Will you ever put a penny in your 401k again?

I stuck my neck out, and made a candid admission; as expected, I copped a little flak – after all, I admitted to the world that I don’t even know how much is in my own Retirement Accounts 😉 Whoo boy!

What surprised me is that I didn’t lose readers … I even gained some; Josh pointed to the reason why in his comment to that post:

Controversial? This article was absolutely controversial and that’s why I come here. If you want extraordinary results you need to make controversial moves, a.k.a “taking risk”.

Thanks, Josh. Here’s how I see it:

I’m not a risk-taker, far from it … to me, the so-called controversial move is usually not “a.k.a. taking risk” …

… blindly following Conventional Wisdom can be the riskiest move of all because you may unwittingly be risking a good proportion of your financial future!

To prove my point, and (hopefully) change the way that you look at investing in your 401k forever, let’s take this example from another comment to that same post, by Alex:

This strikes me, in a good way. I am about to be eligible for the 401k at my company. Normal people who cannot think of anything else better (and safer) than sticking their money in the funds.

Correct me if I’m wrong, what you are really saying is: instead of saving diligently and sticking $30,000 into a fund, maybe that same $30,000 can be used as a down payment for a rental property that will both appreciate and generate cash flow.

Now, I cannot advise Alex – or anybody else – on what to do with their money … that’s the job of financial advisers.

But, isn’t it Rule # 1 of Personal Finance to FIRST PUT YOUR MONEY IN THE 401K TO GET THE COMPANY MATCH?

After all, isn’t that FREE MONEY?

If the employer matches your entire contribution, aren’t you getting a 100+% return on your investment … impossible to match anywhere else?

Absolutely, which is why almost every personal finance writer (be it books, magazines, or blogs) recommends to at least invest to the limit of your employer’s matching contribution …

…. except for one problem, this thinking doesn’t hold up to scrutiny!

You see, your money is in the 401K for the long-run (isn’t it?) … your contribution – and your employer’s match is only a Year One issue; over the long run, your Contribution (with the employer’s match) will tend to a much, much lower return.

Alex’s question is: will that $30,000 be better off in the 401k or in a rental property?

The only way to find out is to run some numbers over the expected life of your ‘plan’ to see what happens … fortunately, just like a cooking show, I have prepared the numbers for you and here are some very interesting results:

SCENARIO # 1 – Assumptions

A. Let’s simply take Alex’s question ‘as is’ i.e. make a one-off $30,000 contribution to the employer’s 401k:

We will assume that the employer is VERY GENEROUS and match 100% of the entire $30,000; and we will assume that the markets are equally generous and compound an 8% return for us – tax free – for 30 years.

B. Alternatively, we can put that entire $30,000 as a 20% deposit against a $150,000 house; and we will assume that it’s value increases by a more conservative 6% (also compound) each year. We will also assume that Capital Gains Tax (15%) is payable.

SCENARIO # 1 – Results

1. We know that in Year 1, the employer’s 100% match provides a 100% return on the 401k; but, in year two that return drops to 58% (the employer’s $30,000 ‘match’ effectively becomes a $15,000 ‘return’ over each of the two years … then add the 8% Net Managed Fund Return).

This rate drops each year – because we are looking for the equivalent compound return, it drops fast – so that it only takes 9 years for the overall compound return to drop below 20% and by Year 18 through to Year 30, it averages a compound return of ‘just’ 11% – 12%; still almost twice real-estate, though!

2. The total amount available to cash out of the 401k at the end of the 30 years is $559,000

3. However, if the entire $30,000 was used as a deposit on real-estate, even with a 15% Capital Gains tax on any increase, the total 30 year Capital Return will be $713,000.

That’s a 28% advantage by putting the $30,000 into real-estate instead of the 401K …

… a greater overall $ return even though the % growth was half that of the 401k!

How can this be so?

The power of leverage (we borrowed 80% on the real-estate and nothing on the 401K except for the employer’s Year 1 ‘match’).

But, wait, there’s more!

The property is an investment property (if you choose to live in it, simply figure that you pay yourself a ‘market rent’ and these conclusions still hold true) … so, we can assume:

That we fix the mortgage at 5.25% (that’s $8,000 a month), and average a 5% rental return based on current market value (means that our ending-rent grows to nearly $36,000 a year!), and assume that 25% of rents will go towards expenses (other than the mortgage) and vacancies (a useful Rule of Thumb).

4. The net income (with any ‘surplus’ over mortgage and expenses being held on CD at a 30 year average of just 5%) is an additional $217,000 for the real-estate option.

Taken together, here’s how it looks:

 Total Return:       
 401k   $    559,036  CGT+Income   CGT Only  
 Real-Estate   $    930,476 66% 28%

So Alex, by (a) forgoing the exceedingly generous employer match in your 401k and (b) putting that $30,000 into a pretty tame residential real-estate investment instead, your overall 30 year return increases by 66%

Now, this is not how the ‘real-world’ usually works:

We don’t usually invest in one lump sum … we usually make annual contributions to our 401k of 10% – 20% of our salary. So, how does The Alex Plan work under this ‘real world’ scenario?

Let’s see …

 SCENARIO # 2 – Assumptions

A. Let’s adjust Alex’s question to instead make an annual contribution of 10% of an assumed annual salary of $50,000 (4% inflation-adjusted, so that the contributions also increase by 4% each year)  to the employer’s 401k:

We will assume that the employer will remain generous and 100% match the employee’s contribution each year; and we will assume that the markets are very generous and compund an 8% return for us – tax free – for 30 years.

