FIRE transition - How to manage IRAs, cash, rental properties for income / taxes

[Kevin Aster Tin Obin]

I am trying to get to the point where I can leave the day job if I choose.  I have rental properties, retirement accounts, etc. but need to define my path to FIRE, looking for suggestions.

Financial situation:
2 rental properties, 2 mortgages totaling $370K, cash-flow is $2400/mo with us living in a unit "paying" $800/mo 
real estate last year cash on cash return 17%
Vanguard 401K = $250K
Roth account $40K
cash $90K
lending club/ loyal3/ I-bonds  $12k

Plans:
This is where I go back and forth..  We spend around $4k/month loving life, could easily get it down to $3K or $2500/month if needed. Would like to use cash to buy another property(17% ROI), but that's more work land-lording, etc.  Or would like to pay off 1 mortgage and get 4.25% return from saving the interest payments.  Or cash out my 401k/IRA to pay off both loans and gain $1800/month cash-flow from no-mortgages.  Then there is taxes and fees on distribution, I am cash poor, but have plenty of monthly "passive" income!

So looking for ideas of what paths to take? Should I reduce income next year so I can backdoor Roth to get money free'd up to pay off a mortgage, Invest cash in dividend stocks, or pay off mortgage and take max income from rentals? What is best tax situation? 

Long term plan is to keep income below $75K line to have tax free dividends (if I have stocks still) or work on the rental business and keep income coming from rents..  Either way I want low-maintenance finances..  Was going to start options investing, but high risk and learning curve...  The land-lording I have down to just a few hours a month, or a few hours a week when I have a tenant turnover, but that is infrequent.  I know how to mow grass, paint, and fix a faucet. ;)

Cheers
 

[hodedofome]

Can't speak to the rest of it, but 'trying' out options trading is the wrong way to start IMO. Unless you are going to start with a very small amount of money. But still, you are starting at the hard part. If you can't make money trading stocks, you aren't gonna make money trading the derivatives of stocks either. Start simple and then work your way to the complex. And understand that it could take 2-5+ years of really hard work before you become a profitable trader/investor.

[Cheddar Stacker]

Questions:

1) You need $4K/month and you receive $2,400/month net rental income, so you only have a $1,600/month gap to fill?
2) What is your annual taxable rental income (loss)?
3) Age? Time until collecting social security/RMDs?

I love that you consider yourself "cash poor" while you have $90K cash. We are a demanding group with high expectations for ourselves.

If buying one more rental which you already have the cash for would fill your $1,600/month gap I would do that right away. That would allow you to leave the day job which lowers your taxable income. Now hopefully your net rental income is low enough to allow for annual 401K to Roth conversions of maybe $20-30K/year with almost no taxes.

I would not pay off the mortgages, particularly if you have to cash out retirement funds to do so. This would not be tax efficient.

[Kevin Aster Tin Obin]

Hi Cheddar:
1) yes, need to fill ~$1600/month, good way of putting it.
2) taxable rental income is $15000 after depreciation and mortgage interest
3) thirties

No I don't think I am cash poor right now.. cash poor comment was in relation to spending most my cash and liquid assets to payoff mortgage.

guess I'm looking for another rental... seems best way to fill the passive income delta, but its more real estate eggs in one basket..

cashing out retirement funds would happen slowly with back door IRA and lower income with part-time work.. So its looking like my plan is buy more RE. 

What is rental income limit to convert $30K/yr from 401K as you state? 

And if stock trading is really 2-3 years of work, then not interested in new career ;)

[Another Reader]

Your statements about your real estate income make no sense. If you will continue to occupy one unit, there is no income from that unit.  Start with the gross income from all the remaining units and subtract out a reasonable vacancy and collection loss.  Then subtract out all the operating expenses, including a reasonable allowance for larger repairs and capital improvements.  That approximates your anticipated net operating income.  From that, subtract all the mortgage payments.  That's your anticipated cash flow.  I hesitate to say spendable cash flow, because it's going to vary.

What are your job incomes and where is the money going now?  Do you have a budget or at least a record of what you spend?

