Ask Big Ern: A Safe Withdrawal Rate Case Study for “Mr. Corporate Refugee”

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):

  1. 0 to $16,030 -> 1%
  2. $16,030 to $38,002 ->2%
  3. $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:

  1. After 12 years, the pension kicks in.
  2. After 25 years, Mr. CR’s Social Security kicks in.
  3. After 27 years, Mrs. CR’s Social Security kicks in.
  4. After 30 years, the mortgage is paid off.
Case Study MrCF Chart01
Supplemental cash flows (real, inflation-adjusted flows as % of initial Net Worth).

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!
Case Study MrCF Table02
Main results from the Google Sheet. A SWR of more than 6% is feasible.

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!
Case Study MrCF Diagram01
Roth conversion plus Roth withdrawal of principal from 5+ years ago. This avoids the early withdrawal penalty!
  • 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.
Case Study MrCF Table03
Retirement Simulated Balances and Cash Flow Table, Part 1.
Case Study MrCF Table04
Retirement Simulated Balances and Cash Flow Table, Part 2.


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!

Retire later

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.
Case Study MrCF Table05
Retirement Simulated Balances and Cash Flow Table, Part 1.
Case Study MrCF Table06
Retirement Simulated Balances and Cash Flow Table, Part 2.


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.

College savings

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.

Case Study MrCF Table01
Nominal 529 balance and withdrawals. you could withdraw $21,893 in 2027, then adjust for 2% inflation every year and exhaust the money after 8 years.


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!

We hope you enjoyed today’s case study! Please share your comments and suggestions!

34 thoughts on “Ask Big Ern: A Safe Withdrawal Rate Case Study for “Mr. Corporate Refugee”

  1. Big ERN,
    Always a pleasure to see what you cooked up for Wednesdays!

    One thought on the college expenses planning via 529 accounts….It may be advantageous to NOT fully fund a child’s college expenses ONLY through a 529.

    Current tax law limits the amount of tax-free-ness (is that a word?!??!?) that someone can utilize for college expenses. For example, one tax credit for higher education expenses is the American Opportunity Tax Credit ($2500 per year for up to four years subject to income limitations). “Double-dipping” or utilizing more than one tax benefit for the same educational expenses is not allowed. If you claim the AOTC for a child, then you cannot claim the full tax exclusion on 529 funds used to pay for your child’s “Qualified Higher Education Expenses” (QHEE). Claiming the full $2500 AOTC reduces your QHEE by $4000 which means your “tax-free-ness” on 529 gains is now the QHEE – $4000 each year for the first 4 years of college!

    There are other credits/deductions for higher education, but I think the AOTC example of $10,000 in tax credits over 4 years shows the general idea fairly well.

    1. Interesting point DrFIRE.
      Do you know what would happen if I used the I Bonds for part of the payment? I am guessing it would have a similar impact no? Lots of research to do.

      1. Mr. CR,
        Don’t know the answer off the top of my head about how i-bonds affect the tax calculation for QHEE. I only became of aware of the AOTC/529 issue when my oldest started college and was unpleasantly surprised when reviewing the results of some quality time with TurboTax.

        I would encourage you to follow the current tax reform packages wrt i-bonds. If memory serves, the House bill (at least at some point in November) has provisions that repeal the tax-free use of i-bonds for higher education expenses. The proposal has a fairly narrow window to convert i-bonds to a 529 to avoid being affected by the repeal.

        Who knows what will actually happen, but it is clear that higher education tax-free savings are on some lobbyist’s radar and only time will tell what is actually passed and signed into law.

        1. My goodness, I am enjoying this wisdom on the tax-credit college education fronts. Great to share your experience. Our kids are 8 and 10 years away from college but never too soon to arm yourself with these nuggets of information.

          Did I mention “gold” there? Sorry ERN, I know how you love that precious element…..

        2. Just for the record, the tax bill that passed preserved the ability to use treasury bond interest for education (qualified).

  2. Mr. Corporate Refugee here,

    Thanks Big ERN! Lots of decisions for me.
    If folks have questions I’ll do my best to answer.

  3. Hi,
    I just read the introduction for now, but will be back to read Big ERN’s analysis.
    I must commend on frugality of Mr.CR’s family. Living in a HCOL area and average only $40-50K of expenses a year is truly impressive.
    I’m curious if his children attend any extracurricular activities or plan to in the future. Another thing is to consider prices of future braces and driving related expenses for the kiddos. I wonder how I’m going to deal with them myself. Not braces, but driving. I wish my kids don’t want to drive LOL when they turn 16 because an extra outlay for another car, a jump in auto insurance premiums can be big…We might need to consider increasing our umbrella insurance cap from $1M to $2-3M probably.

