The "Middle Class Trap" Is Real—But We Need a Better Name

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1:37Mindy Jensen:Last week, my episode with the money guys came out. Actually, mine and Carl's episode with the money guys came out. And in the beginning of that conversation, I said that Carl and I had fallen into the middle class trap. And And that sparked quite a bit of discussion in the comment section of that video, with some listeners agreeing and others questioning whether we were using the term correctly. So today, we are going to unpack what I meant, whether the middle class trap is still a useful concept, and whether you'll be hearing us use that phrase going forward.

2:18Mindy Jensen:Hello, hello, hello, and welcome to the BiggerPocketsMoney podcast. My name is Mindy Jensen, and with me as always is my not middle class or trapped co-host, Scott Trench. Thanks, Mindy. That was a great socioeconomic intro. Really appreciate it. I'm excited to talk about this today. It was an awesome episode, and the money guys were really, really fantastic. I mean, they both did a great job, but Brian in particular was just outlining the tax advantage he was proposing from a Roth conversion strategy, and he just crushed it. It was so eloquent the way he described it, talking about today's tax code, smoothing out the tax brackets.

2:53I was listening to the episode. I couldn't see the YouTube for that particular part, and it was just so clear the way he visualized it. I mean, they just do such a great job over there at MoneyGuy. But the top comment was, ah, yes, the$10 million middle class trap. So I think we have a problem with this terminology as it applies to your situation, because clearly$10 million is top 1 % or very close, almost certainly top 1 % for your age bracket. And it's not a middle class problem. This is a high achievers, as they called it, or a larger problem.

3:24Mindy Jensen:Yes. I liked somebody said, oh, this isn't the middle class trap. This is the achievers trap. And then somebody else chimed in. Do you mean the blind achievers trap? they should have seen this coming. So all valid comments. When I said that Carl and I found ourselves in the middle class trap, the middle class trap in air quotes is a phrase that Scott and I have coined, which describes a situation where you have done everything right. You're contributing to your 401k. You are not paying down your super low interest mortgage if you don't want to, et cetera. But now the bulk of your net worth is in your pre-tax accounts, in our case, the pre-tax 401k, and your home equity.

4:11Mindy Jensen:And this is true. The numbers are not middle class, but the middle class trap, as I just described, is exactly what we find ourselves in because the bulk of our net worth is in our 401k and our home equity. And yes, we do have money in our after-tax stock portfolio. We do have money in our Roth. But where this quote-unquote middle-class trap comes to hit us, and the whole reason we wanted to go down and chat with the money guys in the first place is in the future. We have RMDs that are sitting there just waiting for our 401k to continue to grow so that they can come and snatch out a lot of money from the 401k.

5:01Mindy Jensen:So we want to avoid that as much as possible. The reason why this term, the middle class trap, aside from it being perhaps incorrectly applied to a$10 million portfolio is so controversial is because people are right in a general sense that an optimal approach to financial independence often involves maximizing these pre-tax accounts, firing and stopping working, and then harvesting them in lower tax brackets. And that works for a lot of people. I mean, that's a real appropriate strategy. And where it doesn't work, though, is when you overshoot that fire number. I think that this really triggers a good section of the financial independence community.

5:42And I I got no problem triggering that section of financial independence community because they're wrong to be this dogmatic about what's right and wrong. Right. For a person who's going to retire at 40 with a one and a half to two and a half billion dollar portfolio, stop on the nose and begin withdrawing at zero income at that point. They're absolutely right. You should max the 401k the entire time or as much as possible and begin withdrawing. And you're going to be able to do that for a good chunk of that. Right. You're going to have a heavy balance there, but you're going to be in those low income tax brackets.

6:09And I think you're going to get that arbitrage.

6:10Mindy Jensen:I'm going to argue if you retire at 40, how are you going to get into your 401k balance, Scott? You do the Roth conversion strategy or your 72Ts, right? You can do that, right? As long as you have some balance, it can't be literally everything in there, but as long as you have some balance in your tax brokerage or your Roth or in a cash buffer, you're going to be able to do that. And there's a real case to be made that it is tax optimal to go that traditional route and then pull it out at lower tax brackets after retirement. I completely agree with that. And to me, that's not really a debate in that sense.

