Early Retirement Part 2: Income

In part 1 of this series, I covered a particular mindset that can help you retire early.  In this part I will cover ideas for generating income in early retirement.  Part 3 will address managing expenses.

My income plans for retirement are focused on two primary sources: Interest/Dividends and Rental Income.  I would like some other sources to diversify my income streams but so far have not been able to find other investments that meet my criteria or turn this blog into a cash cow 🐄

The Stock Market

I like investing in stocks.  It is fun to research and try to pick winners.  It is very tough to beat the market over the long run, however.  I typically put a large part of my nest egg in index funds and ETFs (low expense ones only) and invest smaller amounts in individual stocks in hopes of hitting a home run on one to juice my returns.  I have tried trading options to generate income and never did well.  I can't get excited about bonds and have never followed the conventional wisdom to allocate an increasing portion of your assets to bonds as you get older.  As I near retirement, I am more concerned with capital preservation and have been wary of overheated markets and have moved investments to cash until the stock market returns to a reasonable valuation.  This served me well in the unusual bear market of 2022 where both stocks and bonds got hammered at the same time.

During the years leading up to early retirement, growth is paramount, and income is not a concern.  As soon as you retire you need to generate income to cover your monthly expenses and your investment makeup may need to change to achieve that.

Growth

My approach to growing wealth is buying and holding market index funds or ETFs for the bulk of my non-retirement savings.  For some people, this is all they need to do.  But I'm a tinkerer.  I like to allocate some portion to individual stocks that I think are going to outperform.  Because I am a saver and this is not money that I need to live on day-to-day, at least until I retire, I am more aggressive than what most financial advisors would recommend.  Everyone says you should not try to time the market to sell high and buy low.  Admittedly, I have trouble following this advice.  I have had mixed success with timing the market and in the long run would have been just as well off buying and holding.  Most recently, I pulled a lot of money out of the market too early (late 2018 as I thought the market was overvalued) and missed a lot of the irrational exuberance runup of stocks in 2019 and 2021.  On the plus side, the big drop in 2022 hasn't impacted me as much and I have a lot of money that I'm starting to put back into the market at, what I hope, turn out to be the bear market lows.  Still, at this point in time, I would've been better off not selling in 2018.

I like to use the Shiller P/E ratio as a general guide to determine how risky the stock market is at any given time.  I think it is a bit distorted right now due to the extraordinary period of low interest rates and quantitative easing.  So, while it shows the market as overvalued relative to historical averages, it's currently (in November 2022) right around its average for the past 30 years.  Maybe this is the new normal.  Or it could be showing the markets need to drop another 40% beyond what they have lost already this year to revert to the all-time mean.  If that were to happen, it would be a tremendous buying opportunity.  As it is, I think now is a good time for a buy and hold strategy and to try to pick some beaten down stocks that will emerge as winners when things recover.

Income

Once I decide to retire, my focus for my non-retirement accounts needs to be on generating income to live on rather than growth.  One way to do that is by selling a portion of my stocks as I need money.  Another way is to invest in dividend paying stocks.  Conventional wisdom says you can live off 4% of your stock portfolio a year in perpetuity.  

Selling portions of your stock can be relatively tax efficient if your holdings are all long-term gains.  I like to be very conservative in my estimates and use a drawdown of 2% or 3% to allow for an extended period of poor returns or even larger income later on.  For some reason I can't put my finger on, this approach doesn't appeal to me as much as it probably should.  Maybe it is something about the active involvement of having to sell something each month.  Concerns about commissions are a thing of the past as most brokerages have no or very low commissions, so that isn't a valid reason to avoid this approach.

My preference is to use dividends to generate the income I need.  These are automatically deposited into your account when they are paid.  No action is needed on my part.  The low interest rate trends over the past decade have resulted in lower dividend yields on stocks as a whole compared to their historical averages.  The market doesn't demand a 4% dividend on stocks when interest rates are 0 or 1%.  That puts a crimp in the dividend plan, and I probably should re-consider the sell 4% of your portfolio approach.  The S&P 500 is yielding a rather paltry 1.6%, and that's after the index dropped 20% over the past year.  With interest rates going up, savings accounts are paying more than the S&P dividend right now.  Unfortunately, savings accounts will almost always pay less than inflation and aren't a great long-term plan.  In short, dividends suck right now.

