The first thing you need to do is determine what income level you need to replace. Often, the retirement Gurus recommend you need 85% of your pre-retirement income to be replaced to live in a manner you have been accustomed to; let’s do some analysis on this. I think it is quite a bit less than that, if you have been living your life like you really want to retire.
Lower Expenses
First of all, once you retire, you do not have certain expenses. For instance, you no longer will have to pay Social Security and Medicare taxes, which are 7.65% of your current salary. If you are above the maximum of social security, then your formula might be slightly different. I am going to assume a $100,000 salary.
You will also not have to save any additional money in your 401K. If you are making 100K a year, and are over 50, you should be contributing the maximum of $23,000. That is $17,500 for the under 50 portion, and the additional $5,500 for the over 50 catch up portion.
Mortgage Payoff
By the time you get to be retired, you should have your own home paid off. If not, you better get started. Too many expenses are the major obstacles in a retirement plan, and of course having enough income. So, assuming that you were living fine for a long time on a budget with a house payment while you were working, you should be able to live fine on the same amount of income or budget after you have your house paid off. You do not need to make that amount of money.
A typical house payment, for principle and interest only, might be $1400 per month. This will depend on how large your mortgage was, and what your interest rate was. In this case, $1400 is $16,800 per month.
There are a lot of expenses that you no longer need to spend on after you retire. Things like expensive lunches in at restaurants, or the company cafeteria. You can cut commuting costs, bus fare, parking fees, dry cleaning, and maybe even doggie day care. If you want to go extreme, you can now eliminate any shaving and haircut costs too. But these are all very subjective costs, so they will not be factored in.
If you are retiring at 65, you may find that Medicare is cheaper than your portion of your employer’s health care expense. If you can ‘buy’ vacation at your workplace, where a deduction is made from your paycheck to get extra time off over and above the company vacation allocation, you can deduct that cost from what you need too.
Since you are also making less money, you can offset the amount a bit by the reduced federal and state income taxes that you will pay after you stop working. In some states, pensions and social security are not taxed at all, so that is a major expense that you no longer have to pay.
Rental income is considered passive income, and can be offset by depreciation. Any income that is offset by depreciation is money in your pocket, tax free. You may never have to recapture the depreciation if you do not sell. Your heirs will inherit he property at the new basis, no recapture tax needed. (check with your accountant…)
Let’s Run the Numbers…
Salary $100,000
FICA ($7,650)
401K ($23,000)
Mortgage P&I ($16,800)
Total Salary Equivalent $52,550.
That is only 52.5% of your working salary. And that assumes a lot of expenses that you will no longer have to pay now that your salary is less, and you do not have work expenses. You can live in exactly the same lifestyle as you do now, just because you were able to live in a manner that is reasonable up to retirement. And this does not even count the lower taxes and lower expenses of not working.
Once again, some investment Gurus recommend to have 25x your salary in savings, but really it is 25x your spending or expenses, not income $52,550 x 25 is $1,313,750. That is a lot of money, but it is not $100,000 x 25, which is a crazy large sum of $2,500,000.
If you have investment property bringing in a mere $1,000 a month, it drops that $1,313,750 figure down to $1,013,750. Factor in some social security of $2,000 a month; that figure drops to only $412,500. If you work for a company with a pension, and have an additional $1,000 coming in from the pension, you only need $113,750 in the bank to replace your income.
To get $1,000 a month in rental income, after all expenses, including management fees, vacancy fees, maintenance and all other fixed expenses, you should be looking for an 8% cash on cash return. I do not think anyone should invest in a property that does not have at least an 8% cash on cash return. You will likely be required to put up 25% for a down payment.
To get $1,000 a month or $12,000 a year from rental income, you need to put up $150,000 at an 8% return. This can be on one property, or several.
Conclusion: Real Estate is a great way to get a great investment return. With higher returns, you have higher risks. If you are using real estate income for retirement, you should to have other, more secure sources of income to help out and diversify your income streams. You should also mitigate your risk by only accepting quality tenants.
Real estate income, investments in the stock market, bonds, social security, pensions, etc. all go a long way to a well-rounded retirement portfolio.
What income are you planning on retiring with?