6:43But I want to get to the debate point here because it is too rigid for people to just say, max out the 401k at all costs, because it's not how life works for a huge percentage of the people who listen to BiggerPocketsMoney.

6:55Mindy Jensen:Okay. So you just outlined two strategies, the 72T and the Roth conversion. assuming our retiree is age 40, the 72T is less enticing because you have to take that for a minimum of five years or until you turn 59 and a half, whichever is longer. So your 40-year-old retiree is signing themselves up for a 19-year 72T. That's going to be more of an issue. The other option is the Roth conversion. And when you convert to a Roth, that money is not available for you for five years. So a 40-year-old retiree still has a five-year gap between when they can access their Roth converted money. And also, I don't think is a good candidate for the 72T.

7:49Mindy Jensen:But like you said, having the money in an after-tax brokerage is great. Again, I wanted to highlight what happens when you max out your 401k. I'm 53. I've been maxing out my 401k since I was like 24. Well, actually, okay, I didn't have earned income for the eight years that I was a stay-at-home mom. But other than that, and Carl has been maxing out his 401k for the same amount of time. So that's a lot of money that's sitting in the 401k. We also have after-tax brokerage. We also have some Roth money. But if we would have been a little more forward thinking when I started at BiggerPockets, they had a Roth 401k option.

8:34Mindy Jensen:I think that would have been a better choice. And another comment in that video, Scott, was somebody saying this really highlights the importance of having a financial advisor or having a CFP or a CPA look at your specific holistic position so that they can make suggestions. I have always been under the assumption that a financial planner just helps you with your investments. I don't need any help with my investments. We're doing okay. But that's not all that they do. They also do tax planning. They also just are a wealth of this specific knowledge and they can help you look at the the bigger picture.

9:16I think going back to this concept here, though, we are not Dave Ramsey here at BiggerPocketsMoney. We're not, you know, money guy over here at BiggerPocketsMoney. You know, we're not some of these other shows. We are creating this show to help people who want to reasonably aggressively pursue their version of financial independence early in life. We presume that many of the listeners here want to retire in their 30s, 40s, or 50s and get there very rapidly. Some want to do it in their 20s. And for that population, you're going to have a high savings rate. And I think that there's a real possibility that a third of you listening are going to want to start a business or continue working in your version of early retirement or financial independence.

9:58Another third are going to be open to it. And a third of you don't want to do anything after you retire and have no intention to make money at all. And so the pure five strategy of maxing out the 401k throughout your career and then retiring and stopping earning money and really being in that lower income tax bracket, I think the deferred approach works really well for that cohort. I'm not arguing that that's not an optimal approach. I think I'd recommend that approach for many of that group because the 72T is less impactful for that group because they're locking themselves in correctly because that's their goal to that level of spending across that entire duration.

10:34And they're likely going to need a fairly low income. So they're not going to come close to those magi cliffs for ACA subsidies, that kind of stuff. And or the Roth conversion works because again, we have a very long-term worldview. We knew we're going to work. We knew we were going to stop and we knew we're going to spend at this level for the rest of our lives. I think that's not for me. That's not for a lot of people. I wanted flexibility that expanded across my lifetime from age 25 to at age 30 to age 35. And that's why I prioritized the brokerage account first, my after-tax position first, my house hacking, that kind of stuff, because I thought that would give me options across my life.

11:06And then after those first three to five years, I started maxing the 401k. And that has produced those options for me. And I think the advantage I see now that I didn't see at 25 when I was doing this approach is that I'm probably going to continue to make money through Various Ventures. I got real estate. I continue need to do this podcast. I may advise companies in the future. So that income would make it very hard for me to do Roth conversions or 72Ts or those other types of things, right? How many people have we talked to, Mindy, who have a spouse who continues to work while they're living the financial independence lifestyle?

11:40That's going to make it hard to do 72T, right? That's going to make it hard to do a Roth conversion in those instances. And you can argue that that's a good problem and that's just padding the wind, and it is. But it also creates this feeling of trapped liquidity that constrains your thinking. And that money is really not as easily accessed as we thought. You can pay the taxes, but I find that that to be very rare in practice. And I think the advantages of liquidity are great for a much bigger portion of the financial independence space than I think the purists who have their tax-deferred account, tax-optimized approach, would argue.

