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Happy retirement? Location, location, location …

Thinking about early retirement? There is no way you can afford the cost of living in your area? You are not alone. I live at one of the most expensive areas in the world: San Francisco Bay Area. Although my home is smaller than most homes around and the schools are not that great, I paid enormous amount of money for the mortgage and there is also a property tax attached which I have to pay until I die or move. Property tax is rising, together with home price on the market. Zillow is a great source of data, if you want to see an estimated market price for particular home year after year. Currently, my home price is estimated at $1,169K and in June 2009 it was just $619K. Great news, isn’t it? Yes if I want to sell it. However, if I want to live in this home for a long time, property tax will be growing: I already have to pay around $12K for this year. For comparison, my property tax was $8,380 in year 2009. It is easy to see, that property tax has not grown proportionally to the market home price. Thanks to California’s Proposition 13, assessed value for any home not being sold can not grow more than 2% annually. Therefore, currently market value is $1,169K (according to Zillow, you never know the real market price until you sell it) and county assessed value is $881K. As a result, the property tax is still high enough because I bought this home in year 2007 when selling price was almost $800K.

Can anyone retire in a home with annual property tax $12K which will most likely on a rise in future? It depends on the available liquid assets. The home price can be high, but you can not count on it while living in this home. Using 4 percent rule, it is easy to have a rough estimate how much money you actually need to afford this home based on projected cost of living. Also there is a great calculator available. It is true that most people with ordinary engineering income can not afford it and I am not an exception. What do I do then? Work until the age of 70? Another option is to move to other area with lower cost of living. How to determine which exactly area is the best fit? Well, it depends on your personal preference. For me, these are the most important factors I consider to make an educated choice:

  • where you feel comfortable and enjoy a social life, presence of relatives and friends, favorite activities and shopping
  • climate (I personally enjoy warm weather but not as hot as for example in Arizona)
  • insurance cost (health, home, car)
  • cost of living, including home or rent price
  • property tax, sales tax, income tax

While feeling comfortable is a personal feeling, we can discuss other factors here. There is an excellent living wage calculator, provided by MIT for major metro areas in United States. I found it useful to compare not just absolute cost of living, but the ratio between maximum salary and minimum income required to live for single or married couple in the particular area. The ratio clearly show the areas where you will have the best bang for the buck, while continue to work. But if you are looking for a place to retire, then minimum income is the most important number to consider. Although not guaranteed, the areas with lower ratio and relatively high minimum income may also indicate the future home price increase. It may be good for investment home, but you do not want property tax to be on a steep rise when you retired.  I combined the data for some areas into the table.

Actually I found this table quite interesting. Metro areas are sorted according to the maximum salary. According to the data, living in San Jose may give you better income stream if you manage to get higher compensation. But places like Houston provide even better standard of living for single person. From the other side, areas with minimum income $20K or less are great candidates for retirement location. But I would not completely rely on these numbers: you may need greater than that to live a quality life. But these numbers provide some guidance where to look.

After carefully comparing different states and metro areas, I included a few places into my short list: California, Nevada, Texas and Florida. Is there anything common between these states? Of course, they enjoy warm climate around the year and there is no state income tax in all of them except California. But they are actually quite different in many other aspects. For tax purpose, I found this article quite useful. You can sort the table for property, sales or income tax, as well as for the total tax burden. Obviously, California is #11 in total tax burden, followed by Nevada #34, Texas #41, and Florida #44. However, not all taxes are equal in a retirement. If you are like me, income tax will not be a big deal during the retirement because of low tax bracket. Sales tax is definitely more important, but you always can live a frugal life by limiting the number of items you purchase. We all have to pay property tax, no matter what we do. Even those who rent are paying a property tax indirectly, through the rent. According to the table, the highest property tax burden is in Texas, followed by Florida, California and Nevada.

Another important factor is insurance, in particular health insurance. There is another great article on this subject. Apparently, California has the lowest health insurance rates in my list, followed by Texas, Nevada and Florida. In fact, health insurance cost in Nevada and Florida is quite high, compared to California and Texas. Home insurance is another important criteria for comparison. In Florida, home insurance can be as high as $5K annually in some counties (see the data) due to the potential hurricane damage, and it does not even include flooding insurance cost. In Texas the average cost is running about $1K per year, but can be higher at places like Galveston. I pay $512 annually for home insurance in California, which is apparently the lowest across all states of my choice. The home prices and income tax are terribly high in California, however home prices are quite different across metro areas. In this table, I summarized all findings.

