Welcome back for the 2nd post in our series of Go Curry Cracker Reader Financial Reviews, where we dig deep into the finances and ambitions of a lucky anonymous reader. Together, we can overcome limiting beliefs, change the rules, and exceed our goals
This month we go to Manhattan where Mr and Mrs NYC have discovered that lifestyle inflation is one of the world’s most powerful forces, second only to compound interest.
We will also learn a little about the difference between owning real estate and investing in real estate, the high tax burden of NYC, and why the Backdoor Roth is not necessarily a great investment choice.
We exchanged many emails over the past several weeks, which inspired a lot of creative thinking on both sides. Let’s see how it turned out
Hi Jeremy & Winnie,
Happy 2015! My wife and I have been following your adventures and trying to figure out how to follow a similar path. Keep making life on ~$40k/year sound sublime!
The handful of retirement calculators that we’ve tried agree we are on pace to retire in 10 years when we turn 50 (me) and 52 (my wife). We’re relatively health-conscious non-smokers so I expect to live until we’re about 85-90.
Here is our financial picture:
$850k 401k ($150k is after-tax)
$110k Traditional IRAs
$110k Roth IRAs
$1MM home value in NY, NY with $440k owed @ 3.33%, on schedule to be paid off when I turn 50
All low-cost index funds, about 85% equity
$100k/yr goes for taxes (Fed + State + Local NYC)
$80k/yr goes for spending
$60k/yr towards mortgage (through 2025) & HOA
$60k/yr savings (401ks + Roth IRAs + taxable)
We have planned to reduce our spending on several occasions, but because we make a comfortable living we don’t have any “gun to our head” to be disciplined, and so we get lazy and ignore our budgets. We estimate we could reduce our spending by $14k/year once we stop work, but believe we would spend all of that savings on health & life insurance and additional travel
Our NYC lives revolve around work, but we love our condo here and would like to keep it. Still we would consider selling it if it made financial sense, but would then like to buy another property in a lower cost of living area. We feel like we need some kind of “home base” to feel grounded. Most of our family is located in Texas and Florida, so maybe in one of those 2 areas. Were we to follow this path, we estimate our annual spending would decrease to $55k
We estimate we can rent our condo for $4k/month before management fees, and it would be helpful for minimizing travel expenses since we could home swap instead of paying for hotels. We also view our home as the closest thing we have to a pension, as we can use it for rental income and even sell it later in life if we need to
- Do you agree that we’re on pace to retire in 10 years if we maintain our current spending levels?
- Should we continue to make after-tax contributions to our 401k to take advantage of the Backdoor Roth?
- At what annual spending levels would we have to reduce to in order to allow us to retire in just a couple years? If we sold our condo, could we retire earlier?
Our dream is to travel a lot more, to thrive on the stimuli of new lands and new cultures! How can we do it as soon as possible?
Mr & Mrs NYC
Hello Mr & Mrs NYC
Congratulations on your success! No doubt about it, you are at the top of the economic ladder with incredible incomes. In your early 40’s, you’ve already amassed a net worth that would put you near the top of the Ultimate List of Blogger Net Worth
You’ve done this despite high taxes, the high cost of NYC real estate, and a high cost of living. When including Mortgage Principle, your after-tax savings rate is a very respectable 50%. Well done
This level of income has afforded you a number of luxuries, such as dining in fine restaurants, the outsourcing of cleaning and laundry, personal fitness trainers, and 5-star vacations.
But… Perhaps the biggest luxury you’ve enjoyed is the luxury of inefficiency.
This is common amongst high income earners, and is even encouraged by our economic system. By focusing on career, you can maximize earnings and simply pay others to perform lower return services.
The downside of this is that cost of living inflates with income. Is it possible to reduce spending? It isn’t clear, because you’ve never had to try. Your frugality muscles are weak and flabby.
Is all of this spending making you happier? Who knows, since there is no other reference. This can make the idea of reducing costs intimidating, even terrifying, making it impossible to get off the treadmill
It’s just easier to keep working and save more, right?
Working Harder Isn’t the Answer
According to the mainstream online retirement calculators, you are on pace to retire in 10 years if you maintain your current level of spending
But 10 years is a long time. Over the coming decade:
3.5 years will be spent paying taxes
2.5 years will be spent on food, clothes, and taxis, just the price of daily living
2 years will be spent paying off the mortgage
2 years will be spent increasing your savings
At this point, your dollars are much better earners on an after-tax basis than you are. Most of your money goes to taxes and inefficient living
This brute force method is akin to using a battering ram to bash open the doors of financial independence
We could dissect your $80k annual spending, and make a significant reduction (a very worthy exercise I encourage you to do with the same discipline and energy you apply to your careers)
But what if instead we just sprinted into Financial Independence through the wide open side door?