12:17And I also will posit that this is like kind of semantics here, right? So even if you dig through and just pay the taxes in various points, you're not really talking massive percentage differences in post-tax net worth, regardless of which path you choose. You're talking about much more muted outcomes because it all is getting taxed one way or the other. You're just arbitraging these brackets. In some cases, it can be really big, but in most cases, it's actually not like this huge outcome. Your girls are getting a big inheritance if you go option A, and they're getting a big inheritance if you go option B, according to the plan that we talked about a money guy.

12:49Mindy Jensen:Yes, you're not wrong. I do want to say that plans change. So in the beginning, 13 something years ago, when Carl and I first discovered this concept and started working towards it, our plan was he was going to retire. I wasn't working at the time. I was raising the girls. We're going to retire and then we're going to live off of$40 ,000 a year forever. And then I became a real estate agent. And then I became kind of a successful real estate agent. I sell as many houses as I want to. We have a lot of income currently. Some of our investments took off and then some other ones took off and we have had a lot of success.

13:29Mindy Jensen:So our plan completely changed. And like, I think that that's something you got to be open to as you go down this journey, right? You might win. You might not be dependent on winning, but if you might win, that's going to change the tax calculus to some degree if you factor that in as a probability assessment here. And I think, you know, at the point that you're talking about Roth conversions, and you're needing to do that even while you're continuing to earn income because you're still going to have an RMD at that point, then you know it's time to stop digging. So if we can concede that point by stop digging by continuing to contribute to the 401k, right?

14:00And so if we can concede that point, then yes, there comes a time when we've over-contributed to the 401k by definition, and we should have stopped before then. And if we can concede that point, then we probably shouldn't have contributed to the 401k earlier in our journey when our income was at lower tax brackets. That's my argument there. And I'm very happy with my decision to not max it out for the first few years. Again, I'm not like, this is not like don't max out the 401k. It's like, there's a prioritization here about going through this tax advantage stack. I think that that liquidity building that first after tax provides that whole lifetime of optionality at the lowest opportunity cost from a tax optimization standpoint.

14:36That's my argument. And I'm, I'm standing by it after all this time for many.

14:39Mindy Jensen:I think it would be a very interesting exercise to look at what our obligations would be if we had been maxing out a Roth 401k over the last 10 years. But then also, I don't want to do that math and be like, because I can't go back and change it. So what's the point? And again, this is not a middle class. The middle class trap, I think, is polarizing. And we're kind of stuck with it a little bit here. We called it the LAFOF, the Liquidity First Optionality Framework. And that has not caught on yet. So the middle class trap I think we're kind of stuck with for a little bit here. But the LaFaugh or the middle class trap, it's a problem that begins when you're in the middle class, right?

15:17So many, many households who are doing everything right with money in the middle class contribute, and then 10, 20 years of disciplined saving go by, and you're no longer middle class, but your wealth is locked up pre-tax. And unless you stop earning money and actually fi, which some people want to do and some people don't, or the life looks different at that point, and they're not sure, then it's actually quite hard to access that money. And that's where the The challenge comes from why people feel like they got hundreds of thousands of dollars or even maybe a million bucks in net worth, but still feel like they're stuck in their day to day.

15:47That's a real feeling. This is not like you can debate whether it's technically you can access it or not. No, this is how people feel. Millions of Americans in this country feel. And so the challenge is what do you do there? And again, my first point is stop digging for a little bit to build the balanced portfolio across these different accounts.

16:03Mindy Jensen:Yeah, we have stopped contributing to the 401k. Another point here, Mindy, is Bo had a really good point in the show with the money guys where he said, and this is casually thrown in there in like minute 32 or something like that, where he was like, at today's tax bracket, you're going to have this amount of tax liability here. And I think that that sentence is doing quite a bit of work in your situation because I believe that Uncle Sam, one day the political spectrum will shift and voters will come after the Jensen's 401k. That's an easy target. What do you think? Am I being too hyperbolic with that statement or is that something that you worry about?