Carefully considering all factors, I vote for metro areas in California with reasonable home prices. In addition to all these factors, I personally like climate in California more than anywhere else in United States. But I know other people may have different opinions. Home prices are sky high in San Francisco Bay Area and surrounding cities only. Around Los Angeles for example, you can find a descent home for half the price in Bay Area. Sacramento enjoy even lower prices. This is not just my opinion: prices in lower cost areas across California are rising, which means more people from high cost areas are moving there. Still, at this time I do see California as the most viable option for retirement.

Homeowner? Pay no tax for 401K


Retirement saving plans such as 401K or IRA are increasingly popular, because they allow contributing money before tax. Especially for those who are in high tax bracket. Also, some employers are matching a part of 401K contribution, which makes it even more attractive while we are at work. However, disappointment comes later at the age of 59.5 when it is a time to withdraw money. At that time, we have to pay tax. The greater amount we save, the greater tax will be. For those like me who live in a state with income tax, the state tax will be added. Is there a way to collect money completely tax free?

There is a great article written by MadFientist, who give some idea how to do that. The idea is to contribute into 401K or traditional IRA during the working years, but after retirement convert small portions of savings from 401K or traditional IRA into Roth IRA each year. The converted amount needs to be carefully calculated, to offset personal exemptions and deductions. In this way, conversion will be tax free. This is in assumption that you retire before the age of 59.5 and you can not withdraw money from 401K or traditional IRA directly without penalty. Money are available tax free from Roth IRA at the age of 59.5.

In a reality, this excellent idea works for married couples rather than singles. I combined all 2016 exemptions and deductions any person can always claim in a typical situation in the table. I assume the person lives in California: other states may have different numbers and some states does not have income tax at all. Also, I added Health Savings Account, which become more and more popular these days and can add up into deductions. It works pretty much in the same way as 401K or traditional IRA, but permits withdrawals for medical expenses.


Also, let us take a look at tax brackets, both federal and California. I intentionally included three lowest brackets only, because I assume most people with limited lifetime savings will most likely fall into 10% or 15% federal brackets after the retirement.


How to collect money from 401K tax free? The idea discussed by MadFientist is to deduct certain amount of money from the total income before tax, and take the same amount of money out of 401K or traditional IRA into Roth IRA. For example, combined personal exemption $4,050 and standard deduction for married couple $12,600 deducted from the income can be replaced with $16,650 collected from 401K plan. As a result, the taxable income and tax will not change because of 401K money transfer. In other words, $16,650 comes with no tax. Obviously, there may be other income which can not be deducted and the tax must be paid for that income. But the good news is that no federal tax will be withheld from long term capital gain in federal tax bracket 10% or 15%. By replacing ordinary income with long term capital gain, it is possible to avoid federal taxes completely. Some states do not have income tax, but others like California does. However, California tax rates are much lower than federal rates. There are other types of investment such as California issued municipal bonds, which are exempt from both federal and state tax.

The deductions for married couple are twice as large as for single and tax brackets are also doubled. As pointed out in another great article by Curry Cracker, married couple can deduct up to $19,500 from income (which comes to $23,400 for those who file tax return for year 2016 and contribute into HSA). What does it mean? It means that anyone who is married can offset $23,400 income by annual withdrawal of the same amount from 401K or traditional IRA into Roth IRA. For example if someone has $250K in 401K plan, then it would require 10 and half years to collect all money from 401K without paying tax. Which is probably a reasonable time, even for those retired after 50. However, if we take a closer look at deductions for single person, then we have $13,700 only to deduct. For the same amount of savings, it would require almost 20 years to withdraw all money. It is a long time. Moreover, we need to reduce $13,700 by annual taxable income (I assume it still exists in some form), which raises withdrawal time to 25-30 years. Not every person live that long after retirement.