There are some options for higher yielding stocks. Utilities can pay good dividends, just don't expect much capital growth.  REITs (Real Estate Investment Trusts) typically have a relatively higher yield and there are ETFs and mutual funds that focus on dividend paying stocks.  As always, there are drawbacks to these, such as a higher tax rate for REIT dividends and market-lagging capital appreciation on some of the fund ETFs.  There are even riskier options that use leverage to generate very high returns, but they may not be reliable for the long run and can get crushed when the market moves against them.  

I could also use CDs and CD ladders to generate income.  A CD ladder is where you buy a series of CDs so that you have one maturing every month or every three months or however often you need the money.  Depending on what interest rates are and whether they are expected to go up or down, this can be a good way to lock in some relatively high yields for a longer period of time.  It may soon be a good time to set up a CD ladder.  Interest rates are going up and I expect inflation is coming down.  My guess is interest rates won't stay high for very long, so locking in some long-term CDs at a high interest rate could be a good cash generating investment for a few years.

My approach is going to be a sampler of all of these: interest on savings accounts and CDs, dividends on stocks, dividends on REITs, and maybe even some bond income once we turn the corner on inflation and interest rates start going down again.  The diversity of this approach should help insulate against fluctuations in any one area.

Real Estate

Real estate is the second major portion of my retirement plan.  Owning rental properties is often mentioned in "how to retire early" articles, and I wholeheartedly agree.  Mrs. Wisdumb and I own two rental houses in addition to our own house.  We were patient with the market and bought our current house and the second rental house at the lows in the real-estate market during the Great Recession.  As my dad (Father Wisdumb?) likes to say, "You make money in real-estate when you buy, not when you sell."  All three properties have gone up ~75% in value over the past ten years and the rentals have been generating positive cash flow as well.  Like the stock market, most real estate goes up over time and is a good way to diversify your investments.

Owning rental properties isn't for everyone.  Unless you pay someone to manage them for you (not the Wisdumb way), they take some amount of work.  If you don't want that kind of hassle, maybe REITs are a better way for you to add real estate income to your portfolio.  You do lose out on the leverage that mortgages can provide, though.

Debt

Purchasing a house with a mortgage is likely only time you will see me take out a loan.  A loan for an investment property is especially useful.  As long as you are not buying when the market is hot and prices are out of line, your investment should increase in value and rental income returns should easily exceed the interest you are paying on the loan.  This may not always hold true, particularly as interest rates rise.  Guess what I use to help determine if a house/loan is a good investment?  If you said "A spreadsheet" you'd be right!  I plug in the down payment, interest rate, estimated rental income, taxes, insurance, maintenance, etc. into a spreadsheet and estimate what the return on investment is for a property.  Ideally, I want it to be >10% to justify the effort.  If it is below about 6%, I wouldn't consider it (might as well buy an REIT yielding 6%), unless I thought the market was very undervalued and the house price and rent was going to appreciate significantly.

A note on taxes:  Most of us don't have enough deductions to itemize and take the standard deduction when we pay our taxes.  As a result, the interest you pay on your home loan (and real estate taxes) does not actually reduce your tax bill since it, and your other deductions, are typically less than the standard deduction.  This is not the case for rental properties.  The interest on your rental property loans is an expense and is subtracted from your rental income and therefore reduces your taxes.  As a result, it makes more sense to pay off the mortgage on the house you live in than your rental houses.  I use some version of this question to test financial advisors to see how well they know their stuff.

Advantages

In addition to taxes, there are a lot of other benefits to owning rental real estate.  Price appreciation was mentioned previously, but there is also rent appreciation to consider.  Rents go up over time, often in line with or faster than inflation.  This means your cash flow from your rental properties will grow over time.  This is great for retirement!

Cash Flows.  The debt mentioned above can be a real benefit.  If you buy a $300K house with 20% down, your cash outlay is $60K.  A monthly 30-year mortgage at 5% would run ~$1300.  Add in property taxes, insurance and maintenance and your total cash outflows are around $1900.  If you rent the house for $2500 a month, you are generating $600 a month in cash flow.  That's a 12% return on your $60K investment (not a $300K investment since you only put up $60K).  And that return doesn't even consider the equity you are building in the house.  

Note:  These numbers were realistic when we bought our last rental property in 2014 at the bottom of the housing market.  Since then, the housing prices went way up without as much increase in rent and the equation looks much worse- the same house would cost $575K today and rent for $3000 a month.  At today's mortgage rate of 7% this property would have negative cash flow.  Remember, you make money in real estate when you buy!  Sadly, this is why we have not purchased any additional rental properties since then.  If the housing market in our area crashes back to earth, I'll be ready to buy again.

