Case Study: How Diversifying Investments Affects Net Worth & Income in Retirement

by | BiggerPockets.com

Lexie (not her real name) is an actual client, while Mark is fictional. We’ll have Mark mirror Lexie’s age and financial circumstances with income, savings, and beginning investment capital. The two strategies are as follows:

  • Lexie: She’s 35 and invests in small residential income properties; discounted first position notes and land contracts, performing and non-performing, both directly and indirectly in her own name and her self-directed Roth IRA; and an EIUL (insurance policy primarily geared to tax-free income instead of a death benefit). Her income is currently $125,000/year before taxes. She manages to save roughly $2,500 monthly, about $30,000 yearly. She lives in California. Her preference is to retire at 60, if not sooner. She doesn’t contribute any more into her 401k at work, as the returns and periodic losing years discouraged her. When she was headhunted from her job several years ago, she rolled her modest 401k balance of $50,000 into a self-directed IRA, then slowly but surely rolled that balance into her self-directed Roth IRA, as she could comfortably afford the taxes. Her current Roth IRA now sports a balance of about $75,000.
  • Mark: His strategy is to buy rental homes as he can afford ’em. His goal is to end up with at least 15 free ‘n clear rentals nearby so as to have a pretty nice retirement income. He’s not tryin’ to be a hero, what with dangerously high leverage, or investing in less than quality neighborhoods. He’ll use 20% down as a minimum. He puts the maximum he can comfortably afford into his 401k at work. His current balance is also around $75,000.

They both have $100,000 to begin their real estate investment strategy. They both have roughly 25 years to make things happen.

Note: At this point, it’s important to convey the reality that both of their strategies, though very different in approach, will indeed yield a fairly impressive retirement income relative to most. Both have safe, reliable, winning strategies. This is merely to point out some possibilities to investors for whom a more varied strategy is appealing. Furthermore, by using multiple strategies in combination, sometimes incorporating the principle of synergy often enhances end game net worth and income.

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Mark

Mark successfully retires with 15 rental homes. The monthly cash flow from them is around $10,000. Who knows if that’s too high or not enough. Your crystal ball is as reliable as mine.

He averages the same yield on his 401k, as do most, ending up with around $1,000,000 or so. We assumed an annual contribution, including help from his employer, of $15,000. At the typical “risk averse” return most 401k advisors counsel, also 4% once retired, this would produce an additional income of roughly $40,000 yearly, pretax. If Mark indeed retired at 60, he’d have approximately 11 years depending on the month of his birthday, before attaining the age of 70.5.

At that point, the government tells him exactly how long he has to live. The government knows all, right? They then take the number of years he has left, divides that into his 401k balance at the time, and says the answer is how much he’ll be forced to distribute to himself yearly from that point (required minimum distributions or RMD). It’s still all taxable, and once those years have all passed, he’ll likely no longer have capital inside that 401k.

Mark’s done very well for himself. Between his rental homes, all of which are free ‘n clear, and his 401k income, he’s managed to retire with an annual pretax income of about $160,000. That is clearly above and beyond even the vast majority’s goals for retirement income, much less their actual reality.

work-from-home

Lexie

Let’s turn our attention back to Lexie.

We’ll begin with her self-directed Roth IRA. From 35 to 60 years old, she dutifully contributed the maximum into her account yearly. That’s $5,500/yr for 15 years, then $6,500/yr for 10 years. She’ll invest mostly in note investment groups that will have a solid/safe mixture of performing/income producing first position notes/land contracts on homes with a safe LTV (loan to value). It’s important to establish a baseline for both yield and capital growth over the long haul. In this case, that’s 25 years just gettin’ to retirement.

If you’ve heard this chorus from me before, feel free to sing along. In the spring of 1976 as a WhipperSnapper with the help and guidance of a couple of my mentors, I bought my first discounted note. Fast forward to the present, 40+ years later. Without exception, every performing discounted note secured by real estate I’ve ever owned has, lookin’ back after payoff or sale, from first day in to last day out, generated a minimum of 10% annually. And yes, that includes those for which foreclosure was required.

