Author Topic: FIRE Investment and Drawdown Strategy – Buying Property and Building a Home  (Read 4885 times)

LazyBones

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When my DW and I reach financial independence, we plan on purchasing some property in our desired retirement location, and then building a nice downsized home to meet our needs.
I was recently looking through our investment and drawdown strategy to see how I can fit a property purchase and home build into the FIRE plan, but with planning to heavily rely on tax-deferred investment vehicles, I feel like it would be really difficult to execute everything without paying some penalties or higher tax rates.

Here is where we are currently at:
  • Age 31
  • Gross Income: ~$130k
  • 25% marginal tax bracket
  • His 401(k) contributions – Maxed out at the current annual contribution limit of $18,000/year.  Receive 4% company match
  • Her 401(k) contributions – 3% of pay, with 3% company match

Current Investment Plan:
  • His 401(k) – Continue to contribute annual maximum allowed for given year
  • Her 401(k) – Within the next 4 weeks, contribute annual maximum allowed, divided equally into bi-weekly paychecks: $18,000/26
  • Traditional IRA 1 – Fall of 2016; contribute maximum allowed, divided into equal monthly payments: $5,500/12
  • Traditional IRA 2 – Some time 2017/2018; contribute maximum allowed, divided into equal monthly payments: $5,500/12
  • Taxable Account – After 401(k)’s and IRA’s are maxed out, skim excess monthly savings into Taxable Account

Current Drawdown Plan:
  • Assume $40k annual spending
  • Reach financial independence – work the following year and max out 401(k) and Traditional IRA contributions as quickly as possible
  • Retire at age 43ish – receive no additional income from job/career
  • Roll 401(k) into Traditional IRA
  • Establish a Roth IRA account and use laddering method to access funds 5 years later
  • Use money out of Taxable account to pay for annual expenses until Roth Pipeline is established

When my wife and I reach financial independence, our accounts might look something like this (assuming 5% average return):
  • His 401(k): $508,000
  • Her 401(k): $341,000
  • Traditional IRA 1: $86,000
  • Traditional IRA 2: $72,000
  • Taxable Account: $121,000

Our current home has a current estimated value of $240,000
Estimated Property Cost: $75,000
Estimated Home Build Cost: $250,000


Problems:

The first big problem is that at early retirement, our taxable account will not have enough in it to sustain us for 5 years at $40k annual spending until the Roth Pipeline is established.

The second problem is, is that I have no idea how to sequence all of the events together to make the transition, and how to drawdown the accounts to purchase the property and build the home.

This is what I was thinking of possibly doing:
Retire -- Establish Roth IRA and begin laddering method -- Use money from Taxable Account to secure a Construction-to-Permanent Loan (~$85,000 down payment) -- Once house is built, sell existing home and use the proceeds from the sale to pay off the Construction-to-Permanent Loan -- Continue to use Taxable Account to pay for annual expenses (at this point, only have about 1 year of money remaining) -- Once Roth Pipeline is established, used money from Roth to pay for annual expenses -- Live happily ever after

So we can use the money from the Taxable Account to put a down payment on a Construction-to-Permanent loan, but as earlier mentioned, with the existing investment plan, there won’t be enough money in the taxable account to sustain us for 5 years of annual expenses until the Roth Pipeline is established.  With the above plan, we are missing 4 years of cash flow.

So how do we make up this difference?

At age 43, it looks like our options would be limited and we may end up having to pay penalties to withdraw some money from the Traditional IRA/401(k).

Instead of investing in Traditional IRAs, do we invest in Roth IRAs?  If we went that route, we would have about $120,000 as the Roth basis, but minus 5 years of contributions, we would have about $65,000 for immediate use, with $11,000 every year thereafter.  This route would give us an additional 2 years, extending our annual spending from 1 year to 3 years, but we are still missing 2 years until the Roth Pipeline is established.
Going this route, we would be growing our IRA investments with after-tax money, instead of tax-deferred money, meaning that we would be missing out on some free money up front, and limiting our future IRA balance.  This won't help us much with our annual taxes from now until FIRE, and it would also extend our projected FIRE date by a little bit.

Do we scale back our contributions towards 401(k)’s and IRA’s and put more into the Taxable Account?  Might be good at the end to make things easier, but it won’t help us much with our annual taxes from now until FIRE, and it would also extend our projected FIRE date by a little bit.

I could extend my working career by 2 years, to age 45, but for reasons that I wish not to disclose, I wouldn’t want to go past that.  That being said; the earlier the better.
If I begin a Roth conversion while I am still employed, I will have to pay taxes on the conversion at the higher 25% marginal tax rate, as opposed to starting the conversion when being retired and being in a lower 15% marginal tax rate.

