The Boring (& Completely Effective) Way to Build Wealth

Both my kids are in their 30s. I suspect they’re like the majority of their peer group in that they simply wanna make good decisions, live their lives, raise their families, have fun in the process and retire well. Today, let’s take a typical 30-year-old from their peer group and see what’s possible for her.

First, though, let’s set up what she and her husband’s financial picture looks like these days.

As related to average income in their age group (for those with have degrees), Maggie makes pretty much the median income for her peer group and age range. Her husband, Jim, works for a private firm dealing mostly with the military, on his way up the ladder, earning just under $60,000 annually. Add in Maggie’s earnings of $48,000, and their household pre-tax income is just over $100,000 yearly.

Let’s Get Started

Maggie ‘n Jim bought their first home a bit over two years ago. It has room for a couple kids, which are part of their ultimate plan. They’ve been traveling like crazed banshees the last few years due to his job. They figure better now, before any little ones come along. Though their travel costs are lower than we’d think, they’re still a chunk of change, for sure. All that traveling has them counting continents, not countries, to which they’ve been. THAT kind of traveling. 🙂

They have around $20,000 in savings. They have no student debt, as they both worked their way through college. She as a nanny, him at Costco. Sure, it took ’em longer to get their degrees, but on the plus side, they graduated without any student debt.

Neither one of ’em contribute to any 401k or IRA, though in order to buy their first home, much of the FHA down payment came from Jim “gutting” his Costco plan right after he graduated. After talkin’ with a highly regarded EIUL (Equity Indexed Universal Life) expert, they decided on a policy costing $500/mo, indexed to inflation. It was structured for 30 years, meaning the tax free annual income would begin when they turned 60.

To maximize the ultimate income benefit, they’ll grease the skids with a modest $3,000 up front at inception, based on the expert’s advice.

Results

At age 60, they’ll begin receiving $9,000 a month — tax free — ’til they’re 90. That’s $108,000 a year, which means they’ll end up collecting about $3.24 million over 30 years. Remember now, it’s all tax free. Since they live in a high income tax state, that annual income would likely hafta be roughly $150,000 a year pre-tax. Not a bad way for a young couple starting out in the world, right? 😉

Note: Can’t yet budget in a $500 monthly premium? Then just do half that, $250/mo. At inception you’d put in just $1,500. Your tax free income at 60 would be half of Jim’s/Maggie’s, about $54,000 yearly. Still, that’s slightly in excess of $1.6 million over 30 years from 60 to 90 years old. The vast majority of Americans over 60 and retired don’t make that much pre-tax.

Sad, isn’t it?

Maggie decides to take the plunge, opening up a small home “nanny” care biz. She loves kids to death, so this is a natural. Jim’s gone to work in the morning as kids would arrive, and they’re gone by the time he gets home. A perfect fit. The gross annual income will be approximately $50,000, maybe slightly higher. Her actual taxable income will be much less, likely around $36,000.

It’s Now Five Years Later…

Jim rose to become office manager locally, reporting only to the regional boss. His pay is now at just under $85,000. Maggie’s business has consistently produced a pre-tax net income from her business of around $36,000 yearly. Four of the last five years, she’s put between $20-25,000 after tax money in to the Roth side of the Solo 401k she started after her first year in business.

Each year, this Roth Solo acquired one discounted first position note. The solo now owns approximately $135,000 in actual note debt for which it paid just over $100,000. Total payments annually now exceed $12,000. That means Maggie’s Solo can now buy an additional discounted note every couple years from accumulated payments alone. Since they have ’til they’re 59.5 years old before they can collect payments tax free, that’s gonna add up.

Note: As time passes and Jim’s salary continues escalating, Maggie will be able to take after tax savings and add to her annual Roth Solo contributions. She does that now, but on a limited basis suiting their family budget. She’s allowed to put in a maximum of $51,000 each year, via contribution, profit sharing, and after tax personal savings.

Once she’s 50, if she still owns a business, the overall maximum allowed rises to $56,500. These numbers change more often than expected, and it’s usually upward.

Caveat: The owner of a Solo can only contribute to the extent of the company’s salary to them. So, in Maggie’s case, if she still made $36,000 a year pre-tax, that would be her ceiling for money into the Solo that year, regardless of whether or not she had more money available.

Moving On Up

At 40 years old, and now with a couple kids in school, Jim and Maggie decide to move to larger digs. They’re feeling a bit cramped in less than 1,300 feet. Besides, their home has gone up in value, and Jim has been adding a bit to the monthly payment for a decade now.

In addition, each time he got a promotion/raise or bonus, he’d get rid of a little more debt on the home fort. Since their property is worth more than they paid, and the loan is lower by far than it woulda been, he’s strikin’ while the iron’s hot. In 10 years at the same firm, Jim has become a favorite — and somewhat of a rising star. His salary is now five figures monthly, roughly $140,000 a year, which doesn’t include bonuses.

The net proceeds from the sale of their home amounted to just over $350,000. The home they found will have payments about $1,500 more than they’ve enjoyed the last decade. However, since Jim’s now making more than twice what he did as a rookie so long ago, this works out just fine. In fact, the new house payment is actually a smaller percentage of his income alone than their first payment was.

It’s a winning move.

He set aside around $125,000 from his home sale proceeds to invest in their first small income property. Counting down and closing, it took around $85,000 for a modest out of state duplex. With the other $40,000 or so, he bought the first discounted note for their own portfolio, outside the Roth Solo.