Related: Retirement Might Be Closer Than You Think—If You Do These Two Things

I’m gonna throw out my own experience with notes and say that in the 25 years she invests her Roth IRA into notes, she averages just 8%. She’ll slaughter that in real life, but we’re makin’ a point here. She’d end up with around $930,000, but let’s round down to $900,000, okay? At a mere 8% cash-on-cash return, her tax-free income would begin at roughly $72,000 a year. Again, that’s TAX-FREE. Just for kicks ‘n giggles, let’s see how she’d do if she had my experience—10% annual yield—for those 25 years.

Rounded down to $1,350,000, her annual tax-free income woulda been about $135,000. Did I mention the phrase, tax-freakin’-free? 🙂

Now let’s move to her EIUL.

It’s an insurance policy structured not primarily to generate a death benefit, but for tax-free retirement income. For 25 years ’til she’s 60, she’ll pay monthly premiums beginning at $500. That premium will be indexed to inflation. She’ll also add a very modest $4,000 at the beginning to more or less turbocharge growth. Here’s how it comes out. I’ll give a couple scenarios, one with the low government mandated annual yield, the other with a rounded down yield based on that last 25 years actual yield.

Beginning at age 60 and continuing through age 90, her monthly tax-free income using the mandated annual yield will be $6,250. If she benefits from .25% less the actual annual yield (rounded down) of the last quarter century, it’ll be $10,000 monthly. I picked 60 for a good reason. That’s also when she’ll begin taking income from her Roth IRA’s notes.

Both sources of income, completely independent of each other, will be tax-free.

How ’bout her real estate investments?

  1. She combined her monthly cash flow with about $1,000/mo. of her own money to eliminate the loan on her Texas duplex in about 10 years. At that point, she’ll hopefully have a couple options available:
  2. Refi the loan to buy one or two more duplexes or whatever makes sense at the time.
  3. Move the entire net equity into 2-3 duplexes via a tax-deferred exchange.

The thing is, both of those options share a potentially option killing factor: They assume interest rates will be relatively reasonable, whatever the heck that means—not to mention supply/demand at the time. Will there be a reasonable demand in a decade? The latter is likely, but not if interest rates are 11.5%, right? She could just end up with a free ‘n clear duplex and nowhere to go for awhile. That’s why long-term plans should be taken with a truckload of salt. I learned the hard way that making plans as if the universe is noddin’ its head in agreement can lead to unanticipated results.

The key (Captain Obvious alert) is to assume the various markets, interest rates, and the economy won’t act in concert with our plans. If Lexie finds herself with a debt-free duplex in 10 years, she’s still just 45 years old. Meanwhile she’ll have $20,000-whatever annual cash flow ’til things allow her to make more moves. Who knows at that point in time what would be the best use of that cash? I don’t. But I bet I will if/when it happens.

life-on-half-income

Related: 5 Ways to Dramatically Increase Your Cash Flow in Retirement (Regardless of When You Retire)

So far, Lexie’s made use of three of the four pillars I use in purposeful planning—notes in a Roth wrapper, an EIUL, and residential income property. The last one, discounted notes in her own name, will come as the investable capital makes itself available. That often occurs when her salary increases over the years to the point she can invest small amounts into both performing and non-performing notes. (I don’t put clients directly into non-performing liens secured by real estate. I do invest for them, allowing my team to do the work. Ninety-nine percent of investors simply don’t have the knowledge or ability to mess with non-performing notes and the like close to home, much less 1,000 miles away.)

Here’s how her retirement should shake out.

  • Real Estate: She ended up with just a couple Texas duplexes free ‘n clear. If the NOI (net operating income) never went up for all those years, her income would be in the range of $44,000-50,000 yearly. We’ll call it $45,000.
  • EIUL: We have a low of $75,000 and a high of $120,000 as the range. I’m gonna err on the low side and say $85,000 yearly—all, of course, wait for it, tax-free.
  • Notes in a Roth Wrapper: Again, there’s a wide range as I used an annual return far less than I’ve experienced the last few decades. It goes from $72,000 to $135,000 yearly. Let’s use $90,000 and be absurdly conservative. A reminder: This income is also tax-free by definition.