What about using a HELOC or some other sort of LOC? If this is a possible route, how should this be fit into the timeline of things?


Any thoughts on how to make this all work out while minimizing taxes and penalties?

boarder42

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assuming rates are low why not just expect to have a mortgage.  conversely you could just save a little less in tax deferred accounts.

Cromacster

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Roth IRA isn't a bad Idea.  Your marginal rate should be in the 15% bracket with both of your 401k's maxed.

I believe you are also going to be in the phaseout stage for the Traditional IRA anyway,  So you could contribute the max allowed to the Trad IRA, probably around 4,000, then contribute the remaining into a Roth

One thing that I don't see accounted for is any raises or promotions you might earn over the time period before retirement.  Assuming you keep everything else relatively static your after tax account might be more substantial.

LazyBones

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assuming rates are low why not just expect to have a mortgage.  conversely you could just save a little less in tax deferred accounts.

That's a possibility, but to account for that, the anticipated FIRE date would get pushed back to cover the additional expense...3 years or more.
If the mortgage balance is small, I might not mind, but if it's large, I might not feel comfortable carrying the burden of the mortgage into retirement.
I'd like to just have the peace of mind knowing that there are no debts looming overhead.

LazyBones

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Roth IRA isn't a bad Idea.  Your marginal rate should be in the 15% bracket with both of your 401k's maxed.

I believe you are also going to be in the phaseout stage for the Traditional IRA anyway,  So you could contribute the max allowed to the Trad IRA, probably around 4,000, then contribute the remaining into a Roth

One thing that I don't see accounted for is any raises or promotions you might earn over the time period before retirement.  Assuming you keep everything else relatively static your after tax account might be more substantial.

With both of our 401(k)'s maxed out, we would still be in the 25% marginal tax bracket.
For 2016, Married joint filers fall into 25% when taxable income is between $75,300 and $151,900. 
We gross about $131k, subtract the $36k for the 401(k)'s, we are still at $95k of taxable income.
Am I missing something?

We are approaching the phase out for the Traditional IRA.  Once our MAGI exceeds $98k, you can only take partial deductions.  Above $118k, there are no deductions.
MAGI takes into account your 401(k) deductions, correct?
If that's the case, we still have a little bit of room, before we start getting phased out.
So sooner or later, we won't be able to get a deduction for contributing to a Traditional IRA, so we will switch over to contributing to a Roth IRA.

My numbers in the original post do include annual raises.  I did go a bit conservative with those, so yes, we may see a larger balance in the Taxable Account  than what I am currently projecting.

zolotiyeruki

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With both of our 401(k)'s maxed out, we would still be in the 25% marginal tax bracket.
For 2016, Married joint filers fall into 25% when taxable income is between $75,300 and $151,900. 
We gross about $131k, subtract the $36k for the 401(k)'s, we are still at $95k of taxable income.
Am I missing something?

We are approaching the phase out for the Traditional IRA.  Once our MAGI exceeds $98k, you can only take partial deductions.  Above $118k, there are no deductions.
MAGI takes into account your 401(k) deductions, correct?
If that's the case, we still have a little bit of room, before we start getting phased out.
So sooner or later, we won't be able to get a deduction for contributing to a Traditional IRA, so we will switch over to contributing to a Roth IRA.

My numbers in the original post do include annual raises.  I did go a bit conservative with those, so yes, we may see a larger balance in the Taxable Account  than what I am currently projecting.
I've actually gone through much of the same thought process as you, and with not-too-dissimilar numbers, as it turns out.

So your gross income is $131k and your maxed-out 401k's take you down to $95k.  The standard deduction ($12,600) and two exemptions (2x$4000) will get you below the threshold of the 25% bracket. You might be able to itemize in order to drive your taxable income down further, and if you have kids, you get extra exemptions and tax credits.

I'd like to emphasize one thing, though:  You're in a VERY nice place, income-wise, but that also means that you start losing out on the various tax-minimizing strategies.  It's simply the way the system is designed.

