Today, we’ve got our first reader case study post and it’s about reaching financial independence and having the option to retire early with real estate. We’ve had a few readers contact us and ask for guidance and direction with various FIRE related topics. Our reader, Mike, offered the most concise avenue for guidance yet and so we felt we could provide some input.
If you’re interested in asking for our point of view regarding a similar question, feel free to use our contact form. Of course, you can also reach out via Twitter or the comments section.
We’ve edited the text of what Mike sent for clarity and length.
Disclaimer: We’re not trained financial professionals and don’t encourage readers to make serious financial decisions based solely on what people on the internet advise. We encourage everyone to do their own research to determine the best course of action for their finances. We’re not financial advisors, nor are we your financial advisor.
With that, let’s get on with Mike’s questions and our answers!
Mike’s Family FIRE Journey
Would you be willing to do a post on giving advice for structuring a stock market account setup? I’m having trouble getting started and the information is overwhelming, and there are vultures everywhere in the industry.Mike
We reached back out to Mike and his family to ask some followup questions. Mike delivered! We’ll go through Mike’s related questions and address them following each respective section.
My main question is about how to supercharge our FIRE accounts. My wife and I are both trying to max out 401(k)s but they have contribution limits and penalties if we withdraw it before 60. So it’s no good for another 25 years.
I’d like to know your recipe for retiring early using the stock market. Do I set up a taxable brokerage account and try to grow it to my desired FI number? Do I use a small business owner strategy for supercharging the fund somehow?
Our goal is $1.5M in under 15 years. We have three kids, the oldest is near four years old and in 15 or so years, they will be in college or working from home rent-free, etc.
Mike delivered lots of details we’ll work through below, but we’ve already got some common misconceptions and useful information to work through!
Avoiding 401(k) penalties when retiring early
When I was much younger, I had a very similar thought about 401(k) accounts: I’d be locking the money away if I contributed. While there were some tax advantages, I might need the money soon! My goal was to have the option to retire early, after all!
It wasn’t until later in my twenties that I started contributing to a 401(k). Having most of my money in brokerage accounts created a sort of risk unto its own, after all, you can’t really trade individual stocks and lose your shirt in a 401(k). Jenni was fortunate to witness these mistakes while she was still in pharmacy school. By the time she’d paid off her six-figure debt, she had the hindsight of my failures pushing her to fund her 401(k).
But, we’re still retiring early. We’ve got over half a million bucks in our 401(k)s, so what changed? We learned about two ways to take money out of a 401(k) before the age restrictions without incurring penalties.
72(t) equal and consistent withdraws rule
The IRS 72(t) equal and consistent withdraws rule allows you to avoid 401(k) early withdrawal penalties. It’s complicated, but if you follow the amortization tables (effectively beginning withdraws in the same amount and never stopping), you can withdraw from your 401(k) at any age without penalty if you follow the rule guidance.
The biggest downside of this approach is that once you initiate the withdraws, you have to keep making them until the account runs dry. This calculator might be helpful in running the numbers.
Roth IRA conversion ladder
You need to plan ahead, but check out the Roth IRA conversion ladder—here’s a great summary from Root of Good. Basically, you can take a few steps in transfers from a 401(k) to a Roth IRA and withdraw the transfer amount from the IRA with no penalty.
The biggest downside is that you need about five years to let the transfers “mature” before you withdraw them.
Jenni and I are planning to follow a Roth IRA conversion ladder in order to access our 401(k) funds early. In the meantime, we’ll live on our taxable brokerage accounts and Roth IRA contributions (which can always be pulled out tax-free). In the near future, we’ll have a post (series?) on our early retirement withdrawal strategies.
Reader income/expense and asset breakdown
Back to Mike: we’ll address their $1.5M goal (relative to their current net worth and income) later in this post but it’s a great sign that they have concrete numbers to work with. Mike also asked about business tax strategies that we’ll address.
Let’s take a look at the family’s numbers.