Although it’s probable she’d own notes in her own name or an interest in a note investment group or fund, we won’t even speculate on how much income that might be. Suffice to say, it’s significantly more likely than not she’d have that portfolio too.

At 60, her retirement income would total roughly $210,000 dollars annually. Approximately 78% of that would be tax-free by definition. It’s usually at this juncture that somebody wants to know, why even bother with the real estate? So glad to asked. Sure, the cash flow vs equity pales in comparison with notes and the EIUL. However, when opportunity or emergency comes knockin’, do ya really wanna cannibalize your tax-free note income or EIUL income? No, you don’t! Instead you go to your free ‘n clear real estate, get whatever cash you need tax-free, and use that. Think she cares about missing whatever amount of cash flow she’d give up? Not when she’s pullin’ down nearly $14,000 a WEEK tax-free. No, if she wants that small little cabin by the lake she loved so much as a girl, she can now write a check and it’s hers. She won’t have lowered her net worth, just rearranged it. If the cash need is for a negative event, she’ll be grateful for not having to kill off tax-free income.

Furthermore, her note income will rise from retirement ’til she’s gone, cuz you know, notes tend to pay off early. When they do this in a Roth wrapper, there’re no taxes. She’ll simply reinvest into a slightly larger note with a bit more monthly income and get a pay raise every now ‘n then. How does that not work, right?

Lexie will retire with more income from tax-free sources than will Mark with mostly taxable income. Also, if Mark needs cash for an opportunity or an emergency, he cannibalizes his retirement income. What Mark did was impressive, no doubt about it. But his options once retired are fairly limited given his investment preferences.

The buy ‘n hold strategy is superior when comparing it to Grandpa and Grandma’s plan back in the day. When the smoke clears, however, it tends to eliminate wiggle room in retirement—never a good thing. Also, Mark will have all those properties which by that time will be significantly old. That never bodes well for operating expenses, vacancy rates, or, gulp, tenant quality.

I love investment real estate and have promoted it for over four decades as a pro. But though it hurts my heart to say this out loud, it doesn’t do well as the Lone Ranger in retirement. Treat it as ‘The Bank of Smith” or whatever your family name is. It provides the spending money for all the traveling you’ll be doing, while also acting as an asset allowing you to access tax-free cash for both opportunities and emergencies without gutting your higher yielding and often tax-free portfolios.

Which of these strategies would you prefer? Why?

Let me know your thoughts with a comment!

About Author

Jeff Brown

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

18 Comments

  1. Wilson Churchill

    The primary advantage of RE (buy and hold) is leverage. If Mark is putting 20% down, why stop at 15 properties? As his cash flow increases, he will be able to buy homes more and more quickly, assuming he chooses to keep reinvesting all of the cash flow. While putting 20% down and financing most, he will be shielded from taxes at least partially, considering depreciation. If he purchased properties that enjoyed any appreciation, he could consider doing a tax-deferred exchange.

    • Jeff Brown

      Hey Wilson — I get your point for sure. Allow me a bit of Devil’s Advocate. Mark’s also tasked with paying off well over $1 million in debt by the time he retires. This puts him in an ‘either or’ position. Does he take extra money to pay off debt, or buy more properties. He doesn’t own a printing press, so both options aren’t available. It’ll require an additional $419/mo to pay off an $80k loan in 10 years at 5% interest. But we haven’t factored in currently rising interest rates. How will that affect his strategy going forward?

      Furthermore, to get access to more cash for down payments, Mark’s gonna need to make the decision to stop putting $15k/yr into his workplace 401k. That sacrifices roughly $40k/yr in 401k pretax retirement income. All this doesn’t come close to addressing the reality of owning that many rentals which were bought cheap for a good reason. They weren’t in neighborhoods in which you’d feel comfortable letting Mom live alone. They were also, for the most part older at the point of purchase. I see this often, Wilson. When the investor retires they find themselves the victim of the punchline to a good news/bad news joke.