All that said, here are a few thoughts:
Thought #1)  When you hit 41, you can roll your 401k's into an IRA and set up a SEPP.  Short version:  you lock into yearly withdrawals of 1.5-3.5% (depending on your age)  from your IRA for 5 years or until you hit age 59.5, which ever comes later.  Advantage: you get penalty-free access to your money earlier.  Disadvantage: you're locked into it.  According to this calculator, a SEPP on a balance of $840k at an age of 41 would give you nearly $30k of income.  The remaining $10k can come from your traditional investments.
Thought #2)  You're 31.  Do you currently have a mortgage?  Will you pay off that mortgage before you hit 41?  If yes, you can up your retirement savings once the house is paid off.
Thought #3)  I've heard it recommended that rather than permanently and immediately move to a location upon retirement, you should take some time and spend a few months in a few different locations, to figure out what actually works best for you.
Thought #3b)  If you do this, you can use the money from your old house as the down payment on the new one.
Thought #4)  In your situation, a Roth IRA has no advantages over a traditional investment.  Neither are tax-deferred up front, and as long as you keep your income <$75k in retirement, you won't pay taxes on the back end on either as well.  The traditional has an advantage in that you can withdraw the entire balance whenever you want, whereas with the Roth you can only withdraw contributions, and only after 5 years.
Thought #5)  With an expected retirement income of $40k, you'll be just over the top of the 10% tax bracket when you subtract out the standard deduction and two exemptions.  So setting up a Roth ladder wouldn't actually benefit you--you'd pay 15% taxes when you convert from the traditional IRA to the Roth, vs 10% if you just set up a SEPP

So for you, here's what I'd do now:
1) max out both 401(k)'s for the tax-deferral and AGI reduction.
2) plow everything else into traditional investments.

And when you retire: ($840k in 401(k)s, $280kish in traditional investments)
1) roll the 401(k)'s into traditional IRAs
2) set up a SEPP for your IRAs at the maximum rate you can (about $30k/year)
3) whatever else you need to spend, pull it out of traditional investments ($10k/year, which is less than 4%)
4) sell the house and use that money to pay for rent and the down payment while you build the new house.

For a better explanation of the advantages of a SEPP over a Roth pipeline, see this comment over at jlcollinsnh.com

Is it really downsizing if you're going from a $240k house to a $325k property? :)

LazyBones

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I've actually gone through much of the same thought process as you, and with not-too-dissimilar numbers, as it turns out.

So your gross income is $131k and your maxed-out 401k's take you down to $95k.  The standard deduction ($12,600) and two exemptions (2x$4000) will get you below the threshold of the 25% bracket. You might be able to itemize in order to drive your taxable income down further, and if you have kids, you get extra exemptions and tax credits.

I'd like to emphasize one thing, though:  You're in a VERY nice place, income-wise, but that also means that you start losing out on the various tax-minimizing strategies.  It's simply the way the system is designed.

Forgot about those, didn't I?..We currently have 1 kid.

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All that said, here are a few thoughts:
Thought #1)  When you hit 41, you can roll your 401k's into an IRA and set up a SEPP.  Short version:  you lock into yearly withdrawals of 1.5-3.5% (depending on your age)  from your IRA for 5 years or until you hit age 59.5, which ever comes later.  Advantage: you get penalty-free access to your money earlier.  Disadvantage: you're locked into it.  According to this calculator, a SEPP on a balance of $840k at an age of 41 would give you nearly $30k of income.  The remaining $10k can come from your traditional investments.

I will have to do some further reading on 72-t distributions as I am not all that familiar with it.  I appreciate the links to get me started.

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Thought #2)  You're 31.  Do you currently have a mortgage?  Will you pay off that mortgage before you hit 41?  If yes, you can up your retirement savings once the house is paid off.

I do have a mortgage, but it will not be paid off by my early 40's.
My kid is currently in daycare, and I didn't account for when they are out of daycare full-time.  I did this on purpose, so that I can be pleasantly surprised when I can save more than planned and hopefully beat my current FIRE goal.

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Thought #3)  I've heard it recommended that rather than permanently and immediately move to a location upon retirement, you should take some time and spend a few months in a few different locations, to figure out what actually works best for you.
Thought #3b)  If you do this, you can use the money from your old house as the down payment on the new one.

I have heard this as well.  Currently, we have two locations on the radar.  One of the locations, we used to live in, so we are very familiar with the area.  The other location is a less expensive area to live in that is about an hour away from the first location.  I've been through the area, but neither of us have ever spent any time there.  We plan to go for an extended weekend trip there later this summer to see how if we like it enough to keep on our list.

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Thought #4)  In your situation, a Roth IRA has no advantages over a traditional investment.  Neither are tax-deferred up front, and as long as you keep your income <$75k in retirement, you won't pay taxes on the back end on either as well.  The traditional has an advantage in that you can withdraw the entire balance whenever you want, whereas with the Roth you can only withdraw contributions, and only after 5 years.

I agree.
I think the only benefit of the Roth IRA at this point would be for any beneficiaries after we're gone. 

