Let me introduce you to a married couple who began their retirement planning a couple years ago. They’d been doing what most couples do for retirement, which is contribute to their 401K at work, figuring that’d do the trick. The bottom line reasoning for their reliance on the two 401k plans was the usual. “We get $X in matches, so since it’s ‘free’ money, why wouldn’t that be a good thing?” they wondered. “So, how’d your 401Ks do in the crash of 2008?” I probed. 🙂 Silence.
Before we continue with their plan, allow me some time on their initial path. Let’s talk about the ultimate effectiveness of your 401K. Oh, and for the record, this couple is real, not hypothetical.
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Why Your 401K Will End Up Disappointing You — Big Time
They’ve been around for over 35 years, easily long enough to establish efficacy. Boomers are the first generation granted the opportunity to have had them for almost their entire working lives. They’re now hitting 65 with an average of $100,000 or less in their work-related retirement accounts. Hardly impressive. In fact, it’s downright depressing.
Many of you are now yelling that the match is free money, and how can you pass up that deal?! Those retiring Boomers — though many simply can’t retire — are wondering where they went wrong, though most of ’em had the matches many think are magical.
The Role Investor Behavior Plays
When we have a Nasdaq crash like we did at the turn of the century, or the Dow in ’08, people often respond less than objectively. They find themselves selling too late in the downturn and sometimes buying too late in the upturn to make up for it. Never mind that in the example of the Nasdaq crash, it took about 13 years to get back to the level it was before the crash. Thirteen years. That’s a whole lotta gettin’ nowhere fast on the financial treadmill. Meanwhile, the investor keeps having those pesky birthdays. Yeah, I know, not funny.
For Heaven’s sake, the investors who insist upon executing the hugely inferior buy ‘n hold, never sell strategy with real estate come out so far ahead of those counting on 401K plans. it’s unfair to compare the two. That’s how badly 401K plans have “performed” since their inception. Finally, let’s take the outlier, which everyone thinks they are, of course, and see how they fare.
Let’s Assume You Arrive at Retirement With a $2 Million 401k Balance
You won’t, but let’s pretend. Let’s also assume you’ll always get a 7% yield on that balance while retired. Again, you won’t, but keep pretending. Virtually every Wall Street type with whom I’ve discussed this will stick with the party line: “You’ll either be drawing out 4% of the principal yearly or yielding no more than a 4% yield on the balance.” Four percent ain’t much to be sure, but we’re pretty risk aversive once retired, right? Think about the retired folks you know today trying to make the best of their relatively disappointing 401K balance. The 10 year Treasury Bond is now (as I write this) hovering around the 1.75% mark. Is generating a yield more than double that on Wall Street still gonna pass the risk aversive test?
Seven percent on $2 million is $140,000 a year before taxes. Let’s say you live in a state without income taxes. Current tax brackets say your federal income tax hit will be (rounding up less than $700) $30,000/year. If you contributed to your 401K for 30 years and saved an average of $5,000/year in income taxes, that means you save about $150,000 in taxes over the 30-year period. However, in retirement you’ll have paid the same tax bill in just five years! In other words, you set yourself up to pay the same amount of taxes in five short years of retirement that it took you to save in 30 years. But that’s not the worst of it. You did that to yourself on purpose. Why would anyone do that if they knew the ending? (Don’t answer, it’s rhetorical. :))
The numbers get horribly worse in states with income taxes and downright depressing in high tax states like Illinois, New York, and California, to name just three. For you Californians out there, the annual tax woulda been around $40,000/year.
Back to Our Investment Couple’s Plan
They began by investing in a new duplex. They put 25% down. It cash flows fine. They’ll close a second duplex in the next month or so. They’ll be executing what I’ve come to call the “cost segregation strategy” on the first duplex, retroactively. This will generate at sale net proceeds in the approximate amount of $250,000, virtually tax free. It could be up to $50,000 more depending upon the loan balance at close of escrow. The sale will happen, barring Murphy’s entrance, in around three years, give or take.
