Welcome! It’s time for another Safe Withdrawal Rate case study! Please click here for the other seven installments. Today’s volunteer is “Mr. Corporate Refugee,” not his real name, obviously. But as the name suggests he is ready to pull the plug on the corporate grind. He and his wife did everything right to prepare for early retirement. Pay off the mortgage on their house (as recommended by yours truly) and accumulate a nice nest egg close to seven figures. The only problem: they reside in a high-cost-of-living area in California and more than half of their net worth is tied up in their primary residence. Even a portfolio as large as $1 million will likely not be sufficient to cover expenses in your current location. What to do now? I’ll propose two routes to early retirement. Move to a cheaper location, a “secret” low-income-tax paradise – more on that below, and be able to retire now. Or work for only four more years and retire in the current location. Let’s go through the math…
Mr. CR’s situation
I am looking to get time with my family just garden putter around the house building things and taking cheap community college classes. I probably will never stop working altogether but I want to be able to leave if I get fed up with the race. Can I do that yet?
Me: 42 and primary breadwinner at around 120k. Wife: 40 works part-time from home makes around $16k a year. 2 kids ages 5 and 9
We live in HCOL California and would definitely consider moving elsewhere to save. That being said we own our home free and clear and rent out the lower flat. The home’s value according to Zillow is $1.1 mil, we bought it for around $450k.
Very nice! I ascertained that the rental income for the small flat is around $15,000 per year.
We average around $40-50k a year in spending (not including potential medical costs). We save around $73K a year (max out 401K, SEP, Roth IRA and Megaback door roth, sometimes we manage to save a bit more in our individual account)
Our current invested assets are ~$1 million and as follows:
- Individual Taxable $201,223
- his Roth IRA $230,000
- his 401k $235,000
- her Roth $13,000
- Her Traditional $165,000
- Savings Account averaging around 2% $48,000
- IBonds-$70k (potentially part of the school payment plan)
- 529: $92k (I figure if the kids don’t use it I can go back to school, I’d love to)
Congrats on accumulating such an impressive nest egg. How about future supplemental income?
His Pension- if retire in December of 2017 we will collect ~8k a year starting at 55, If I wait until 65 to collect $11K until we both die.
If I wait until 2021 I also get access to a Medical pension that can be used to help pay Medicare Part B or allow me to continue to pay into the company medical from 55 until medicare eligibility.
I am interested in paying part of the kids college costs–around $25k each per for 4 years in today’s dollars (in state California tuition.)
So lots of questions here? Can I retire early? Should I take out a home equity line of credit and invest it? Should I sell the house and move somewhere cheap (how does that balance out vs. potential rent increases which act as a great inflation hedge?)
So what do you think? Can I retire anytime soon? What if the wife continues to work for a while? Can I retire and pay for college and leave a small inheritance? Keep or sell the house?
All great questions! We’ll get to that later! In my view, there are two routes to retire:
- Retire now but move to a lower-cost area. This might involve either selling your current primary residence or turning it into a rental.
- Work a little bit longer and build more assets. Then you can certainly retire in your current location and keep current house and lifestyle.
Base case: retire now
Let’s start with the scenario where you retire now but move to a cheaper area. But where? Do you have to move out of state? Nevada has no state income tax. Arizona has a low tax rate. But you don’t even have to go that far! Here’s a newsflash for everybody:
Welcome to California – a low-tax retirement paradise!
That’s not a joke. While crunching the numbers I was surprised at how low your California state income taxes can be! True, taxes are high for high-income households, up to 13.3% marginal. But in retirement, if you keep your taxable income low you will hardly pay any taxes. For example, for married filing jointly, the 2017 income tax brackets are (source: The Motley Fool):
- 0 to $16,030 -> 1%
- $16,030 to $38,002 ->2%
- $38,002 to $59,978 ->4%
So, in other words, you can earn up to $60,000 a year and pay less than $1,500 in state income taxes. That’s an average tax rate of only 2.5%. If you can find an area with low housing prices you should probably stay in California. At least the health care exchange will work better than in Nevada and Arizona and you’ll be closer to your rental property. I checked on Zillow and all three HCOL areas in California (Bay Area, LA, San Diego) have areas within two driving hours or less where you can buy a nice property for $350,000 – less than one-third of the value of your current house. Another advantage of California: Proposition 13! Your property taxes are locked in and can never go up by more than the inflation rate or 2%, whichever is lower. See also fellow bloggers Our Next Life who proudly announced that they’ll stay in California, for basically all the same reasons!
So, for this base case, I make the following assumptions:
- I assume that you both retire now. Some of the calculation will show that the numbers a little bit tight so I wouldn’t blame you if you consider keeping that side gig worth around $16k per year for the first few years of retirement.
