
00:40:45.540 | But that switched once you became the employee and you said, "Now I've got this high income.
00:40:49.300 | I've got this asset that I don't know what the terms of your payout were but it was either
00:40:52.400 | deferred or it's being paid out over time.
00:40:54.460 | I don't need all this income right now because I have low lifestyle expenses.
00:40:57.900 | Now the retirement account is a good fit."
00:40:59.920 | So removing the emotion from it and then comparing and saying what's the actual tax benefit versus
00:41:05.060 | tax cost.
00:41:06.620 | For example, if you're 18 years old and you're making say $20,000 a year, you're not paying
00:41:11.740 | much tax.
00:41:12.740 | And in that situation, deferring the tax from today at a 0% tax rate to the future when
00:41:18.500 | you're going to have millions of dollars, there's not much of a reason to fund that
00:41:21.580 | kind of account if you can find a better place to invest it.
00:41:24.860 | Absolutely.
00:41:25.860 | That's all for this week's episode.
00:41:27.660 | In next week's episode, we'll have the second part of the interview with Joshua.
00:41:32.300 | In that part of the interview, we talk more about entrepreneurs and the question of tax
00:41:36.700 | strategy for entrepreneurs.
00:41:39.180 | As always with financial topics, it's your responsibility what you do with your money
00:41:42.780 | and this is meant as food for thought and not as advice.
00:41:46.640 | So do your own research and make a decision that works for you.
00:41:50.260 | But I hope you found the discussion helpful.
00:41:52.300 | We'll be back next week with another episode.
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00:42:11.020 | [MUSIC PLAYING]