At that point, IF the market and the overall economy are cooperative, more likely than not, they’ll replace that duplex with two more. They’ll spend the rest on discounted notes secured by real estate, either directly or indirectly in a note investment group. The overall goal is to have all investment property loans paid in full by 62 or sooner. That’s not a random age, as another pillar of their plan comes to fruition at that point.
To review, an EIUL is nothing but an insurance policy, but with a different structure to create a different outcome than a typical life insurance policy. With life insurance, the person dies, and the designated person(s) get paid a lump sum of cash. With the EIUL, though there are some similarities, for example there’s cash value buildup, but the core difference is that the payoff is while you’re still alive. You get tax-free income in retirement for however many years for which your expert structured the contract. Here’s what this couple did.
Their premium is $12,000 yearly, and they kickstarted the policy with $8,000 up front. The premiums are indexed to inflation so they don’t get spanked on the income side at retirement. This will go for 23 years. At that point, they’ll be in their early 60s and will begin receiving $117,000 a year — tax free — ’til they’re 90. Now, in California to net $117,000, you’d need to make somewhere in the vicinity of $180,000 at today’s fed/state tax rates.
Back to Their Real Estate Portfolio and Strategy
They’ll be executing the cost segregation strategy on their first duplex, acquired a couple years ago. In a nutshell, here’s what that involves. Cost segregation (CS) is merely a different flavor of depreciation. Depreciation is a “paper” loss on investment real estate that isn’t an actual loss out of your pocket. The concept is that your building is deteriorating so depreciation allows for that physical process. It has nothing whatsoever to do with the actual deterioration of your property. Again, it’s all on paper. All CS does is take all the components used to construct the building and give them a much shorter lifespan than the normal “straight-line” approach does. In smaller, residential income properties, i.e. 2-4 units, it tends to double the annual dollar amount available depreciation.
This strategy’s success is based upon the investor(s) making over $150,000 a year on the job. At that point the tax code literally bars them from applying any depreciation leftover from sheltering the property’s cash flow. It must go to the sidelines to gather dust. However, during the first five years of ownership, the loan is paid down to (preferably) zero. A sale at market value is then closed about the same time. This allows the investor/taxpayer to then utilize all five years of unused depreciation against that year’s household income. Bottom line?
Their tax savings on the personal income tax side tends to mostly or completely offset the cap gains/depreciation recapture tax liabilities. My experience is an average offset of around 75-100%. This results in avoiding a 1031 tax deferred exchange and all the baggage it brings to the party. It also allows the investor to replace the sold property with two new properties if that’s their plan. They’d still have money left over to make some significant discounted note investments directly or indirectly. I’ve also had a few clients take a large sum, low-mid six figures and open a second EIUL policy, using only that money for premiums paid five times, over a period of just four years and a day.
What About a Discounted Note Portfolio?
They have roughly $200,000 combined in their self-directed IRA accounts. One is Roth, the other isn’t. Before they retire the pre-tax IRA will have been fully moved into Roth status. Their timeline is roughly 20 years. Here’s their scenario.