- You get a $350,000 mortgage on your current primary home. 30-year term, 3.75% rate, monthly payment $1,621. You use the proceeds to purchase a home in a lower cost of living area. Paying cash. One caveat, though: It might not be proper to get a mortgage on your primary residence and then turn the property into a rental right away. You might have to wait for about 12 months before renting out the entire house. See section “Converting Your Primary Residence to an Investment Property” in this post. Maybe rent out the new property first, for a year, and then switch and move into the new house and rent out the current house. Another option: get a $280,000 mortgage on the new property and use the $70,000 in iBonds as a downpayment. The advantage of getting the mortgage on your current home is that you can eventually write off the interest expenses against your rental income. The mortgage interest on the new home will be below the standard deduction, so it’s not deductible.
- You’re able to rent out your current home for around $60,000 in gross annual revenue (your estimate). But you also have to cover $24,000 in annual overhead (even before the mortgage!!!): property taxes, repairs, maintenance, insurance, vacancies, finding new tenants, bookkeeping and legal fees, etc. You may be able to have a much lower overhead. Your own overhead estimate was much less but let’s play this super-conservative here!
- I assume that both your gross rental income but also the overhead grow at the rate of inflation! That means that the $3,000/month in net income will grow with inflation as well! Yay, you got an inflation-protected cash flow that covers a good chunk of your expenses already!
- You take the $8,000/year corporate pension at age 55. Waiting until age 65 for a measly extra $3,000/year is not worth it.
- You take Social Security, estimated at $13,600/year at age 67. This already includes a 15% haircut to account for future benefit cuts.
- Your wife claims Social Security at age 67, 2 years after you and she opts to receive half of your benefits. Once you reach age 62 you may look again to reoptimize the benefit timing, depending on your respective health conditions.
- I assume an asset allocation of 70% stocks, 25% bonds and 5% cash/money market. Why a lower stock share than usual? We’ll see below that your financial portfolio has to cover only about 30 years. After that, you should generate enough cash flow (rental income, pension Social Security, no more mortgage) to fund your retirement without the help of your portfolio! Shorter horizon means higher bond share!
- I assume a 55-year (660-month) horizon. Since this sheet covers only the financial assets I target a zero final value (capital depletion) because your heirs will still have two mortgage-free houses even if you leave them zero dollars in your portfolio!
Let’s punch all those inputs into the Google SWR Spreadsheet. First, let’s look at the supplemental cash flows chart. In the Google Sheet, I created a separate tab “Cash Flow Calculations” if anyone wants to check how I created those numbers. Notice that there are 4 discrete jumps:
- After 12 years, the pension kicks in.
- After 25 years, Mr. CR’s Social Security kicks in.
- After 27 years, Mrs. CR’s Social Security kicks in.
- After 30 years, the mortgage is paid off.
Also, notice the high the supplemental flows are after a few decades: You’re eventually generating 0.5%/month or 6%/year worth of today’s financial net worth of supplemental income. Effectively, you have shortened your withdrawal phase to about 25-30 years.
And here are the main results:
- A fail-safe consumption amount would be about 6.28%. Given the initial net worth of $962k, this implies a safe consumption level of around $60,400k per year. Make that $56k after taxes, budget $10k for health expenses and you arrive at $46k. Given your $40-50k target range, this seems like it will work. But check with “Covered California” if $10k per year suffices. You should get some pretty substantial O-care subsidies since you keep your taxable income pretty low. Keep that part-time job for a while if unsure!
- Notice that included in the $40-50k spending goal was the maintenance of your current primary residence. That’s now already covered by the rental property calculation. But you have a new primary residence, so I assume that the property taxes and maintenance for the new house are about the same as for the existing one. Property taxes might actually be lower due to the relatively low purchase price of the new property.
- A very important caveat, of course, is that the 6% SWR does not mean that we can withdraw 6% of the portfolio every year. It means that we can consume the equivalent of 6% of the initial financial net worth in year 1, then increase that amount by inflation. If, say. 2.5% of that comes from the supplemental cash flows (rental income, pensions, etc.) then we withdraw only 4.5% from the portfolio!
Cash Flow Analysis
As always, let’s look at how the cash flows evolve, just to make sure we don’t have to tap into the 401k and/or Traditional IRA before age 59.5. Let’s make the following assumptions:
- You draw down your “cash” holdings (savings account plus iBonds) by up to $20,000 p.a. until you reach 50% of your target consumption. Yup, this is a slightly lower cash cushion than I’ve used in previous studies, but given your low taxable savings, you have to sharpen your pencil and skimp on the cash cushion! Sorry. you will have to cash in some of the iBonds early (which means you might forego some partial-year interest), but your taxable equity portfolio is just a little thin right now.
- You start with Roth conversions at $27,000 p.a. and raise the amount by the assumed inflation rate (2%):
- For the first five years, you leave the money in the Roth IRA (hence the withdrawal<0 for five years).