To date, you have amassed a fortune of nearly $2.1 million
The 4% Rule is a reasonable metric to use as a starting point, which would allow annual spending of ~$84k/year, $7k/month, or $229/day
It’s interesting that you opened your email by mentioning our own ridiculously extravagant lifestyle of global travel and international intrigue. To date, we have averaged less than $110/day on serious Rock Star LivingTM!
You could quit your jobs now, today, and live life on your own terms, spending twice as much as we do. All you have to do is try. If I had to double our spending tomorrow, I have absolutely no idea how I would even begin. We are already operating at maximum happiness, and spending more might even make life worse
There are just two little problems that we need to overcome first
Sell Your House and Rent It Back
Let’s assume for a second that you were currently renting, and were considering purchasing your current property in order to meet your goal of having a pension like income in retirement
Yes, you love your property. But as an investment, logic and math should prevail
Professional Real Estate investors use a metric called Cap Rate to determine if a property is worth a deeper look. In its simplest form, it is a ratio of total profit over the property value; Cap Rate = (income – expenses)/property value
I asked a very successful Real Estate Investor friend of mine what he would pay for a property with $4k/month rent and $1.1k/month HOA/Taxes/Insurance.
Did he offer $1 million for the property? No. He offered $250k
Now people are crazy when it comes to Real Estate in Manhattan, and will accept much lower rates of return because they expect appreciation. Maybe that will happen, maybe New York is underwater in 50 years.
From what I gather, pro investors in the NYC area may target a minimum cap rate of 3.4% to purchase an entire building. For a single condo, risk is much greater so the required cap rate would be higher. Still, a very generous investor might pay a maximum of $810k for your property.
Note that this cap rate is roughly equivalent to the rate on your mortgage. Any income would barely cover the cost of debt, and the property would be cash flow negative
This is what you are experiencing now, with annual costs $15k greater than the cost of renting. This doesn’t include the lost opportunity of your estimated $560k in equity, or consider that at this point in your amortization schedule, were it not for your ridiculously large State and City Tax bill, there is near zero tax benefit over the standard deduction
Another common Real Estate investment metric is cash on cash return, a simple evaluation of cash flow to total cash invested. If you paid off your mortgage today (which you can), you would be earning less than 3% on your investment. By contrast, Vanguard’s Real Estate Investment Trust index is paying 3.45%
Financially, perhaps the best thing you could do is sell the property and rent it back at the market rate
There are many who would agree with me. One of your neighbors, James Altucher, says he would rather shoot himself in the head than own a home. Or consider the wisdom of Jim Collins, as he explains why your home is a Terrible Investment.
As for providing an income in retirement, there are many ways to accomplish that goal. Real estate is one option, but you could find a far superior property for that goal, maybe even one that will provide the same income at 1/4 the price.
There are also many that will disagree with me, many of them almost violent in their passion. I recommend you sell the property to one of them
Leave NYC, Run Don’t Walk
Manhattan is one of the most expensive places on the planet, both in terms of cost of living and taxation. This puts New York in 1st place on Bankrate’s list of 10 Worst States for Retirement
Kiplinger’s recently reported: “Manhattan, New York City’s most expensive borough, is the only area in the country where living costs more than double the US national average. Housing costs are more than 4.5x the national average”
Your regular living expenses reflect that statement, and then some.
Taxes in New York, already amongst the highest in the nation, are even more onerous by the addition of New York City’s own income tax. For a retiree with an interest in travel in 1-6 month stretches, it is one of the worst possible choices for a home base
Most of the techniques we discuss on Go Curry Cracker for tax minimization and maximizing wealth are neutered by the effective 10%+ tax rate
Or, as stated in Forbes: “New York deserves an honorable mention in this rogues’ gallery of places not to live if you have a lot of taxable dividend income.”
The surest way to make to make an immediate 50% reduction in your cost of living, is to simply leave
When you want some Manhattan time, do what everyone else does: Go as a tourist. You could certainly afford it
But It is a Home, Not an Investment
Money isn’t everything, especially when you have a whole lot of it. Maybe your condo is a home, not an investment
In that case, you have 2 main options:
- Work up to 10 more years, per your current plan
- Let somebody else pay for it
If you were to find long term renters, you could quit your jobs and begin traveling today. Continuing to pay the mortgage would just require managing your cash flow. In other words, you would need to spend less
The combined impact of paying mortgage interest each month, along with having a large portion of your assets in your home, would reduce your sustainable budget to $4.2k/month or $140/day. This is still a 25% boost over what we have spent on our travels to date
Ideally, much as in the previous case you would establish residency in a low/no tax State. Since your home would be exclusively used for rental purposes, you could fully depreciate the property, resulting in low or no tax on the rental income. In 10 years, if you chose to return to NYC you would have a paid for home and your assets would be able to fund a similar lifestyle to the one you have today.
But if you sell your NYC property in favor of better investments, where can you setup a home base?