There is actually a way to attack this problem for single people. But single person must be a homeowner. Because property tax is the important deduction, which may have substantial impact to overall numbers. The property taxes in US for single family homes vary from $3K to $20K in most cases. It depends on home size and area. In areas with high cost of real estate, property tax can be higher than federal or state standard deduction. For example, I pay around $12K property tax annually and obviously use itemized deductions to reduce taxable income. It helps to offset taxable income when you have high wages, but may have opposite effect once you retire. Suddenly you realize that your income is so small that this deduction does not make sense anymore. But actually it does, when you want to withdraw money from 401K tax free. Property tax must be paid anyway, because we need a place to live. Let us use it for our own favor.

This approach works better when property tax is high, and its effectiveness degrade with amount of tax approaching standard deduction which is $6,300 for single. For California, you will end up paying more than that because of the high home prices (property tax is relatively low), but in Texas it is also achievable because of the high property tax up to 5% in some counties. But the real question is: can you afford this house during retirement? People tend to move to lower cost areas and live in cheap apartment, when amount of savings is limited. Can you afford the house with property tax high enough to offset income tax? It is easy to estimate, using 4% rule. The rule definition can be found for example here. The rule say that in a retirement, we can safely withdraw 4% of the total assets to make sure some money will be still available until the end of life.

The maximum home price and associated property tax depends on two factors: total amount of assets available and projected cost of living. I am single and I can not see myself spending more than $3K per month, unless some emergency happens. I can probably live on $2.5K, by taking special care about daily expenses. It would be a challenge to survive with $2K per month at expensive place such as San Francisco Bay Area, but someone else living in Texas for example most likely can live on $2K. Therefore, I prepared a chart about the impact of property tax and cost of living on the maximum home price retired person can afford. I use the ratio of annual property tax to cost of living from 10% to 50%, as I do not believe it is reasonable to spend more than 50% on property tax. I used Santa Clara county property tax rate 1.36% to calculate the home price. 401K conversion tax can be offset by property tax within a green area: homes priced above $463K are well within the range for many metro areas now. At least 20% to 30%  of annual expenses are required to spend on property tax in order to collect tax free money from 401K plan, which seems reasonable to me.


You can determine where you are in this chart with the help of 4% rule, using the total amount of assets you have as follows: [home price] = [total asset] – [cost of living] x 12 / 0.04. Then you can see if you are within the green area or not, and determine the optimal property tax to cost of living ratio to eliminate tax. For example, with $1M in assets and cost of living $2500 per month the home price would be: $1M – $2500 x 12 / 0.04 = $250K and the goal can not be achieved. However, with $1.5M in assets and cost of living $3000 per month the maximum home price would be $750K. It means that you can buy a home within $463K to $750K price range and achieve the goal by spending 20% to 30% of annual expenses on property tax. But most likely property tax is higher than 1.36% in a county where you live. In this case, the lower bound for home price to achieve tax free 401K goal will come down to $252K for property tax 2.5% and it can be as low as $126K for property tax 5%.

Finally, a few words about Health Savings Account (HSA). It definitely can help to offset 401K tax, when included into deductions. It is not required to have earned income to contribute into HSA, therefore it can be done even during retirement. After the age of 55 the contribution limit increases by $1000, which makes it even more attractive for tax purpose. But the advantages of each individual plan compared with ordinary health care plans must be carefully reviewed for an educated choice. The advantage of HSA can be combined with the advantage of some 401K plans, which allow withdrawing money without penalty if employee left job at the age of 55 or later. Then the most effective strategy can be, assuming enough financial assets are available at the time of termination:

  • quit your job at the age of 55
  • contribute into HSA and withdraw money tax free and penalty free from 401K directly to personal account between the age of 55 and 65
  • withdraw money whatever left on HSA tax free and penalty free between the age of 65 and 70
  • apply for social security benefits at the age of 70

Social Security: what to expect?