- After that, you still continue the Roth conversions as before, but now you withdraw that same amount you convert from the Roth. That creates a net zero cash flow into the Roth. You will have an amount almost that large that you converted 5 years prior, plus all the cost basis you already have right now. So, this can be done penalty-free! Again, just to be clear, because in the table this looks like a withdrawal from the 401k, subject to the 10% penalty. It isn’t! Money moves from the 401k to the Roth and then you withdraw the principal from the Roth that was paid in 5+ years before to avoid the penalty. See diagram below!
- Until age 59, you withdraw enough from your taxable account to make sure the net-of-tax withdrawals match the consumption target.
- At age 60, your taxable account and 401k are almost depleted. You just withdraw small amounts from those accounts and withdraw the bulk of your cash needs from the Roth. Tax-free and penalty-free!
- Expected Stock/Bond/Cash returns are the same as in previous case studies.
- I assume 100% stocks in the taxable account, 80/20 in the Roth and 60/40 in the 401k.
Well, it took some FIRE engineering but you should be able to roughly maintain the portfolio purchasing power over this 30-year horizon. You just barely avoid running out of money in the taxable account and in the 401k. But you also build up a very nice Roth IRA portfolio along the way! Also, notice that after age 71, the mortgage is paid off and you should require no further cash flows from the portfolio. You would then have two paid off houses and a huge Roth IRA! So, theoretically you could have even depleted your portfolio, but you roughly maintained it. So, it looks like by turning your current house into an income property that generates nice stable, inflation-adjusted cash flow you’ll likely be able to retire in a cheaper area just a few hours outside of your current metro area!
If you like to make your early retirement absolutely watertight you should probably work for another 4 years. This would qualify you for the “medical pension” you mentioned, though in the calculations here I will ignore the cash flow from it. I simply wasn’t sure how much this is worth in dollars. It also turns out that even without that medical pension you should easily make it through early retirement. Just consider the medical pension an additional layer of safety.
Retiring in late 2021/early 2022 would also allow you to retire in your current location, which has some advantages: kids stay in the same school and you have only one small rental unit that you can easily manage while you live in the same house.
Let’s use the following assumptions:
- I assume your pension is now $12,000 p.a. at age 55 since you work for 4 more years.
- You contribute a total of $73,000 p.a. for the calendar years 2018-21: $25,000 into the 401k (your contributions, your wife’s contributions plus matching), $30,000 into the Roth (both through backdoor Roth and the $5,500+$5,500 regular Roth) and the remaining $18,000 into the taxable account.
- You draw down the cash reserves by $15k every year to cover expenses until you reach 100% of your spending target. After that, only withdraw the interest income and let the cash reserve grow to match the spending target each year.
- You do the Roth Conversion ladder every year to max out the $24,000 standard deduction (if that Trump tax plan actually becomes law, but even without the tax law change $24k is roughly your itemized deduction plus exemptions):
- For the first four years you do only the Roth Conversion and don’t withdraw anything from the Roth. (hence the Roth withdrawal is exactly (-1) time the 401k withdrawal)
- After that you run out of the extra money in the cash account and you’ll need to withdraw some funds from the Roth (hence, the Roth withdrawal > (-1) times the 401k withdrawal). Without the money from the Roth you’d run out of the taxable account too soon!
- Once you reach age 60 (actually 59.5, to be precise) you can withdraw from the 401k and let the Roth grow again.
You almost wipe out the entire taxable account. But that’s fine. You will accumulate enough in the 401k and especially in the Roth. After 30 years, you almost double your financial net worth even in real terms and it’s all in the tax-advantaged Roth! Starting in the year 2043 you should generate so much extra income from Social Security that you can finance the bulk of your expenses from Social Security, rental income, and the pension. Even more so in 2045 when the wife gets benefits. In fact, you accumulate so much money in the Roth you probably have enough of a cushion to assist your kids with the college education beyond the current 529 account.
Let’s see how the college savings are going to evolve without any further cash flows. Well, projecting forward the $92,000 balance, applying some conservative equity expected returns (same as for the cash flow study above), let’s see how much you can withdraw once the kids reach college age. You could withdraw $21,893 in the year 2027 when kid 1 is 18, then adjust for 2% inflation every year. That sum is worth $18,319 in today’s dollars (i.e., divide by the inflation factor). Not quite the $25,000 you aimed for but almost three-quarters there! Maybe consider chipping in more money if your stock portfolio plus real estate “empire” perform well over the next 10 years and your retirement is on track.
You can retire now. Thanks to geographic arbitrage. Within-state geographic arbitrage, to be precise! Moving out of state to afford retirement is probably not necessary because with your relatively limited taxable income you’ll like not feel the brunt of the Commie-fornia, uhm, California tax code (sorry, couldn’t help myself). If you decide to retire right away you should probably stop contributing to the 529. Your own retirement takes priority. But if you wait for 4 more years, it seems like you have such a large cushion you might contribute some more money to the college savings account. Either way, best of luck in your retirement. Enjoy the weather and the scenery in the beautiful low-tax retirement heaven called California!