We chose to skip a home base entirely, preferring the flexibility of an itinerant lifestyle. But it won’t necessarily always be this way
Were we to establish a Home Base, we would consider the following criteria:
- Easy access to an International Airport
- High Quality of Life (climate, access to outdoors, great food scene)
- Zero or Low Taxes (e.g. Texas and Florida have no State Income Tax)
- Proximity to Family
You have the option to design your ideal lifestyle, and there is no need to rush in. You might explore areas near your family, or a few international destinations that you’ve always been drawn to.
Renting in the short term is a fine option. I was always perplexed by the people that we hired into Seattle, who would immediately buy a house. Inevitably they found themselves in a job that wasn’t ideal, an unhealthy commute, a neighborhood with overbearing covenants, or a school district that wasn’t a good fit. In the rush for stability, they reduced their quality of life.
Funding Early Retirement
Assuming you fetch a cool million for your home (minus agent fees), and roll your 401k pre-tax contributions to a Traditional IRA and after-tax contributions to a Roth, you would be looking at the following arrangement:
Traditional IRA: $810k
Roth IRA: $260k
Total: $2.03 million
The first thing to do would be establish residency in a low-tax environment. Florida or Texas would be great choices
The Taxable account, primarily invested in VTSAX / VTI, would throw off ~$20k in tax free dividends and you could harvest an additional tax-free $70k in long term capital gains when available.
Some years, this would be sufficient to fund your lifestyle, but over time you would most likely deplete the taxable account, particularly if you chose to purchase a home.
Assuming your estimated $55k/year annual spend, cFIREsim estimates an 85% chance the taxable account would carry you until Mrs NYC reaches Age 59.5, at which point you would have unrestricted access to her Traditional IRAs which have enjoyed tax-free growth over the previous 2 decades
In the off chance that you deplete your taxable accounts before Age 59.5, you could establish a SEPP to get access to Traditional IRA funds a few years earlier. Note that this is a remote possibility, in most cases your taxable accounts continue to grow. The Roth IRAs should be used last
In all years prior to formal withdrawals from the Traditional IRAs, I recommend you make annual Roth IRA Conversions (as demonstrated here) in order to minimize lifetime taxes
Even without Social Security, cFIREsim estimates a 100% success rate for a 60 year retirement based on the above plan, which would bring you to 100 years of age.
But We Aren’t Ready to Quit Yet
No problem at all. Working longer has a twofold benefit. You are able to save more, and you need less savings because you have fewer years to live. Maybe working longer is more comfortable than experimenting with spending less
Because your tax rate is so high, I would continue to take advantage of your 401ks.
However, I would focus on increasing the size of your taxable Brokerage account. To do this, I would stop making after-tax contributions to the 401k and I would stop making additional principle payments on the mortgage
The Backdoor Roth
Stop making after-tax contributions to the 401k?! But isn’t the Backdoor Roth an amazing opportunity to reduce taxes and maximize wealth?
So they say. But let’s analyze the impact
In 2015, if you contribute $30k after-tax to your 401k you save $0 on taxes this year.
Depending on how you invest that $30k, you could realize a small tax savings on dividends. In a fund like VTSAX / VTI, you might realize dividends of 2% for a total of $600. These would be taxed at 15% by the IRS, and maybe 10% by the city and State of New York, for total annual tax of $150. For context, this is a mere 1/5 of what you currently spend on manicures
Were you 20 years away from retirement, this small tax savings might be appealing. Being just a few short years away, 100% unrestricted access to your savings AND earnings is far more important. And as soon as you stop working and leave NY, the tax rate on those earnings drops to zero
Conclusions and Final Recommendations
You have amassed a healthy fortune, and have a world of opportunities available. By selling your home and leaving NYC, you could retire today and live a lifestyle that would be the envy of many
While having a solid pension like income late in life is desirable, your home isn’t the ideal investment for that purpose. If you prefer to think of it as a home rather than an investment, you have a choice to make: Trade many more years of your life to pay off the mortgage, or rent it out and cut your spending significantly
Due to your high tax burden and high cost of living, increasing your net worth through work is increasingly difficult. Most of your money goes to taxes and inefficient living. Your dollars are now much better after-tax earners than you are. It’s something to consider as you plan the next 10 years of life
Were you to prefer continuing to work for a time, I would recommend focusing on increasing the size of your taxable accounts, even eliminating after-tax contributions to the 401k and additional principle payments on the mortgage.
When you do pull the plug, I would spend down the taxable account first while doing tax-free or low-tax Roth IRA Conversions. This should carry you to Age 59.5, when you would have unrestricted access to your Traditional IRAs. Spend down the Roth IRAs last
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As a random guy on the Internet, this is the actual value of the recommendations I provide This is for entertainment purposes only. Always consult a professional.
What would you do in Mr & Mrs NYC’s situation? Would you sell the condo and leave NYC? Would you find a long term renter and learn to love spending less? Any other ideas?