16:38Mindy Jensen:Not at all. If you look back and take politics out of the equation, if you look back to 2020, the government wrote checks to every American or almost every American for a while. Those checks need to be cashed. We're in a deficit. Then we're spending money on upkeep and upgrading the DC area. Those checks need to be cashed. There's all of this money that's going out of the government that will need to be funded because you can't operate at a deficit forever. I mean, contrary to government spending, somebody is going to have to pay for this. And I hope I'm believe that tax brackets will go up in the future.

17:27Mindy Jensen:Maybe not the next administration, maybe the administration after that, but tax rates are going to have to go up because it's not sustainable the way that the government is spending right now. Let's talk about some of the things not covered in the Money Guy show. They had great advice with the Roth conversion here, but I want to call out, I don't know if you're going to do this, you and Carl, but I want to call out that real estate, I think, is a potential lever in your situation that we can pull to get out of this particular track. Now, there's pros and cons with this, but I think that in your situation, let's say that you had rentals, right?

18:00You had my portfolio of rentals. The year of the Roth conversion would be a very good year to be particularly active as your real estate agent in your real estate business, if not earning a lot of income, at least doing a lot of hours to get your real estate professional status. And then that's when I would hire the cost seg person and run a big depreciation year across all the portfolio, including anything I bought in that year, that might generate a nice big loss that would be really compatible with a big conversion event in the portfolio. So either a real estate purchase or just using that one-time big tax hit to take a big loss and then still go up to the 22 % bracket through the 22 % back with the conversion, that would make a big dent in a rollover like yours.

18:38If you're willing to put in that year of work, that might be more than several years of salary for many people if this has been a lifetime and accumulating it. What's your thoughts in response to that as a tactic not discussed on MoneyGuy, but maybe appropriate here on Bigger Pockets Money.

18:50Mindy Jensen:Hey, Scott, you want to sell me your portfolio for a couple of years? Gift it, depreciate it. Yeah, I think then we'll have a real talk with the IRS. That will be fun. Yeah. That'll make a great podcast though. Yeah. Live from prison. Bigger prison podcast. Yeah. The bigger prison podcast. I had a conversation with Carl about this. Like, hey, here's an idea. And he said, I don't want to own real estate. I don't want to put in the work. And I'm like, well, hold on. You won't have to. I'll have to do all the work. And he's like, I don't want that. We're trying to simplify our life. And that is not simplifying our life.

19:30Mindy Jensen:And ultimately, I think that we have decided that we are just going to near the end of November or December of every year, look at our income streams for that year, look at what we own, and Roth convert up to the top of whatever tax bracket we're in. And just say, we saved all this money when we put it into the 401k, and now we have to pay because I do appreciate having roads to drive on and having public services. So that's kind of nice, not driving down dirt roads all the time. Another conjecture here is if you have a self-directed IRA, which I know you do to a certain degree, and you have private assets like a syndication investment or a hard money note or a private company investment that is illiquid at this point, and you get those revalued, they may be valued at a lower basis than what you invested in them.

20:27And you can then use that in your Roth conversion years. And if, for example, the loan is valued at something less than it's a par value or repayment value, the principal balance, and it gets paid back into your Roth, now you've exhibited a larger Roth transfer. So that may be another item there is if there's a component of your portfolio that's going to be in these kind of alternative assets or syndication space anyways, it might make sense to do that in the 401k and then consider, you know, hire somebody to value this. This is a kind of real technical tax challenge here, but there may be an opportunity to roll those over at a favorable valuation for you that results in less taxable income in the year of the rollover.

21:04Mindy Jensen:So that is an idea that you floated to me, Scott. And I thought, that's interesting. I need more information. So I went over to Long Angle. I asked in the Long Angle group, and I was actually surprised I didn't get a ton of responses on this specific, very niche idea. So I've got to do a lot more research. But again, when I floated this idea to Carl, he said, that doesn't sound like we're simplifying our life. And I believe this is a huge red flag for the IRS. Yeah, you got to definitely hire professionals and do this by the book. But you have that impulse company, right? This rocket company with the guy who's only worth$50 billion because he didn't own SpaceX or whatever.

21:47That may be a candidate. I don't know. But that may be one of those things you'd ask your tax pro about, about whether that is you already own it. So if it was in your 401k, you would just value it and say, okay, it's valued here. Let's roll it over this year if we're going to do the Roth conversion.