    Also, thank you, DrFIRE, for a note about the higher education and taxes. I’ve never heard of this before! I’m curious what would be the most efficient to ‘sponsor’ college education and take the advantage of tax laws at the same time. OTOH, it might be a moot point in case the tax law overhaul goes through.

    1. Great questions Mrs. Greece.
      First off HCOL Area. What I have found is that this is usually due to housing prices. Other items are more expensive too but really only by a few percent or so. It doesn’t hurt that we like simple things and simple foods.

      Braces are a great question. There is a bit of flexibility in what we do. It is unlikely that I will ever stop working completely and Mrs. Corporate Refugee likes her part time gig enough to stay for a while. As far as an extra car, well we only have one right now. Our lifestyle doesn’t lend itself to more cars. At least for the near term we live in an area with decent public transit or we are close enough to walk places. If we move for the geographic arbitrage we would likely consider another car. But CA does have a decent train system with even better to come. Still we should probably think about it more and make a plan. Good point on the insurance jumps and the need for more umbrella insurance.

    2. Mrs. Greece,
      Not sure that I am the best source to answer your question on the “most efficient” means to fund a college education. However, I am happy to share what we are doing with the understanding that, as you state, the current tax reform may completely upset the apple cart.

      For college savings, we have about 2/3 in 529s and 1/3 in regular investment accounts. When I stumbled on the 529/AOTC issue, we stopped funding the 529s with monthly contributions as we wanted to try to be able to claim the AOTC and avoid paying a penalty on withdrawing excess 529 funds not used for QHEE. We have 4 Little FIREs, so the amount of $$$ is quite large if we can claim the AOTC every time possible.

      With respect to driving, 2 Little FIREs are on the road. Car insurance for teens is insanely expensive. About $2k per kid/car combo per year without collision is the best I have found for limits that were compatible with an umbrella policy. Be aware that even if junior does not have his/her own car, your rates are going up, up, up anyway as you have to add the precious dear one to your insurance policy as soon as they get their full drivers license (but not learners permit; at least in the two states I have lived in). Oh, and the other little nasty surprise (although the cost was not so bad, just insult added to injury), was my umbrella premium went up as Little FIRE #1 got a license and then again when Little FIRE #2 got a license.

      Braces are a walk in the park compared to driving teen expenses; 2 Little FIREs are done; Little FIRE #3 is just about 2 months to go to remove the little torture devices. Shop around for orthodontists. We were able to find docs we were happy with and managed an average treatment cost of under $3k per Little FIRE. We saved a good chuck on Little FIRE #3’s braces by paying up front. Orthodontist for LF1 and LF2 refused to discuss a discount to pay up-front.

  4. I am FI in “low-tax” California, and I have to say this is a brilliant article. I love the idea that they could keep their home as a rental and buy a house in a less expensive area. As a lifetime resident in the Central Valley, I can say that California is large enough for using Geo-arbitrage close to home.

    Also I can say first-hand that we are able to get very large Obamacare subsidies, which might be because we are older than you. I recommend using the Shop and Compare Tool at the Covered CA website. Try different zip codes and incomes with your ages and that may help you to figure out possible places to move. Good luck Corporate Refugees!

  5. I would probably go ahead and retire and not move “yet”. Spend a year figuring out what exactly you want your retirement to look like and what random income might come in. Worst case you decide you never want to earn another dollar and then geoarbitrage. $120,000 is a lot of money, but you can probably easily get another job somewhere near that level if you had to. I hate to see you either commiting to moving today or working another four years, especially when most productive people still make something in FI. Just my two cents and will be a refugee soon too!

  6. Curious to know how keeping the primary house and renting it out compared to just selling it and investing the extra money in equities after buying a 350k house would compare? Determining a ROI for the house vs expected real returns from stocks? Tax ramifications for both ways. Wont rent be paid at earned income tax rates vs lower capital gains rates by being in stocks. Wont they eventually lose the huge 500k in capital gains from turning their primary house into a rental over time?

    1. I was curious about this as well, since there can be “unexpected” costs to using a house as a rental property and getting all the cash from the house should eliminate the problem of not having enough taxable funds, plus both rentals being in literally the exact same location seems to add some extra risk. How would he fare if there was a wildfire/earthquake? Or even just a house fire? I suppose insurance would pay out.

