If you’ll recall in our last episode, Joe Flipper was about 54 years old and tired of the flippin’ grind — pun intended. If you need to get caught up, or review the initial post, here it is. We went back in time, wondering what he might’ve done differently if he’d known what was possible. He played it close to the vest. Still, by executing a Plan taking advantage of his flipping skills as much as possible, he was able to create a comfy retirement income. We’ll be talkin’ this time about the other half of his Plan, the generation of tax free income through the use of notes secured by real estate. Joe will again take advantage of his rehabbing company.
Joe’s income in his mid-40s was runnin’ around $60,000 monthly, after taxes. Yeah, he was doin’ fairly well. Note, that this scenario can be expanded or paired down, depending upon your personal circumstances. My thinking here is that if he’d done what this Plan suggested, he’d be ready or very near ready to retire. Here’s how his Purposeful Plan, Part 2, works out.
First, Joe needs to set up a Solo 401K.
He coordinates this with my expert on the subject, John Park. When doing this the rules allow just the owner and their spouse to be employees. Since that’s always been the case with Joe’s firm, he calls John to set it up. It’s the last quarter of the year, and Joe is now 46 years old. He and his wife, Peggy, immediately make maximum contributions into the Roth side of the Solo 401K. Roth side? Yep, the Solo can do both traditional and Roth plans. Though many do both, my take is that traditional 401s and IRAs don’t make sense. Here’s a quick explanation of that conclusion.
Most folks begin giving parts of their paychecks sometime in their 20s or 30s. They do this for 25-40 years or so. During that time they save anywhere from $50-150,000 in income taxes. Thing is, IF they’re successful in gettin’ to retirement with a couple million bucks in their 401 — which, of course, they won’t — what then? Let’s say they do better than the 4% yield their plan’s advisor said to expect, makin’ 7% on the $2 million. They won’t, but we’ll say they do. That’s $140,000 a year in retirement income, right?
Let’s keep goin’. They paid off their home’s mortgage. Their kids are grown, and the IRS has stubbornly refused to enact a grandkids’ deduction. In other words, they hit April 15th every year almost naked, tax wise. Counting state and federal income taxes that $140,000 could very easily turn into a whole buncha $100,000. That’s probably being kind. That means that in the first 3-5 years of their retirement they paid as much or more in taxes than they saved in the lifetime it took to get there.
Who does that to themselves on purpose?
Most Americans, that’s who. Thing is, the average American man between 50 and 60 has less than $100,000 in their 401K. Ending up with even a million bucks is a pipe dream. They only wish they could have a tax problem.
Anywho, Joe sets it up. He and Peggy each give $17,000 ($34,000 total) into the Solo before the end of that calendar tax year. (max allowable) That allows them to put another $34,000 after the first of the year. This results in a relatively quick $68,000 inside a completely self-directed Roth plan. They now have the capital needed to begin their note portfolio.
Buying the notes
Everyone wants the magic formula, which of course doesn’t exist. What with markets being different from one another, business cycles, recessions, rising/falling interest rates, and a myriad other factors, pretty much every so-called ‘formula’ works great — ’til the day it doesn’t.
Fundamentals however, never die. It’s human nature for us to wanna create a cookie cutter system. To a very limited extent, that’s possible. But when the Firestones hit the pavement, every note stands or falls on it’s own merits — or lack thereof as Dad often said. Suffice to say that finding notes should be left to the pros. Remember, this is all about your retirement income. How important to you is being right?
Joe begins with a note purchase requiring about $65,000. It’s a $100,000 note at 10% interest. Due diligence gives it the ‘go’ signal. His payments are a few HappyMeals over $10,500 annually. The cash on cash return is a bit over 16%. It’s fully amortized over 30 years, and there’s no balloon payment. Here’s where the crystal ball comes in. We’ll never know when it’ll pay off. I’ve been doin’ notes since Carter was in office. We can make broadly based predictions from hard won experience, but when the smoke clears, it remains nothin’ short of a guess. I won’t go into the whys and wherefores here and now, but my take, is that notes like this one have been payin’ off in the range of two to five years or so. Don’t go puttin’ that in a template, cuz there’s no way to know for sure, outside of a Ouija board. They could pay off before you get your first payment, or over 30 years as agreed. In this case we’ll go with five years, as that’s what our research indicates.