      The good news is that they own a lot of free ‘n clear rental homes. The bad news is, ‘see the good news’. The average age is well over 50. There is much functional obsolescence. The tenant quality has decreased. And the operating expenses are significantly higher than younger properties in superior neighborhoods without functional obsolescence. More often than not they also discover they’re getting a smaller slice of the tenant pie as time passes. I’ve seen this in real time/real life for decades in San Diego.

      There’s also the tax aspect to seriously consider. Since Mark invested for so many years, most of his income at retirement will not be sheltered by depreciation. By the time he’s been retired 10 years, it’s as likely as not most if not all his depreciation will have dissipated. So not only will his NOI be less than younger, better located rentals, but it’ll be fully taxable. Not a good thing for what will basically be is retirement income anchor.

      Any of this make sense, Wilson? Thanks

      • Wilson Churchill

        “But we haven’t factored in currently rising interest rates. How will that affect his strategy going forward?”

        I would say it depends on how much interest rates increase. If the Fed decides to really put the brakes on (by increasing rates significantly), housing prices will decrease. So Mark will suffer in terms of net worth if he chooses to stop acquiring properties, but will “average down” if he continues to buy more at lower prices.

        “Furthermore, to get access to more cash for down payments, Mark’s gonna need to make the decision to stop putting $15k/yr into his workplace 401k. That sacrifices roughly $40k/yr in 401k pretax retirement income. All this doesn’t come close to addressing the reality of owning that many rentals which were bought cheap for a good reason. They weren’t in neighborhoods in which you’d feel comfortable letting Mom live alone. They were also, for the most part older at the point of purchase. I see this often, Wilson. When the investor retires they find themselves the victim of the punchline to a good news/bad news joke.

        The good news is that they own a lot of free ‘n clear rental homes. The bad news is, ‘see the good news’. The average age is well over 50. There is much functional obsolescence. The tenant quality has decreased. And the operating expenses are significantly higher than younger properties in superior neighborhoods without functional obsolescence. More often than not they also discover they’re getting a smaller slice of the tenant pie as time passes. I’ve seen this in real time/real life for decades in San Diego. ”

        If Mark needs 20k for each house, at current interest rates, he will have to come up with another 5k plus costs. For the sake of comparison, let’s assume that he is able to do this. He’s retiring in 25 years, so his income will depend on how many homes he was able to acquire. If he has an extra 10 homes at retirement (he should be able to buy more than that), then he should be able to at least make up the difference at an average cash flow of 4k per home. If they are paid off and managed properly, then he should be able to pocket about 50% of the rent as income.

        I agree that neighborhood selection is important. I stay completely away from areas where others specialize, because I want to find tenants that have three times the rent in income. I would never recommend paying actual market value for any home. My preferred method is to buy homes that need work and fix them up. Many first-time buyers don’t want to deal with repairs, so my main competition is other investors (who are probably every bit as cheap as I am). So, while the home may be old, so long as the foundation is solid, cosmetic repairs are not a big deal. Heck, even jacking up and shimming a floor or repairing a basement wall isn’t necessarily that bad, if you know people that can help you to get it done.

        “There’s also the tax aspect to seriously consider. Since Mark invested for so many years, most of his income at retirement will not be sheltered by depreciation. By the time he’s been retired 10 years, it’s as likely as not most if not all his depreciation will have dissipated. So not only will his NOI be less than younger, better located rentals, but it’ll be fully taxable. Not a good thing for what will basically be is retirement income anchor.”

        That’s true. The good news is that rental income isn’t subject to Social Security or Medicare Taxes (except the ACA tax which may or may not be repealed soon). If Mark was bored in retirement, he could always sell the homes and repeat his original strategy, starting the depreciation on the remaining 80% of the new homes (you know all about this, of course), or trade them all for a huge property, if he is really bored.

  2. chris gibbs

    One thing that I took from this (and correct me if I am wrong). The income that she used in retirement is all used up and runs out by the time she dies. If you keep acquiring more and more property then you can pass on that business to your kids and family. Where Lexie’s strategy works well for her I feel it is the somewhat selfish way to go.