They’ll both keep putting $5,500 a piece in. In this calculation, I’m not even gonna include the last 12 years of them putting in $1,000 a piece per year more after turning 50. We’ll use an annual portfolio return of 10%. People often raise their eyebrows at that, which is understandable. Ask anyone who’s invested in discounted notes for a while, and they’ll tell you that’s real. I’ll go another step with that. This month marks the 40th anniversary of my first ever discounted note purchase. The next performing discounted note or land contract I buy that doesn’t produce a yield of at least 10% from the day I acquired it to the day it paid off will be the first. Period. Over ‘n out. 🙂
Anywho, they’ll end up with the following balance in 20 years. I invite you to do the calculation yourself. Start with $190,000 in present value. I use an HP 12C, so it’d be input as a negative. Put in 20 for the number of years, “N” on most calculators. Input 10% for “i,” that is, interest or yield. Then put in a negative $11,000 in “PMT.” The last step is to solve for “FV,” which is Future Value. In this case that comes to approximately $1.9 million. Even if we say they’ll only make, say, 7% overall yield in retirement, which would be a first in my lifetime, their tax-free Roth income from discounted notes would be roughly $133,000 yearly. Experience tells me it’ll exceed that by a long shot. At 10% you can do the math. 🙂
Let’s Now Conservatively Estimate Their Anticipated Retirement Income
Their tax-free income derives from two separate, stand alone sources: Notes in a Roth “wrapper” and their EIUL policy. The EIUL = $117,000 a year. The note income via their Roth IRAs = $133-190,000 yearly. Remember, these two sources are tax-free by definition of the tax code.
Taxable Note Income Both Directly and Indirectly Held
Between investable capital saved periodically over the years, plus after-tax proceeds from executing the cost segregation strategy 1-3 times, they’ll also have established an impressive personally held note portfolio, including both directly held notes and indirectly via note investment groups. They’ll have well over $1 million invested in their personal note portfolio. At a conservative 10% rate, that would indicate a taxable income of about $100,000 yearly.
Whether in a tax-free (Roth) envelope or taxable, the income at the beginning of their retirement will be the lowest they’ll experience while retired and alive. Notes pay off early usually, at a random rate. The note investor then reinvests in slightly larger notes with equally larger payments. Random Raises In Retirement — the name of my new band. 🙂
Real Estate Cash Flow in Retirement
I’ll assume that over the next couple decades, they’ll end up with no less than three small income properties, all of which will be free ‘n clear by the time they’re 62. The cash flow at that time will be in the range of $20-30,000/yr each. We’ll use a total of $60,000/year, though experience tells me it’s much more likely to be higher. It’s also possible they’d end up with more properties, but let’s stick with the conservative take for now.
What goes unsaid by most at this point is what the real value of debt-free investment real estate is once you’re retired. As you can clearly discern by the comparative incomes from the EIUL and notes, cash flow from real estate comes in a distant third. Their real value can be found in your ability to draw out tax free cash when needed. Call it “The Bank of (Fill in Your Name Here).” In this case, their real estate portfolio’s more modest amount would be around $1 million or so. If they wished to pay half a million bucks for a cabin near their favorite mountain lake, all they need do is call their lender, get a loan, and pay for the cabin with tax-free money.
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They haven’t lowered their ultimate net worth, just rearranged where it is. Sure, they’ve reduced their real estate cash flow, but considering the other sources coming their way, do you really think they care much? 🙂 The same scenario would work if they needed cash in a hurry for a negative reason like medical problems, or…? The reason I’d advise them to borrow against their real estate is that we surely don’t want ’em to mess with either their note or EIUL income. It just makes sense.
So, What’s Their Income When They Retire in Around 20 years, at 62?
- Real estate cash flow: $60,000 at the very least. It’s highly likely it’ll be significantly higher.
- Note income in a Roth wrapper: $133,000 — It’s all tax-free by Internal Revenue Code definition.
- Note income subject to income taxation: $100,000 — Sure, it’s taxable, but you’ll still bank it, right?
- EIUL income: $117,000 — As is the note income from inside their Roth IRA, this income is also tax-free by definition.
Total retirement income beginning at age 62: $410,000 a year. Roughly 61% of which is tax-free!
That’s a boatload of money, to be sure. Thing is, once we get away from Wall Street and begin expanding our options menu, many more outcomes are possible. I’ve said this for years: “Given enough time and capital, the typical American should be able to retire on more annual income then they made in the best year on the job.” It’s not that hard to get done. In fact, it’s boring. It requires a real plan and purposeful execution. Add some serious flexibility, and most are surprised at what’s actually possible.
Any questions about this strategy? How are YOU planning for a comfortable retirement?
Leave your comments below!