- Work-related 401(k): $24K annually including employer match ($100K total value)
- Roth IRA: $6K annually ($18K value of individual stocks)
- Pension: Will be worth about $2K/month if I were to stay until 60 years old
- Work-related 401(k): $24K annually including employer match ($60K total value)
- Roth IRA: $6K annually ($6K value of S&P 500 ETF)
No HSA because our health insurance plan doesn’t allow it. We have no early retirement (brokerage account). We’re trying to figure this part out. We use Bank of America/Merrill if that matters.
- First rental home: $100K of equity ($175K owed), rental income is about $200/mo.
- Second rental home: $100K of equity, ($150K owed), rental income is about $200/mo.
- Primary residence: $100K of equity, ($150K owed)
We’re considering a vacation condo if the market changes and prices go down.
$185K annually. Net income is about $130K after-tax & 401(k) contributions. Our monthly take-home pay is about $10K.
About $4K monthly. We have $5-6K monthly excess money depending on random bills that may occur (fix the car, etc.).
Cash on hand: at all times, $50K total spread out in checking and savings.
Business: we don’t actually have a business but are looking for ways to use a business if you think it will help supercharge the FI account.
Our total net worth is between $550-600K. That seems irrelevant to the 4% rule of thumb in our situation due to a reliance on real estate.
Running the numbers
Totaling up the family’s assets, we reach $1,009,000. Liabilities ring in at $475,000. Net worth comes to $534,000 which is quite close to the range Mike mentioned (which likely includes some other assets like cars).
I count $234K in cash, savings, and investments. To Mike’s point, it can seem wrong to apply the traditional FIRE 4% rule of thumb to real estate assets. We’ll come back to that. However, at this point, we do know that the family’s stock market invested assets total $184K. That’s worth about $613/month when following the 4% rule.
The family’s monthly’s take-home pay is a little more than $10K. They spend $4-5K/month, we’ll settle on $4.5K. That means they should have about $5.5K of take-home pay to save and invest as they see fit.
Savings rate and FI number
By the way, their savings rate is a whopping 68%! Adding their 401(k) contributions and match to their $5.5K in leftover income per month yields $9.5K of their total post-tax income of $14K (including the 401(k) and match funds). That’s a very healthy savings rate.
Working from their expense numbers, following the 4% rule, they’d need to have $1.35M (25 * 4,500 * 12) in invested assets to reach financial independence. Mike mentioned that their goal is $1.5M. Reaching $1.5M would give them a little breathing room with a 3.6% withdrawal rate if they can maintain an inflation-adjusted annual living expense of $54K.
The 4% rule (which I like to think of as a rule of thumb) is also based on a very specific asset allocation strategy: near 80% broad stock market index funds with 20% bonds. It also works from a more limited retirement timeline: up to about 30 years. If you’re not going to match the asset allocation or timeline, it makes sense to use a more conservative withdrawal rate under 4%. With the family’s reliance on real estate, they’ll want to adjust their target FI number.
The 4% Rule When You Retire Early With Real Estate
Mike is concerned about their assets being mostly in real estate and what that means for achieving financial independence.
I think my FI number would be a passive income of $4K/month. If I can increase the real estate property income to $1K/month, then I would need another $3K/month in passive income.
Does that mean a brokerage account balance goal of $900K? How do I set up this account though? I want to keep things as simple, automated, and mindless as possible.
Let me know if there is any other info you need. Love the website, it is simple and entertaining. There is a complexity to it if you want it or leisure stories so it is a unique one and look forward to seeing where it goes!
Let’s first talk about how real estate and financial independence, especially the 4% rule, intermingle.
Working solely from our suggested FI number of $1.5M, Mike’s family would need $5K/month to achieve financial independence with passive income ($1.5M/25 = $60K/12 = $5K).
Valuing the real estate within your FI number calculation could go one of two ways:
- You don’t include the equity, but include your profit as passive income like Mike suggested in the blurb above, accounting for appreciation, tax implications, etc.