    • Paul B.

      “Selfish” seems a little harsh. While it’s nice to leave your heirs something, I don’t think one is obligated to allow that expectation to develop. Maybe she doesn’t have kids. Maybe she does, and she raised them to be financially savvy with methods like these, and they have secured their own future by the time she dies, and the lack of inheritance is not a big deal.

    • Jeff Brown

      He Chris — That’s one of many legit takes. However, I have a couple kids myself, and raised ’em to fend for themselves re: retirement. They’ll do well for sure. They’ll get my stuff too, which makes me smile. Still, they’ll have engineered a retirement for themselves that will dwarf what I did.

      • chris gibbs

        I have a hard time wrapping my head around an investment that runs out being better then an investment that never does. Regardless of if you pass it on or not. But I am also convinced I will never die so maybe its just me. Young mind and all 😛

  3. Sandeep S.

    Good info! There is one correction that I’d like to point out. If Lexie is making $45000 by 2 duplexes – chances are Mark would be making about $15000 monthly from the 15 SFR (not $10000). In reality, I think the cash flow would be even higher for free and clear homes after years of rent appreciation.

    • Jeff Brown

      That’s entirely possible, Sandeep. No quibbles from me. On the other hand, and as I pointed out in my reply to Wilson, Mark’s settin’ himself up for some real attention grabbers with a buncha very old homes that bring all the predictable fallout. Not something I recommend at a time in our lives when fun is the errand of the day.

    • Jeff Brown

      Great question, Shane. You’ll need to know a pretty knowledgeable and experienced investment pro versed in both real estate and notes. The insurance ‘Pillar’ definitely requires an expert in that industry which I have had for years on my team. Still, I’m by far not the Lone Ranger as there are lot’s of pros who know what I do. If you ever feel like chatting, get in touch and we’ll make it happen.

  4. Mark Welp

    Jeff,
    Great article. Where can I learn more about EIULs? I have had financial advisors try to sell me on whole life insurance policies, but those come with hefty fees. Are these the same, a lot of fees? Thanks!

    • Andy Terry

      The fees are the cost of insurance. Which can be high for people not in good health. Also, the cost if insurance will increase as you get older. Jeff’s strategy can work great for the right person. Its great for the younger professional’s that have maximized their 401k match and have contributed the max amount to their Roth IRA. Whatever is left over from that is where you would want to consider using life insurance as a retirement vehicle. Having different streams or “pillars” is smart, just be sure you understand the pros and cons.

      • Mark Welp

        Andy,
        I agree with you. I always max out my Roth IRA, but in 2017, I think I am going to be above the income thresholds. But we have a Roth 401k at work, which I have not maximized yet, and that is great because that will all be tax free at retirement.

        Thanks,

  5. Andy Terry

    There are a lot of moving parts with EIUL(Equity Index Universal Life Insurance) or IULs. Please do your due diligence when purchasing them. They can be a good compliment to retirement but it requires you to be a disciplined investor. A Roth IRA is also Tax Free and in my mind is option #1. If you make too much to contribute to a Roth IRA than I would consider investing in an IUL or a Whole Life policy to build some additional tax free income in retirement.

  6. Daniel Odess

    Great article, much food for thought. One difference in their strategies that wasn’t mentioned is the flexibility each provides between now and retirement. If these two are 35, they have quite a few years to go until they hit retirement age. How many of us could have predicted out over the next 25 years where we would be, who we would be with, and what we would be doing when we were 35? As I understand the difference in their strategies, Mark’s looks to be much more flexible. He can access his assets to use for other purposes pretty easily. He could sell one of his rentals, use a HELOC, refinance, etc. The growth of his portfolio would slow, but he would not be hit with any penalties. But what about Lexie? What if she needs or wants to access her money before she reaches retirement age? Doesn’t she take a big hit if she pulls money out of a Roth vehicle? Ditto her EIUL? Can you speak to these issues as well?

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