Hello folks! Welcome back to The Green Swan. Today I will be picking up from where I left off in my last post. Last week I detailed the process of acquiring a business as my small business continues to grow and expand. I walked through the closing and due diligence process, considerations for determining my brothers’ and my ownership splits and the expected return profile. However, one important detail and consideration for me in deciding to invest more money is how the business asset impacts retirement. That, my friends, is what we’ll unpack today, so let’s get at it!
The decision for me to invest additional money in the small business at this juncture was very difficult. If you recall, I put a solid six-figure sum into The Green Condor in August 2016 and I’d be looking at a similar amount as part of this acquisition.
In total, I’ll have $325K into The Green Condor. This is money that I’ve accessed from my taxable brokerage account (not my 401k / IRA retirement accounts). As many aspiring early retirees (such as myself) are aware, money in a taxable brokerage account is very important to bridge 5+ years in retirement before accessing 401k conversion proceeds or before reaching age 59.5 (for reference and more detail, see my post on how I plan to not pay any tax in retirement).
As part of The Green Condor investment, I’m taking a large amount of my retirement liquidity and putting it in something that isn’t as liquid or something I’d even want to liquidate at all in retirement. So why make this investment? I don’t need it to reach my retirement date… Well, let me explain…
An Outsized Return Profile
As I mentioned in last week’s post, I expect an outsized return from the business. That isn’t something unique to my business, many small businesses have the potential to generate outsized returns. And as they should, small businesses carry greater risks. Higher risk should equal higher reward…and if done right perhaps not so much risk, a little elbow grease and solid return…that’s what I’m shooting for.
We’re fairly confident that we can sustainably generate a 20% return on our equity into The Green Condor. Having a business asset that can consistently provide returns in an un-cyclical fashion can do great things for the longevity of retirement assets. Should we ever need to access this money later in retirement, it should be there and have the potential to be significant.
While we don’t need this return profile to make early retirement work, the confidence we have in the business makes it hard to turn down the opportunity to invest more.
A Walk Across My Retirement Bridge
While I will lose some of the advantage from having the extra liquidity in my taxable brokerage account, I think Lucy and my retirement plan is still intact. Beginning in 2018 and annually thereafter, we’ll be contributing about $75,000+ to our taxable brokerage account (not including our IRA / 401K retirement accounts). After about five years, until we reach our set retirement date, this should replenish the account and amount to hopefully $400,000 to $500,000 (when including investment gains).
Upon retirement at age 37, we’ll be able to live on the taxable account for maybe 10+ years, but I’ll assume 8 to be on the modestly safe side. This will take us to age 45. Then we will access our contributions to our Roth IRA tax and penalty free which will be around $160,000 (we began contributing the max right out of college!) and last us a couple more years, say age 47.
At this point we’ll have about 13 years until we reach age 59.5 and have full access to our retirement accounts. So how do we complete our bridge?
The next step across the retirement bridge will be our Traditional IRA to Roth IRA conversions. Upon entering retirement at age 37 we will immediately rollover our employer Traditional 401k accounts to Traditional IRA accounts (no tax/penalty impact on this rollover). Then each year we will convert a certain amount of that Traditional IRA to our Roth IRA as part of a Roth Conversion Ladder. These will be taxable conversions at normal income tax rates. As outlined in my post on the tax reform, there are ways to limit the tax impact and potentially pay no tax at all.
In the simplified scenarios from the tax reform post, if I convert $60,000 I won’t pay any tax. If I convert $75,000 I’d pay just over $1,700 in tax. Not too shabby. That represents a 2.3% tax rate as compared to the marginal tax rate for most my working career of 28%…
Beginning these conversions at age 38 and going through age 47, that represents 10 years of conversions. Five of which would be immediately accessible because of the 5-year waiting rule. The conversion ladder would be depleted if we took out two years’ worth of conversions each year after 5 years (beginning at age 43). While we’d continue our annual conversions in those five years to keep the ladder going, assume we take two years’ worth annually and we’d be sitting at age 52 with another 7.5 years left on the bridge (with cushion from the conversion ladder continuing).