- You include the equity value as if it was any other part of your asset allocation within a FI portfolio and apply the 4% rule to it, ignoring all cash flow aspects
Passive income, dividends, and REITs
Generating passive income from real estate is not unlike owning a high dividend stock that you’re not expecting to grow in value very much. A great example of this is directly related to our case study, real estate investment trusts (REITs).
These entities which are popular on public stock markets own varied forms of real estate (commercial, residential—some regional or industry focused). Legally, they must return 90%+ of profits to share owners in the form of dividends. Because of that, investors don’t generally expect as much growth from the underlying share value but do rely on the dividend production.
If your portfolio was heavyweight REITs, you wouldn’t expect them to grow as much as the broader stock market but you would expect them to make up for slower growth with larger dividends.
Ultimately, you’d be investing in them in hopes of matching or beating the broader market once you include the dividends in your calculations over the long term.
What’s important is that you don’t count the dividends as a form of passive income AND count on the growth from the shares like you would for the broader market. You’ve got to go one direction or the other.
Valuing real estate in a retirement portfolio
You can think of income producing real estate in a similar manner as we discussed with dividend producing stocks above. You own them in hopes of producing an increase to your net worth, over the long term, that would match the broader stock market—or beat it.
Once you include appreciation, cashflow, and tax benefits, you should be able to match or exceed the 4% rule in terms of the capital you have tied up in the real estate investment. That means your real estate investment needs to produce about 9% real return per year, on average. That can be a combination of appreciation and profit from cashflow.
If you don’t think that’s possible—perhaps because the investment isn’t producing enough cash flow or is suffering from market depreciation, I think you’d need to reevaluate ownership of the asset and your goals for it.
For some people, owning real estate isn’t solely to forward a goal of increasing net worth. Most FI chasers own broad market index funds and don’t think much of them after they purchase them. If your reason for owning real estate is for future planning to provide housing to a loved one, to give you a place to settle down, or has other non-monetary benefits (that likely hinder the asset’s financial performance), you’ll need to adjust your calculations to attempt to account for this lagging performance.
On other hand, many landlords have built empires of real estate through cautious investing divorced from any emotional association with the underlying assets. BiggerPockets is a large, well-known community of savvy real estate investors building their empires which we highly recommend for the nitty-gritty of real estate investing.
For the purposes of Mike’s family’s finances, we’re going to assume that their goal is to match or exceed broad stock market growth with their two rental properties. Working under that assumption, we can apply the 4% rule to their underlying equity and analyze asset performance with a goal of 9% real return.
Asset Allocation and Performance
Let’s take a look at how the family’s portfolio breaks down into various assets:
|Asset||Portfolio (%)||USD ($)|
|Cash & Savings||9||50,000|
Including the rental properties and residence, real estate accounts for a majority of their portfolio (57%). It’s often tempting to keep doing what’s been working for you. However, diversity tends to produce more consistent, safer returns over the long term. It’s worth reconsidering this weighting.
Now, let’s look at the performance of those real estate investments which represent more than a third of the portfolio. Mike told us that each unit is producing a net income for $200 per month, so $400 total. With Mike’s phrasing, we’ll assume that’s all-in profit—he’s accounted for all maintenance costs, property taxes, mortgage interest, ongoing renovations to keep the units rented, and adjusted for projected vacancy rates. We’ll assume this number doesn’t account for appreciation in the underlying asset value.
With those assumptions set, we can determine that Mike’s $200K investment is producing $4.8K/year or 2.4% real return without including appreciation. In order to reach our 9% goal, the two properties would need to be appreciating 6.6% per year. The FHFA suggests that housing price appreciation typically ranges between 3 and 5 percent per year. While some areas can experience growth at nearly 7%, it’s unlikely to be sustainable.
Diversifying with a brokerage account
One element that Mike mentioned and was missing from the family’s asset allocation is a simple stock market brokerage account. These are offered by nearly every big name bank out there and they’re quick to setup. The application process isn’t too unlike a checking account and you fund it in a similar manner.