      1. Great questions!
        Both locations will be 2 hours apart by car. Not in the same location.
        I assumed $24k in annual expenses. Normally, in low-cost areas, you’d factor in half of the gross rental income will be lost due to overhead. But since the land is the valuable thing, not the structure, I figured that as a % of the rent, maintenance will be lower. Hence your net operating income is 60% of the gross revenue.
        Fires: you’ll have homeowner’s insurance for that. Earthquake is a concern because I once heard that earthquake insurance is so expensive in CA that nobody has it. Again: the land is valuable. The structure may need some repairs and that can be in 5-figures or maybe even $100k.

    2. Jason,
      As you point out, the comparison selling of the house and investing is not a straightforward calculation particularly because of differences in taxation. Other issues such as inflation protection (rents tend to rise with inflation), long-term capital appreciation, and correlation of returns with other assets in Mr.CR’s portfolio further complicate the apples to oranges comparison.

      Rent per se is not taxed. Taxes are paid at ordinary income rates on rent minus allowable expenses. This is where the calculations get really squirrelly. Under IRS rules, you must depreciate the value of the building, but not the land, over 27.5 years. This “expense” is a non-cash transaction. I have no idea the relative split of land to building values for Mr. CR, but let’s assume 70/30 for the sake of discussion. $1.1M * .7 / 27.5 = $28,000 depreciation value that directly reduces the amount of money that Mr. CR must pay each year. The estimates in the post for rental income is $60k (gross rent) – $24k (cash expenses without a mortgage) = $36k. Now, under IRS depreciation rules, Mr. CR has to pay tax on $36k (net cash profit) – $28k (depreciation allowance) = $8k in taxable Schedule E income.

      Depreciation seems great, but there is no free lunch here. When Mr. CR sells the property at some point in the future, the IRS requires the payment of Depreciation Recapture Tax at a fixed rate of 25%. There are ways to avoid paying this tax that involve further tradeoffs, but we are getting into the weeds.

      The way I look at the sell rental property & invest in stocks vs hold the real estate is whether or not I can get more from a SWR in stocks for someone near FIRE. Since the transaction costs of selling real estate are high (6-8% for a ballpark), Mr. CR will have only about 93% of his house’s value to invest in the stock market. Multiply that by a SWR and you have an idea if selling might be worth investigating in more detail. The more detailed analysis is rather complex as we have to open up the can of worms on taxation differences, correlation of returns with other portfolio assets, etc.

      In Mr. CR’s case, $1.1M * 0.93 = $1.02M (this assumes no CG tax is paid on the sell of the home). Given the $15k in rent for the flat plus $36k net for renting the primary house, his “withdrawal rate” would be about 5% for using the home as a rental property. There are lots and lots of caveats to this number so caveat emptor.

    3. Excellent question! During normal times I would have probably preferred the equity investment. But equities are expensive and I like the diversification benefit of real estate.

      Selling the property would have also triggered capital gains tax (sale price minus cost basis minus previous depreciation)>$500,000.

      Rental income is taxed as ordinary. But you can also write off all of the expenses including mortgage interest (no issue with getting above deductible) and continue to use depreciation. Real estate is a pretty tax-savvy move!

      The trick is to hold on to the house forever and then give it to the kids when they pass. That will reset the tax basis at that time.

      1. Yes very complicated from a tax perspective. Dr Fire your calculation for depreciation was based on land value and not house value. I came up with $12,000 in depreciation from the structure
        I think being diversified is great. But there are some big tax implications if he is forced to sell for equity down the road due to unforeseen circumstances after losing the $500k writeoff in capital gains from the rental conversion. I vote for the extra four years of work to be safe if he holds onto the property as a rental. Also should talk to a tax expert. There’s other things to consider like forming a s corp for the rental and extraction of equity which may be beneficial from a tax perspective.

        1. Jason,
          The situation I described was purely hypothetical. It would have been better if I had clearly stated 70/30 ratio meant building/land. I don’t invest in rental properties in CA, so I have no clue what the average split actually is. To your point, the amount of depreciation can be lower or higher depending on the specific property of concern. I have always used an appraisal from a certified real estate appraiser for setting the initial value of the building for depreciation purposes.

          Just so we don’t miss the forest for all the trees, the key point is depreciation provides a (temporary) shield against what would otherwise be taxable passive income for many folks investing in rental properties. If the property is later sold and the proceeds not invested in another income producing property through a 1031 exchange, the depreciation is “recaptured” at a tax rate of 25%. To Big ERN’s point, the tax basis will reset upon death, but not sure what happens with depreciation.