You don't say how old you are, so I can't comment much on the FIRE idea.  However, if you are spending $4k a month with no rent to pay, you are nowhere near FIRE.  Even if you are getting 17 percent ROI on your leveraged real estate, you don't have enough to make this work as near as I can tell.  If you post the numbers on the real estate we can see how much it really contributes to your income.

[Cheddar Stacker]

cashing out retirement funds would happen slowly with back door IRA and lower income with part-time work.. So its looking like my plan is buy more RE. 

What is rental income limit to convert $30K/yr from 401K as you state? 

Slow conversion from IRA to Roth (the pipeline) is likely your most efficient tax plan, so glad to hear that's the plan.

There is no rental income limit to convert $30K/year. I was merely asking how low your taxable income would be if you quit your job. With $15K rental income as you mentioned above, you would likely not pay any taxes unless you have other income.

You said "I" a few times, and "we" a few times. Which is it? I ask because it changes the tax rules. Are you married?

If you are single, you have at least $10K in deductions (married = $20K). I'm thinking you're married since you mentioned the $75K tax free dividends? So if you're married, your $15K rental income will be wiped out by your exemptions and deductions. You will have at least $5K of "free" conversions/year. If you have additional deductions you will have even more free conversions.

If I were you I would "fill up" the entire 10% bracket of about $18K in taxable income. So buy another rental, retire, taxable income will likely be about $20K from the 3 rentals. $20K rental income - $20K deductions = $0, so you should convert $18K/year and pay 10% federal income tax ($1,800). Use your existing Roth money to fill any gaps when you have vacancies or repairs that deplete your monthly cash flow.

[Cheddar Stacker]

Your statements about your real estate income make no sense. If you will continue to occupy one unit, there is no income from that unit.  Start with the gross income from all the remaining units and subtract out a reasonable vacancy and collection loss.  Then subtract out all the operating expenses, including a reasonable allowance for larger repairs and capital improvements.  That approximates your anticipated net operating income.  From that, subtract all the mortgage payments.  That's your anticipated cash flow.  I hesitate to say spendable cash flow, because it's going to vary.

What are your job incomes and where is the money going now?  Do you have a budget or at least a record of what you spend?

You don't say how old you are, so I can't comment much on the FIRE idea.  However, if you are spending $4k a month with no rent to pay, you are nowhere near FIRE.  Even if you are getting 17 percent ROI on your leveraged real estate, you don't have enough to make this work as near as I can tell.  If you post the numbers on the real estate we can see how much it really contributes to your income.

This all seems a bit pessimistic. I believe the $800/month from the unit they live in is an implied rent. It seems OP has already done the math, and nets $2,400/month. They spend $4,000/month. They are in their 30's.

If they can come up with another $1,600/month, they are ready for FIRE. It might not be the traditional way to go or equivalent to a 3% SWR, but the positive cash flow supports the expenses. In addition, they have nearly $300K (or $12K/yr @ 4% SWR) in 401K/IRA money so there is a nice safety cushion for when the rentals have vacancies and repairs.

[Kevin Aster Tin Obin]

Thanks for reading, sorry for any confusion:
Yes, happily married file jointly.  Real estate income when I move out is $2400, that accounts for all expenses, just not vacancies.  last year vacancy rate was 5% so net income $2280/mo.  Setting aside future Cap Expenses lowers me to say $2K/mo rental income.  Personal expenses with me living elsewhere for $800 rent and other expenses are about $3K.  So I am FIRE if I can close the gap of $1K/mo.

I have tracked spending with Mint since 2009 so I know where money goes.. saving $5K a month with 2 incomes currently.  So closing the income gap with real estate would take 2 new MFR rentals, so ~$130K cash needed for 2 down payments..  just have to find the right properties.. (hard to do). 

Started thread to look at investing options: buy $100K of dividend stocks, cash out Vanguard funds over next few years to pay off mortgages without buying more properties, or buy more rentals..  Trying to work on a spreadsheet to analyze tax implications of backdoor roth conversions into mortgage paydown, more real estate income though more property, or dividend income from new $100K taxable account (with ~ 50 stocks). 