FIRE proponents generally end up opening their own stock trading accounts once they’ve maxed out their available tax advantaged accounts. Typically these include:
- IRA (or Roth IRA if you’re above the Traditional IRA’s income limits)
- HSA (if available with your health plan)
- 529 Plan (if you intend to fund children’s education)
You should consider a brokerage account if you’re fortunate to run out of “space” in these accounts. You can start funding it with after-tax dollars from your paycheck and simply buy stocks with your money.
Our simple four fund portfolio
Our own portfolio is mostly filled with Vanguard index funds that track broad swathes of the economy. The S&P 500 (VFINX), the total US stock market (VTSAX), the international stock market (VTIAX), and US bonds (VBTLX). We aim for an 80% stock/20% bond mix supporting the Trinity Study finding for long term success of the 4% rule.
Our portfolio is quite hands off with this four fund system, only requiring the occasional rebalancing. No late night calls from tenants. Our concern for our portfolio going to zero is mitigated by its reliance on the world economy. That helps us sleep rather than being overweight in any individual stock.
Our brokerage providers are simple: Jenni has an E-Trade account while I have a Vanguard account. I’ve enjoyed Vanguard’s account simplicity which had no fees to setup or fees to open positions in the aforementioned funds. Expense ratios are incredibly low. It really is as simple as setting up the account, dumping money in, and executing purchases of your preferred fund tickers. Making it routine will supercharge your path to FIRE once you’ve maximized all your tax advantaged accounts.
Real estate investing’s 2% rule
A general rule of thumb in the real estate investing world is known as the “2% rule”. That’s not to be confused with FIRE’s 4% rule. In this quick calculation, real estate investors aim for a monthly rental rate of 2% of the home value. For example, a $100,000 home should produce a monthly rent of $2,000.
Neither of us have ever lived in area that would have rent to price ratios anywhere near this. Our current place, purchased in 2013 for $230K and worth about $310K today might rent for $2,000/month. That wouldn’t even reach a “1%” version of this rule. However, appreciation has been pretty good at between 4 and 5 percent annually. My understanding of the 2% rule is that it helps evaluate how dependent a property will be on appreciation versus rental cash flow.
If Mike’s rental properties aren’t renting for a combined $10.5K per month, the properties will be appreciation dependent. The question is just how dependent. Considering that net income on the properties is only $400/month, if the rent is even half our 2% rule amount at $5.25K/month, a 10% increase to rent would more than double his net income on the properties. If a rent increase is in the cards, it could dramatically increase net income while only slightly increasing total rent rates. That depends a lot on the local rental market and the rent Mike is actually charging.
Speculative risk depending on real estate appreciation
A rent increase may be more acceptable to the current tenants if some sort of improvement to the rental property is made to support the increase. This is where I think the 2% rule is more useful. Your goal for an improvement to the property should support the rule. For example, if the tenants and space would support a kitchen renovation at a cost of $10K, you’d need a rent increase of $200/month.
If the numbers just don’t make sense for rental rate increases or a renovation based increase, the assets will continue to be heavily dependent on appreciation. Projecting real estate appreciation into the future is highly speculative, it’s risky business. Try to separate the emotional value of owning real estate from the financial decisions around real estate. This way you can make clear headed decisions.
This does not mean you should discount the value of sheltering a family within our society. It means you should realize why you’re making the decisions you are.
The Business of Real Estate Investing
I think we’re starting to come to some conclusions about Mike’s direction and our guidance. Let’s touch on one other aspect he brought up: the business of real estate investing.
LLCs and S Corps for real estate holdings
From his writing, it seems the family doesn’t operate the ownership of the two rental properties as a business. This is pretty common with small business. Plenty of gig workers and small landlords file a simple Schedule C (Sole Proprietorship) with their 1040 tax form. This doesn’t offer as much protection to the business operator as setting up a simple Limited Liability Corporation (LLC). It doesn’t have the deduction flexibility of having an LLC taxed as an S Corporation.