          In Mr. CR’s case, it would be well worth the time and expense to find an account and attorney that are familiar with rental property concerns in CA. In my case, I was able to ask around and quickly find an attorney that could provide good advice for rental properties. Finding a tax accountant that actually knew the ins-and-outs of rental properties proved more difficult; they all seemed okay for yearly tax stuff, but not so much on the details of tax implications for selling properties. I didn’t “learn” this lesson until I sold my first income producing property. Make sure to request and contact existing real-estate investor clients in either case.

          Lastly, changing the legal ownership to an LLC or S Corp for Mr. CR’s current primary residence really needs the advice and assistance from legal/tax professionals. There may or may not be ways to preserve the existing capital gains on the primary residence by changing the legal ownership structure. The devil truly is in the details. Even more so with the tax reform underway that affects taxation of pass-through entities.

          1. All of these are great comments–
            For what it is worth there are additional issues here as well. I live in the upper flat right now. That means besides the land and property split, there is also the rental/primary residence split that is going on. This complicates things significantly in that there is a “portion” of the land value attributed to my personal residence and a portion attributed to to the rental property. Add to that the current rules around needing to live in the residence for 2 of the past five years, for the portion I lived in. So that means I could theoretically move and rent the place for 3 years and then sell it while still claiming a large portion of the capital gains exclusion. I could move, buy a new house and still get the exclusion after 3 years if I decide long distance rentals are not for me.

            I must say that it has been very beneficial having the rental as part of my primary residence for tax purposes. I am able to write off a portion of property taxes, insurance, and utilities due to the split. Yes on paper the insurance is more expensive but it ends up being cheaper overall due to being able to count it as an expense on the property and thereby reducing my overall profit–for something that i would have had to pay for anyway. It doesn’t work for everyone–you have to like your tenants.

            In the end I do need to visit a real estate accountant about all of this and the possibility and benefits of selling versus. I knew that I could likely retire in a few years and wanted some sort of confirmation of that. BIG ERN has produced in spades and even made me question some of where I thought I might retire to. This really is the baseline for making future decisions.

            Thanks All!

  7. Another great one, ERN.

    And I agree on preferring the real estate vs. the equity investment at this juncture. However, thought it important to conjecture that managing the two rentals will be a small “part time job.” Seems like Mr. CR might want to run the overhead numbers accounting for a competent property manager? After all, he’ll have his thesis to focus on!

    Also, I was just running some retirement projections for my mother-in-law when I discovered that … social security benefits are NOT TAXABLE in the great state of California! Granted, there are only 13 states that actually do tax social security, but it’s a pleasant surprise that CA is not among them.

    Finally, I vote against the in-state geo-arbitrage. There’s a big difference between Santa Monica and Santa Clarita, if you know what I mean. Maybe Mr. CR can take the next four years one at a time, using this study as a baseline and then factoring in possible part time income, ongoing good market returns, etc…

    1. Brian,
      Just to put some bounds on the cost of property managers….In the markets I am intimately familiar with, property management fees range from 5 to 10% of gross rents. Rates vary based on the number of units the landlord has under management and current conditions in the local market when you sign a property management agreement. The landlord may also have to pay leasing fees and lease renewal fees to the property management company that would not exist for an “owner-manager”.

      Not only do they handle the broken toilet calls in the middle of the night, a good property manager gets you easy access to good quality handymen and generally gets better pricing when doing major repairs and updates to properties given the number of units under their management.

      The locating and screening of prospective tenants is another huge plus. The property management companies I have worked with had access to credit reports and a national database on tenant rental histories. It doesn’t stop all tenant problems, but it certainly is better that many owner-managers have access to.

      Like the recommendation in one of my other comments on this page, if someone is looking for a property manager, interview several and get references of current property owners. Follow-up with the references before deciding.

    2. Good point. Once Mr. CR is retired does he want to drive into town regularly to check on the property? Maybe hire a manager
      I didn’t know that Social Security isn’t taxed in CA. Good point! This not make or break retirement but definitely saves you a thousand bucks a year!
      What’s wrong with Santa Clarita? 🙂

  8. Big Ern,

    I really love these case studies. One issue I have on the Case Study tab of the Google Sheet is that if I set Glidepath initial and final to be equal I get a slight difference in Return vs. GP Return. My guess is that the formula for GP Return doesn’t take Cash into consideration whereas the Return column does.??

    Also Year and Month are reversed on “Stock/Bond Returns” tab

    In your Cash Flow spreadsheet above why is Cash separated from Taxable, Roth and 401k? Couldn’t you hold cash in any of those accounts?

    1. Thanks!
      Yes, that’s right. The GP calculation in the case study tab is doing the allocation only with stocks and bonds and zero cash. One easy way to prove they are identical is to set the cash weight in the main tab to zero. 🙂

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.