[Cheddar Stacker]

Dividend stocks are not my specialty, but check out fellow forum members Spoonman (he has journal) and WTJBatman (he has a blog called dividend cave). Based on everything I've read from them, you'd be lucky to earn $5K/year in dividends from $100K invested. That's nothing to sneeze at, but it won't fill your $1K/month gap.

Tax implications of converting all 401K money into Roth over the next few years are pretty bad. How bad just depends on how quick you do it and what your total income will be from the conversion and other sources. In addition, you will have to let the funds "Season" before you can use them which takes 5 years from the day of conversion.

If you convert them over 5 years you would likely have to convert $60K/year (5*60K=$300K ($250K now + gains)). Take your $60K/year times your effective tax rate (25% fed + 6% state would be $18,600/year in tax). Hopefully it won't put you in a higher tax bracket, or phase-out some deductions you currently have. I would need more details to be able to answer that question.

If you put a spreadsheet together I'd be happy to review it and give you my 2 cents from a tax perspective. That is my specialty.

[Kevin Aster Tin Obin]

If I were you I would "fill up" the entire 10% bracket of about $18K in taxable income. So buy another rental, retire, taxable income will likely be about $20K from the 3 rentals. $20K rental income - $20K deductions = $0, so you should convert $18K/year and pay 10% federal income tax ($1,800). Use your existing Roth money to fill any gaps when you have vacancies or repairs that deplete your monthly cash flow.

This is the area I am trying to devise my (our) plan..  using ideas taken from http://www.gocurrycracker.com/never-pay-taxes-again/ 
  If we quit, spouse and I would still have income from occasional consulting work as ordinary income.  Then add in rental income and we can try to keep it under $70K to not pay income tax on any rental income, ordinary income, or ROTH conversions.  Is that correct? Or does this only apply to dividend income and not rental income?

So my path might look like:
1) buy another rental to get ~$3000/mo rental income total
2) quit job end of 2014 (planning for $1000/mo income in 2015)
3) convert $18K/yr into roth at 10% tax rate (What about $70K/yr non-taxable income?)
4) use cash and roth principal for expenses if needed

Cheddar, I will work on my spreadsheet for backdoor and dividends taxes vs. REI.  Thanks for offering to take a look!

[Cheddar Stacker]

Yeah, great article from Jeremy. I've referenced it on this forum many times. Good stuff.

However, I think you're missing the essence of the article. There are many types of income. Most are taxed. Some are not taxed at all. Some are taxed if they are high, and not taxed if they are low.

Play with this: https://turbotax.intuit.com/tax-tools/calculators/taxcaster/ to see how this all works, or better yet read some of the tax code to solidify everything.

Here's a summary of a few of the items you've discussed that are currently or will be part of your income stream:

Wages - Subject to FICA tax (7.65%) Federal income tax (variable) and State and Local income tax (check local listings).
Occasional Consulting Work - See wages above, but you can deduct certain expenses and add another 5-6% tax for the employer portion of FICA.
Rental income - No FICA, same federal and state rules, only net income is taxed, many possible deductions.
Roth Conversions - No FICA (you already paid FICA when you earned it), same federal and state rules
Interest (lending club/bonds) - No FICA, same federal and state rules
Qualified Dividends (not regular dividends) - Not taxed until you reach the 25% tax bracket - This is what the Curry Cracker preaches.
Long-term Capital Gains (not short-term) - Not taxed until you reach the 25% tax bracket - This is what the Curry Cracker preaches.

Short-term capital gains and regular dividends are subject to ordinary tax rates. Social security income will be taxed unless your ordinary income is under about $20K. You will certainly be paying taxes based on your plan, it's just a question of how much. The tax code as it's currently written encourages investing in domestic businesses on a long-term basis. Rental income is not subject to these magical rules.

There is nothing currently in your portfolio, or the plans you've mentioned in this thread, that fits the "never pay taxes again" model other than a slow conversion of your 401K/IRA into a Roth IRA. However, with a 17% ROI you mention, rentals provide a higher cash flow than a 4% SWR would in a qualified dividend portfolio. You will have to choose/calculate which path leads you to a quicker retirement.

Maybe you're not quite ready for FIRE since it doesn't seem like you've factored taxes into this equation. Re-run your expenses after calculating what your taxes will be, then fill the gap with an income stream.