What would we do in this scenario where we are now scrambling for some money with 7.5 years to go? Or say we have even have 10 years to go. We’d have five feasible options as I see it, each of which I’d consider last resorts.
In no particular order:
First, we could begin selling to my siblings a small amount of our ownership interest in The Green Condor to bridge the gap. In the 20 years since my investment, this could potentially have grown to nearly $12.5 million assuming a 20% growth rate, or more conservatively it would grow to $1.5 million with an 8% growth rate.
Second, we could implement Substantially Equal Period Payments (SEPP). There’s an accounting calculation behind this, but SEPP (also referred to as 72t early distributions because of the IRS code it stems from) is an exception to the 10% early withdrawal penalty for retirement plans. The downside is once implemented, they can’t be turned off until you reach 59.5. This could be an issue if implemented looooong before 59.5 if then my income or tax situation changes and you wish to stop the payments. So it can carry some risk. But if beginning SEPP shortly before reaching 59.5, this would be more feasible for me.
Third, we could tap our Traditional or Roth IRA early and pay the tax and penalty (10% penalty for non-qualified withdrawals before age 59.5). Given the recent tax reform and little chance for material reform again in the next 20 years (after all it had been 31 years since the prior major tax reform…), I’ll likely be taxed at the 10% and 12% tax brackets for the Traditional account (0% tax on Roth since those are after tax proceeds). Along with a 10% penalty, I’m not looking at a ridiculous cost to access this money early (22% and 10% marginal rates/fees for withdrawals from Traditional and Roth accounts, respectively). Considering the marginal tax rate I’m at today, this tax and penalty would be even less. Not a bad deal if it worked out this way.
Fourth, we could tap our home equity. At age 47, we’d practically own our home free and clear. Without even assuming much appreciation in home value, we could conceivably access a couple thousand dollars by doing a cash out refi or opening a home equity line of credit.
Fifth, we could get part time jobs. This could be doing anything under the sun that brings in some cash, but right off the top of my head I know a possible small business that would be open to hiring me or Lucy…even if it was for part-time admin duties.
While I haven’t formally modeled my bridge out yet with hard numbers (although walking through it in this post helps me a lot…), it seems reasonable to be able to bridge to age 59.5 even given the reduced liquidity by investing more in The Green Condor. I may have to pay a little more tax and / or early withdrawal penalties, but my broader investment portfolio quantum should be sufficient to handle this and still carry us through our ultimate demise (sorry to be so gruesome here…😊)
A direct ownership in a small business provides diversification and benefits in many ways. Having a business asset that doesn’t necessarily swing up and down alongside the broader economy or stock market can be a good thing for us. Our business is unique as it isn’t cyclical or correlated with the performance of the broader economy.
Plus, in terms of timing, it may not be bad to sell some of the equity index funds currently in my taxable brokerage account to invest into The Green Condor. We’ve seen a heck of a run the last 18 months or so. Might not be bad to take some off the table. Granted, we’ll still have a significant sum invested in the market. And who am I to say anything about timing the market. For all I know, the tax reform may provide more fuel to the fire and spur continued expansion for years to come.
Either way, putting some into The Green Condor should be a good thing from a return perspective and for diversification.
If Things Go Bad
What if things go bad with The Green Condor? Well, another way I like to look at things is how well off I’d be if I ended up losing the money. Last year, when I made my initial investment, I decided it would be worth it in part because the worst case is I’d have to work one more year to cover the loss. Same for this go around. Although combining the two individual cash injections I guess that means a total of two more years now.
I think I can handle retiring at age 39 instead of age 37 just fine. Plus, if it goes really bad I’ll have some great stories to share on the blog. And what would life be without a little excitement here and there? 😊
Let me hear it…what do you think of the plan? Am I crazy for restricting my retirement liquidity more than it already is today?
Thanks for taking a look!
The Green Swan