Social security system in US provides you and your family with benefits, in case you retired, become disable or die. We will focus on retirement benefits here. It works like a federal fund. During our entire career, we contribute some amount of money into the fund as Social Security tax. If you have earned income then in a paycheck, it comes as a separate tax category. Currently the tax is 12.4%, and half of it is paid by employer. Self-employed are responsible for the entire tax. In year 2016, this tax is applied to the first $118,500 of annual earnings, which is Maximum Taxable Earnings. By that reason, if you happen to make more than $118,500 annually then the tax is still the same.  Maximum Taxable Earnings are adjusted with inflation, for example in year 2000 it was $76,200. The money we contribute are managed by federal government (Department of Treasury), and invested in Treasury securities only. When retirement age comes, anyone who contributed into the system for at least 10 years can apply for the benefits. Money will be paid back. Most states does not impose tax on social security benefits, but some does: Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont and West Virginia.

When you decide to apply for social security benefits, there are a couple of important points to remember. First, there is a full retirement age when we can apply for the benefit based on year of birth. Also, there is a minimum retirement age. I can apply at 62 and the full retirement age is 67. Second, the amount of benefit is increasing with age when we apply. It does not increase anymore if you apply after 70. The exact amount the person can receive when applied at particular age can be found at Social Security Administration site using online account. Also, there are multiple calculators available on the web for benefits estimation. I found that this excellent online calculator provide more insight than others. Actually it is even possible to estimate the amount of benefits when you stop working before the minimum retirement age. But unfortunately it does not provide the flexibility to simulate the situation when you stop working early but apply for the benefits later after 62. I tried more advanced detailed social security calculator but it required installation and its report is difficult to read. Also, there is a very good article written by Joe at retireby40 how early retirement affect benefits. But it did not address my specific need either. By that reason, I decided to learn more how benefits are exactly calculated and share the findings in this blog.

The social security benefits are calculated using an average of 35 years when the highest amount of money contributed into the system. Actually, you may not need the exact numbers if the earnings were greater than Maximum Taxable Earning defined for particular year. The earnings are indexed with year specific coefficient, defined according to the inflation. In other words, indexed earning are earnings in current dollars. inflation index for each year while at work provided at the document published by Social Security Administration. I combined the numbers into the table starting from 1999 (when I started career), and computed indexed earnings for each year.


Using this table, I calculated the total number in the right column. I use Maximum Taxable Earnings, because my actual annual income was greater than that. If your annual income is less, then you need to substitute actual annual income for each year. The final number divided by 35 and by 12 provides average earnings over 35 years adjusted for current dollar. Obviously, I do not have 35 years career yet and missing years are represented as 0. For future years, I use the same index number and Maximum Taxable Earnings as for 2016. The benefit at full retirement age (which is 67 for me) is calculated using the average number as 90% of the first $856, combined with 32% between $856 and $5157 and finally combined with 15% of the remaining part. You can clearly see that higher earnings contribute less into the benefit. This will be the benefit at full age. I compared the number computed using this method with the results of online calculator and the difference is just a few dollars. I may be missing some details, but method is working correctly. What if you decided to apply earlier at 62 for example, or later? In this case, full benefit reduction (or gain) coefficients are applied. Coefficients currently in use are available for example at bankrate survey. I compiled a table with coefficients, which provide a clear picture how application delay affects the benefit.


This is a very important table. Logically, you may assume that the benefit does not increase when you stop working and no contributions made to the system. But in fact the benefit increases in any case. It is designed to encourage people to delay their application. With all these data, I decided to figure out what would be the impact of early retirement combined with late application? Again, I use year 1999 as a reference and count 18, 23 and 30 years of career starting from that year. This graph clearly show that the time when I actually apply for benefit is much more important than the time when I stop working. Even if I apply at 70, the difference between terminating job after 18 and 30 years is around 30%. The difference between 18 and 30 years is less if I apply at 62. However, application at 62 and 70 yield a difference of almost 50% (if retired after 30 years). Please remember these numbers are calculated in assumption that index numbers, benefit reduction coefficients and Maximum Taxable Earnings stay the same for future years. But in reality they will increase with inflation sooner or later, and the final numbers will raise as well.


What conclusion would you draw? I believe the correct strategy is to delay application for benefits as long as possible, up to the age of 70. But collecting enough savings to live is even more important. It is not clear what will happen with social security in 20 years ahead. I am sure it will be around in some shape. But it may become private. Inflation coefficients may not grow as fast as in the past. Minimum retirement age can be increased. Or after all we may not live that long. This is why it is important to rely more on savings rather than the benefits, and decide on retirement solely based on your life style and spending counted against savings.