The cost and difficulty of setting up the LLC and S Corp tax filing designation varies from state to state. It’s usually not too difficult or costly. In Virginia where we are, the annual renewal fee is $50 for an LLC. Switching the tax designation requires a form (there might have been a small fee).
The cost of maintaining an S Corp
The only big cost is if you need a tax agency to file your corporate tax form (an 1120S). In my experience, it’s usually under a grand for simpler situations. After paying to have this done professionally one time, I’ve since filed my own 1120S. I’ve used business tax software without much trouble. My domain knowledge of real estate investing and the related tax advantages of certain business entities and strategies is quite weak. I’m merely offering a general point of view of setting up a general business.
The detailed tax implications and legal protection of wrapping a business entity around Mike’s real estate holdings are beyond the scope of this article. They could be significant depending on what sort of taxes the family are currently paying. I’d strongly advise you reach out to a tax professional in your area with some expertise in real estate. Their fee could easily be absorbed by the benefits of properly structuring your legal relationship to the operations of your rental business(es).
Paths to Reaching FIRE
Mike’s family has multiple potential routes to reaching FIRE.
- Focus all savings on the traditional FIRE route from here on out: max the 401(k)s, IRAs, and then brokerage accounts with broad market index funds
- Cut loose the real estate investment properties, then dump the proceeds into the investments as in option #1
- Double-down on the real estate investments: start treating it as business, plow all new money into additional rental properties and grow an empire
Deciding which direction to go is really going to depend on the details of the current rental property portfolio, the risk tolerance of the family, and the desire to more actively manage the assets.
I’d analyze the real estate property’s performance and see if it can reasonably reach that 9% goal. If it’s on the cusp and I had some non-monetary value for the real estate (like having a future place to call home in old age or an apartment for my kids to live in while at college), I might be willing to stick with option 1.
I’d seriously consider #2 if the real estate investing math just doesn’t look like it’s going to perform very well. You have to realize that over the timeline of several years, the difference of a few percent of performance in your portfolio can easily account for many tens of thousands of dollars. That’s the cost of college at an in-state school for a few years, rent for an apartment for years, or the down payment on your “forever home”.
Lastly, option #3. If the numbers actually work out really well for the real estate investments, you’re comfortable with the risk, and want to build an empire, it makes sense to go all in on the idea. I’d start plowing all my real estate proceeds and monthly income-expense balance into this business venture. That’s exactly what I did in 2016 when really going all in on my second business. It paid off with a near half million dollar revenue year, but that wasn’t without risk to what I invested into the business.
Financial Independence in 9 Years
If Mike’s family were to follow option one which was to keep their real estate holdings as-is but focus on growing their investments, they could reach financial independence in just nine years. At that point, they’d have the option to retire early with real estate as a backup.
The math makes it easier than you might think. We calculated they’re able to save $9.5K per month towards retirement right now. If they can keep this up, they’ll add $114K per year to their current $234K cash and investment portfolio. Over nine years, that’s just over a million bucks just in contributions! Add in market growth and their current $234K investment balance and they’ll easily surpass the $1.35M they need to support their $54K/year lifestyle.
This outcome was made while ignoring the real estate investing question all together!
Mike’s family can beat their fifteen year goal, retire in their mid- to late-forties by simply automating their personal finances. They only need to keep up the routine they’ve built. With FIRE no longer top of mind, they can think about how much is enough and pull the trigger on retirement on their own terms. They could use the real estate as part of their plan to support their children, give themselves a holiday home, or leverage it as a way to give back.
The math behind financial independence and giving yourself the choice to retire early is often simpler than you’d think. It’s the decision about what to do with your time and life afterward that is complicated.
We’re not savvy real estate investors, if you are, what advice do you have for Mike and his family’s pursuit of FIRE? Where do you think our thoughts were wrong?
Let Us and Mike know in the comments!