Depreciation.  Rental properties must be depreciated over time on your taxes.  This saves you real money on your taxes now.  That savings only comes due when you sell the property.  It is essentially a tax deferral.  Most people anticipate they will be in a lower tax bracket when they retire and will therefore pay a lower rate when they do sell.  If you aren't in a lower tax bracket when you retire, congrats!  You've done really well for yourself.  That's my dream.

Deductions.  If you manage the property yourself, you can deduct all of the maintenance costs from your income.  Even things like the mileage you drive to get there, can reduce your tax bill.  If you buy a vacation home and rent it out, your travel to that home can be deducted.  You can take a tax-deductible working vacation to check on and maintain your house.

Disadvantages

Of course, there are disadvantages to owning rental properties, too.  You should not pursue this investment without a thorough understanding of what it will take to be successful.

Time & Effort.  Being a landlord does require some effort.  In addition to maintaining the property, you need to find [good] tenants, deal with problems as they come up, track expenses, etc.  If you buy a vacation property to use as an AirBnB, you will have to manage all the bookings and cleanings after each guest.  Personally, I wouldn't want to handle all of this, at least not while working a full-time job.  Luckily, Mrs. Wisdumb is great at it and has the time to put into managing our properties.

Cash Flow Risk.  What happens if you can't find a tenant?  If you miss one or two months of rent, that could wipe out your profits for the year.  Even worse, if you don't have other investments or cash flows, you could risk being delinquent on your mortgage and even face foreclosure.  Another possibility is a major repair that requires a big cash outlay.  We had this happen to one of our properties shortly after we bought it when it developed a major roof leak.  We ensure we are always prepared for unexpected expenses and had plenty of reserves on hand to fund all of the necessary repairs.  

Complicated Taxes.  Those depreciation and deductions advantages don't come for free.  You pay for them at tax time with the complications and forms they require.  I recommend spreadsheets (yay!) for keeping track of all of the necessary expenditures.  And a file for receipts.

Summary

That covers my current thinking on how to fund retirement.  I'll give some hypothetical examples of how I think this can be applied.

Let's say I determine I need $60K of income per year to live on until I reach the age where I qualify for social security.

I would need a non-retirement stock portfolio worth $2M to withdraw at a 3% rate to make that level of income.  

I'm assuming taxes are negligible here.  If it is long term gains, it would be taxed at 20%, but then with standard deductions and other stuff, I would get a lot of that back.  The tax code is too complicated, so I haven't worked out exactly how much would be owed for this scenario.  Instead, I would plan to have some buffer in my expense estimates for taxes.  A $2M non-retirement stock portfolio is a pretty tall order, but achievable if you invest early for the long term and the stock market cooperates.

Now let's say I have a couple rental properties that are generating $20K per year in cash flow.  Now I only need a stock portfolio worth $1.3M to withdraw from at a 3% rate to hit my $60K income goal. 

 Throw in $250K in a CD ladder that is yielding 4% and that adds another $10K in income.  That drops the stock portfolio requirement down to ~1M.

So, 1M in stocks, 250K in CDs and let's say 150K invested in rental real estate can generate 60K in income on $1.4M worth of non-retirement assets.  Now I have a target to shoot for.  If the real estate market cooperates and you are able to pick up more lucrative rental properties, this could be even easier.

If you are more open to risk, you could even retire with a lot less.  That 3% withdrawal from a brokerage account assumes I want to maintain my balance.  If I believe I will have social security when I reach 60-something and have a large retirement portfolio that I can start dipping into as well, I don't really need to maintain my balance in my non-retirement portfolio.  If I withdraw at 7% a year and calculate I will be down to $0 at age 67, maybe that is just fine because I have social security and retirement funds I can live on at that point that will provide the necessary income.  At a 7% withdrawal rate, you only need ~$850K to generate your 60K for 15 years.

I'm leaning more and more towards this latter approach.  The risk is I run out of non-retirement funds before I reach social security age.  In this event, I have some backup plans.  I could sell a rental property which would give a near term cash boost at the expense of long term cash flows.  Assuming I won't need the extra cash flow when retirement funds kick in, this could be a good plan.  Another backup plan is to go get a part time job or do some consulting for a few years to help bridge the gap.  I might even consider this for fun if the right opportunity comes along.

What are your thoughts on this topic?  Do you have other favorite methods for generating income?  Post them below or send an e-mail!

The next post covers managing expenses.  Maybe that $60K is more than I need.  If I can whittle that down to $40K, the size portfolio I need can be even smaller.