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Thought #5)  With an expected retirement income of $40k, you'll be just over the top of the 10% tax bracket when you subtract out the standard deduction and two exemptions.  So setting up a Roth ladder wouldn't actually benefit you--you'd pay 15% taxes when you convert from the traditional IRA to the Roth, vs 10% if you just set up a SEPP

This is true.  To get into the 10% tax bracket, it looks like our expected retirement income would need to be below $39,150.

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So for you, here's what I'd do now:
1) max out both 401(k)'s for the tax-deferral and AGI reduction.
2) plow everything else into traditional investments.

And when you retire: ($840k in 401(k)s, $280kish in traditional investments)
1) roll the 401(k)'s into traditional IRAs
2) set up a SEPP for your IRAs at the maximum rate you can (about $30k/year)
3) whatever else you need to spend, pull it out of traditional investments ($10k/year, which is less than 4%)
4) sell the house and use that money to pay for rent and the down payment while you build the new house.

This makes sense to me, and I will have to research this further to see how this all works.

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For a better explanation of the advantages of a SEPP over a Roth pipeline, see this comment over at jlcollinsnh.com

Thanks again for the link.  I actually read that post earlier this week, but never made it into the comments section.

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Is it really downsizing if you're going from a $240k house to a $325k property? :)

Yes and no? Haha...
The property size will be larger, the house size will be smaller.

I plan to do a lot of work myself with the help of some of my family and a few people that we know.
I'm thinking that all in, we should be able to sneak in under $230k, but the future is uncertain, so I like to estimate on the higher side of things.

Again, thank you for all of the information, I really appreciate it.

boarder42

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you're also kinda basing this off of what i assume are predicted standard 6-7% inflation adjusted returns.  so i dont know that any of this really matters til you get about 2-3 years out.  then you should start evaluating the strategy you plan to use you likely should just maintain status quo and keep socking away money til then.

LazyBones

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you're also kinda basing this off of what i assume are predicted standard 6-7% inflation adjusted returns.  so i dont know that any of this really matters til you get about 2-3 years out.  then you should start evaluating the strategy you plan to use you likely should just maintain status quo and keep socking away money til then.

It's in my original post, but it's kind of squirreled away - I used 5% for my numbers.

We definitely plan to max out both 401(k)'s.  Just contemplating the IRA's and what to do there.

And yes, I agree, we will revisit and reevaluate our strategy as we get closer and closer, and adjust as needed.

LazyBones

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Do either of your employers offer (or could you pressure them to offer) a Roth 401k option?  If so you could throw some money in there, and also have the regular Roth accounts.  It would increase your tax hit slightly now, but leave you with a lot more accessible cash (in the form of your contributions) once you stop working.  Just roll the Roth 401k over to a Roth IRA, and as long as you have at least one Roth account at the same institution that has been open at least 5 years, you can access your contributions as soon as the new account is funded.

I'm hoping we don't have to use it, but this is one of our strategies.  I had a Roth 403b at my last job, and have about $130k of contributions I can tap any time if needed.

Currently, we both only have access to a traditional 401(k).  There might be a slight chance of having one of our places of employment offer a Roth 401(k), but I think it would be very difficult to do based on my observations of both companies.

zolotiyeruki

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Quote
For a better explanation of the advantages of a SEPP over a Roth pipeline, see this comment over at jlcollinsnh.com

Thanks again for the link.  I actually read that post earlier this week, but never made it into the comments section.

Yeah, I'd read the article (several times) before, and never got down to the comments either.  Given the normal expected quality of comments on the internet, it's a pleasant surprise to find a substantive, valuable discussion!

boarder42

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i was actually running i-orp the other day and it recommended that as my strategy due to the incredibly lower taxes.

zolotiyeruki

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i was actually running i-orp the other day and it recommended that as my strategy due to the incredibly lower taxes.
Holy smokes, I had never heard of i-orp before.  That's super useful!

boarder42

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i was actually running i-orp the other day and it recommended that as my strategy due to the incredibly lower taxes.
Holy smokes, I had never heard of i-orp before.  That's super useful!

yeah its crazy fun to play with - but it doesnt use historical data it uses standard return rates but in the end i think i may end up going with the SEPP and if i do start bringing in extra income i'll just drop to the lower withdrawal option its crazy good for taxes since we will have expenses including our mortgage at the upper end of the 15% bracket and with the roth ladder i would be rolling what i need in 5 YEARS over so you have to assume 3% inflation annually but you're going to get taxed at todays rates not taxed at the rates in 5 years.  so i think SEPP will work much better for us anyways, but we're 8 years out so who knows how it will all fall out.