This means the Solo’s first note received over $52,600 in payments. His payoff (in 5 years) was around $96,500. His first $65,000 foray into notes turned into roughly $149,000 in five years. Would I have advised him to accumulate that much cash in payments without puttin’ it out to buy another note? Duh, of course not. But you see the possibilities. Meanwhile, back at SoloRanch, Joe ‘n Peggy have been pumpin’ $34,000 a year into the plan. This means they’ll be acquiring, dependent of course upon availability, $40-60,000 in new notes just from annual contributions to the plan. Is the big picture beginning to come into focus for ya? It gets even better after five years, when they turn 50 years old. At that age the annual max for contributions rises to $22,500 apiece.
13 years investing in notes.
Since Joe started at about 46 years old, give or take, and can’t begin withdrawing income tax free ’til he’s 59.5, he’ll have been diligently building the Solo’s portfolio for quite some time. If none of ‘em ever pay off early, he’d have acquired (face value) just over $600,000 in notes with his contributions alone. Add the reinvestment of the payments into more notes. If Joe ‘n Peggy never have one note pay off early, highly unlikely, they’d own in excess of $1 million in notes, based on original face value. The range of annual payments received would approximate $80-105,000, give or take. It’s my experience they’ll do better than that, as the majority of the notes, given my experience, and the note terms in general, will be paid before they amortize themselves away. But let’s assume every single note they acquire ends up paid in full via 360 ‘boring’ payments.
That means they’d hit retirement at 59.5 with $6,500-$8,700 dollars a month in tax free income. This would be in addition to the income from their real estate investment portfolio. Experiences shows that realistically, their note income would be higher, due to most notes payin’ off early. But wait, there’s more.
Though on the real estate side of their Purposeful Plan we assumed no appreciation ever, and no increase in NOI either, those two assumptions simply don’t apply to notes. Every time a note pays off, there’s a tax free profit, cuz it’s inside the Solo. Joe ‘n Peggy will take that profit and buy more notes. They’ll always be doin’ the same thing with accumulated payments as they grow large enough to purchase another note(s). This means that even after they retire, the process continues. Every time they ‘rinse ‘n repeat’ buyin’ more notes with profits/payments — they get a raise. Think about that, and let it settle in. They never have to take the principle, as the government won’t come to them at 70.5 years old and force them to begin cannibalizing their principal, as will happen to the vast majority of Americans with traditional plans.
Joe ‘n Peggy’s retirement income.
Their income from real estate will be $9-10,000 a month, much of it tax sheltered for the first 15 years or so. Add to this their note income — 100% tax free — about $80-105,000 a year. They’re both relatively conservative numbers. Frankly, I suspect they’ll do much better on the note side, but give or take six figures a year, tax free, probably works for most folks. This is especially true, given the late start by Joe and Peggy. Most investors are able to execute a Plan similar to this for at least 20 years, some much longer.
Remember, Joe retains the option to continue flippin’ property if he feels like it. Most begin to tire of that process though by the time they’re over 50. It’s a job. He can pass it on to his kids. Sell the business. Or, maybe he just walks away. It’s not investing. But you can easily see how flippers have options others don’t have on their menus. When they Purposefully harness their superior earning capacity by combining multiple strategies synergistically, they can create the retirement they always thought possible.
This is real. It’s doable. The best part? Many can incorporate this approach without being a flipper. It just helps if you are one.
Photo: Jaqueline CliffJoe Flipper: Part 2 Of His Purposeful Plan -- Tax Free Income by Jeff Brown