Opting for the Cost Segregation Approach to Depreciation (CS)

Their household income exceeded $150,000 yearly, which meant no depreciation leftover after sheltering the duplex’s cash flow could be used to offset a dime of their ordinary (job) income. Yep, that’s a tax rule. This meant that every year, approximately $15,000 of unused depreciation was put on the shelf to gather dust.

Meanwhile, their family budget was focused like a laser beam on paying the duplex off within five years. Realistically, they won’t be able to pull that off. But they’ll come close. When they sell the duplex in five years, their net proceeds will be about $230,000. The cap gains and depreciation recapture taxes will combine to be in the neighborhood of $35,000.

This is where it gets good.

Since they no longer own the duplex, the IRS can no longer prohibit them from using all that “shelved” depreciation. It’s added up to a pretty healthy $75,000. In simple math, this means that whatever their household income was the year of sale, it will now be $75,000 less. 🙂 Can we hear an “amen”?! In California, taxes alone this means they’ll save a few HappyMeals under $7,000. It’ll be a savings of around $25,000 on the fed return. That’s a total of, give or take, $32,000 or so in tax savings the year of sale.

In other words, they had to pay a net $3,000 in taxes on the sale of the duplex. This means they now had around $227,000 after tax in the bank. What to do, what to do, right?

Where Does That Put ‘Em at 45 Years Old?

Both their kids are now teenagers. Though Maggie’s business is thriving — not to mention making a lot more than when she began — she’s already planning its exit. That will happen immediately after the younger kid graduates high school. What’s Maggie accomplished in her Roth Solo 401k?

Let’s take a look.

She’s had 15 years of contributing annually to the Solo, all of it after tax (Roth). The contributions alone have combined to acquire just under $4,000 monthly in note payments. Her note payments all those years have combined to acquire an additional $2,500 a month in payments. What that boils down to is that three times a year, the Solo’s payments alone are buying notes now. 🙂 Or, put differently, every 12 months, her payments are generating an additional monthly income to the Solo of roughly $800 — almost $10,000 a year. Year after year after year…

Where Are They So Far?

By the time Maggie’s 50, she’ll have either closed her business or sold it. I doubt if it would have much value, as most parents pick home-based nannies or the specific nanny. Bottom line? No more contributions from that point on.

Meanwhile, back at RothSolo Ranch, her rather impressive note portfolio will keep growing. Remember, notes tend to pay off sometime in the range of 6-10 years. Don’t count on that for any particular note, cuz the average or median time periods are still 100% random for any specific note. The point is that from her first note purchase in year 1, to when they retire at 60 years old — Solo’s 30th birthday — the income from her notes will easily eclipse $20,000 — wait for it — a month.

All of which will be tax free. Oh, and that $20,000+/month? That’s the lowest it’ll ever be, as notes have a pesky habit of continuing to pay off. Apparently, they either don’t care or don’t know you’ve retired. 🙂

The EIUL — forgot about it, didn’t you?

About the same time they retire and begin taking all that tax free note money every month, their 30 years of EIUL premium payments came to an end. They’re now the proud recipients of another $108,000 annually, of which — you guessed it — is tax free.

But wait! What the heck happened to the $227,000 after tax proceeds of the duplex sale?

After much cussin’ and discussin,’ they opted to split it three ways. They bought a brand new fourplex with $107,000 used for down and closing. All four units had separate tax IDs, so they got three of ’em at 20% down, and the fourth for 25%. It cash flows just fine, and they’re comin’ at the debt the same way they did on the duplex. It’ll be paid off by at least the time they turn 60, though more likely than not before that.

The cash flow free ‘n clear will range from $3-3,500/mo.

They then took $100,000 and bought more discounted notes for their personal note portfolio. Remember, they’d acquired their first personally owned note back when he was 40. The payments they created with this new money added around $12,500/yr pre-tax. They were now receiving just over $17,000 a year in pre-tax note income in their own names. This boiled down to around $10,500/yr after tax. With another 15 years for random payoffs, new note purchases via saved payments, and new purchases after the payoffs, this personal fund will easily reach $100,000 yearly, pre-tax by their 60th birthdays.

What’s the conservative bottom line for their annual retirement income at age 60?

EIUL — $108,000
Fourplex — $36,000 minimum
Roth Solo 401k Income Via Discounted Notes — $240,000 (As notes pay off over time, the income goes up.)
Their Personal Note Portfolio — $100,000 is a realistic and somewhat conservative guess. That assumes no note ever got paid off, and the only increase in income was generated by payments buying more notes, a highly unlikely set of facts.

That’s $484,000 in annual retirement income, beginning at age 60.

Some Facts to Note

1. In retirement, as is the case always, we can only spend after tax income. Over 70% of Jim ‘n Maggie’s retirement cash flow is tax free by definition.

2. If they’d had significantly more capital in the beginning, or made a lot more money at work, they’d have acquired more real estate.

3. Notice how mind numbingly boring the process was. That’s likely the most valuable takeaway.

4. By the time they reach 70, it’s more likely than not their income will have risen to at least $50-60,000 monthly.

Finally, think of the legacy wealth/income they’ve started for their kids. They’ve likely ensured multiple future generations of their family the best of education and all that goes with it. Who among us wouldn’t like to be the original family author of a legacy like that?

Now, it’s your turn: What do you think? Is this a realistic scenario? What would you change?

Don’t forget to leave a comment!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.