Should You Invest In Real Estate Or A 401(k) Plan To Fund Early Retirement?
Kevin Amolsch is an investor and a private lender who has participated in over 1,700 transactions. PineFinancialGroup.com
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We are told that investing in retirement plans is a good idea, but can that strategy push out your retirement? Although I am a big believer in saving in tax-advantageous accounts and believe most investors should have this as part of their overall plan, here are four things it’s important to understand about 401(k) plans as compared to real estate investing.
Access To The Money
With most retirement accounts, you must wait to start taking distributions until you reach the age of 59 ½. This restriction can cause a problem for those who want to retire early. Let’s say you understand that real estate is a great way to invest for retirement. You start buying rental properties and quickly realize that owning rentals accelerates your retirement. In fact, you realize that you can become financially free, and you begin to focus on creating more passive income than you have expenses. Although you may be able to retire early, your 401(k) will not help that goal. All the money you have invested and are earning in your retirement account is worthless to you in your early retirement. You might find that you can shave many years off your financial freedom timeline by investing that money into other assets like real estate.
Restrictions On Investments
With some rare exceptions, you will be restricted on what you can invest in with a company 401(k) plan. These restrictions are mostly limited to the more traditional type of investment options, such as exchange-traded funds (ETFs) and mutual funds. Because of these restrictions, it is hard to hit the returns that real estate investments are known for. Obviously, lower returns will slow you down on reaching your financial freedom goal.
Note that this is not the case with IRAs, as you can invest in real estate with your IRA. That distinction is why we are focusing only on 401(k) plans.
Ordinary Tax Rates
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If you invest in a piece of real estate, you organically defer taxes on appreciation until you sell the asset. Because this type of investment has a built-in tax deferral, it limits the value a traditional 401(k) brings. This is often overlooked and a powerful argument for real estate. When you do retire and want access to the cash, you will be taxed at a capital gain rate on the real estate when you sell it. Those rates are typically lower than you would pay on your ordinary income. On the other hand, when you sell assets and make withdrawals from your 401(k), you will be taxed at ordinary income rates, even if you have owned the asset for many years.
Leverage
It is unlikely that you would be able to, or want to, use any loans to purchase assets inside a company 401(k) plan. Leverage is one of the primary reasons real estate is a superior investment to many other asset classes, in my opinion. You can control huge amounts of assets for a fraction of the cost. There are certain risks with this, but it magnifies returns.
An Illustration
It is a complicated process to determine how an investment would perform inside or outside a 401(k), to give a clear picture of these points. Every investor will invest in different assets. Each asset has its own unique situation, and there are different advantages and disadvantages — such as a company match plan or access to great real estate deals.
I tried to take an average person and account for all these variables when calculating which option would have fared better over 20 years, from 1999 through 2019. For my example, I used a $50,000 lump-sum investment made in January 1999. In my scenario, each investor makes $75,000 per year from other sources at the time of their investment and at their retirement. I used average real estate values on a national level and prices of an S&P 500 ETF. Real estate values have increased about 5.1% per year, and this specific ETF increased 7.6% per year during the same period. I also made the extraordinary assumption that the rental property purchased would produce no monthly cash flow but would cover all monthly expenses. Because I did not account for any cash flow over a 20-year period, which is a highly unlikely outcome, I used a 20-year loan.
Investor A decided to go the 401(k) route. Because he can invest that money before it is taxed, he was able to invest the entire $50,000. That $50,000 purchased 391.7 shares of the ETF. Twenty years later, he sold them for $321.23 per share, giving him $125,825.80. When he takes that money out of the plan, he is taxed at 24%, leaving him $95,627.61.
Investor B decided to forgo the 401(k) plan and invested her money into a rental property. She was not able to invest with pretax dollars, so her actual investment was reduced to $38,000, which was enough for the down payment on an average-priced home in 1999. She purchased the home for $189,100 and 20 years later sold it for $384,600. She paid a 20% capital gain tax on only the gain, leaving her with $345,500.00.
I am in no way saying you should not invest in your 401(k) plan or other retirement accounts, and I am not giving investment advice. I participate in tax-deferred retirement accounts myself. Every investor’s situation is different, and there are other pros and cons of both investments that are not taken into consideration in the above scenario. For example, I did not account for the effort to manage the property, company match contributions, ease of investment, recapturing depreciation, high costs of tenant turnovers, annual contribution limits and several others.
I give this example to illustrate that these four points should always be considered when investing for an early retirement.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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