B. Alternatively, we can simply put each year’s contribution in a bank account (earning a paltry average of 5% over the entire 30 year period):

When we save around $30,000 [Year 6] , we take that money out of the bank as use it as a 20% deposit against a $150,000 house; and we will assume that it’s value increases by 6% (also compound) each year. We will also assume that Capital Gains Tax is payable.

Once be buy the house, out bank account is depleted, but we are still saving 10% of the employee’s salary, so we start to build the bank account up again … of course, similar properties get more expensive, so we wait until we have saved around $38,000 [Year 11] as 20% deposit and buy our SECOND property … then we repeat: saving around $46,000 [Year 16] for property THREE, and around $56,000 [Year 21] for property FOUR and final.

Why final? Well, we are within 10 years of retirement, so the BEST PLACE for our final 9 year’s worth of annual contributions is probably the 401k … 9 years is simply not long enough to chance the property market (for this reason, we could even be really conservative and also forgo the purchase of the 4th property).

SCENARIO # 2 – Results

1. The numbers are too complicated to measure the effect of the employer’s match on the hypothetical return … but, the overall numbers are far more important.

2. The total amount available to cash out of the 401k at the end of the 30 years is now $1.8 Million (now, you know why you want to make annual contributions to your investment plan!).

3. With the purchase/s of the 4 properties (the last of which we hold for just 10 years), even with a 15% Capital Gains tax on any increase, the total 30 year Capital Return on the FOUR properties (plus the final 9 years of 401k savings) PLUS the net income for each of the FOUR properties, will be $2.4 Million.

That’s a 32% advantage by putting 10% of your salary into real-estate instead of the 401K …

 Total Return:   
 401k   $  1,833,746  CGT+Income 
 Real-Estate   $  2,412,898 32%

Before you say, well 32% is just too much work to worry about … you’re not thinking like a millionaire. Over the 20 years, you will have built up enough equity in properties #1, #2, and probably #3 to also purchase properties #5, # 6 and possibly #7. And, so it goes until rich …

So, Alex, will you invest in your 401k? If you have a lump sum … I’d guess definitely not?

But, for your long-term savings plan: the 401k is certainly more convenient … but, is that convenience ‘worth’ $600,000 (or – a lot – more!) to you?

That’s only a choice that you – and, aspiring followers of The Alex Plan – can make 🙂

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37 thoughts on “Will you ever put a penny in your 401k again?

  1. Great post!

    It’s got me seriously rethinking my contributions. Although, I don’t think I will ever deal with investment properties. I simply don’t want to deal with the hassle of the maintenance, and the tenants. That might be one plus for the 401k, less managment.

    You asked me in a previous post what I expected to gain from your blog. After this post I realize what I’m here to read… unconventional thinking.


  2. @ Q – Thanks! Unconventional thinking is only useful when it provides something that you can act on … let me know if/when it does. Send my regards to Moneypenny …

  3. I’m currently doing both of these actually. I take the company match into the 401k which is up to 8% of salary, and outside of this I’m saving for down payments on real estate investments (although I’ve gotten sidetracked with some hard money lending).

    Great post though. I enjoyed it.

  4. Historically real estate tracks inflation, not 6% annually. You’re also forgetting maintenance and property tax, water/sewage, heat, etc. When you want to retire you’re also forgetting the cost of selling the properties. I believe you’re also forgetting that the 401k, if it works like RRSPs up here in Canada, you get a tax reduction for contributions which can also be used to invest, or reduce your cost to invest.

    For instance in Ontario, Canada, someone making 60000 who gets a incredibly nice 10% match, puts 6000 in an RRSP, the company matches 10% in the RRSP, and then also gets a tax reduction of 1869 dollars which can either be used 1) To reduce the cost and keep in the budget having 12000 invested at a cost of 4131 dollars. 2) Invest outside and RRSP to have 12000 invested tax free and 1869 invested in a taxable account. 3) Re-invest in the RRSP having 13869 invested tax free and getting another tax reduction of around 580 bucks the next year, which will then also be used to help grow the account.

    Now either way you do it, it is ALWAYS the case that doing something will be better than doing nothing. No matter what you pick, I think sticking to your plan for the long haul is the best strategy. There are far too many people I see that are rounding 35, 40, 45, and even 50 that have no plan. That’s just sad.

  5. In the US you can cash out a 401k when you switch jobs. So you could take the 100% match and then say after 4 years (depending on vesting rules) cash out and pay the tax and penalty you might still be ahead. Things are very different here in Australia…

  6. One major flaw in your analysis…and I’m sure I could find others if I look hard enough:

    You’re not accurately accounting for taxes here at all. The contributions to the 401(k) Plan are on a pre-tax basis. If you’re saving money in a bank account to buy real estate, that’s on an after-tax basis. To save $5k in a 401(k) Plan, you have to earn $5k. To save $5k in a bank account, you’ll need to earn $6,667 assuming a 25% tax rate.

    Then we can look at the income from your rental real estate. Again, any income beyond your expenses will be taxed at your ordinary income tax rates…not accounted for here.

    Then you’ve got your assumed 15% capital gains tax rate on the increase in value on your real estate. Not all of that would be taxed at 15% if you took depreciation on the properties. There’s depreciation recapture to take into consideration, so you have to up the tax rate to 28% on that portion. Oddly enough, you didn’t even look at the taxes on the withdrawals from the 401(k).

    This is a very good example of why you can’t look at these situations using quick calculations and assumptions. It’s a lot more complicated than that. I didn’t even talk about the risk inherent in real estate versus a diversified portfolio, or how your analysis of the return on the employer match is a bit off.

    While it is good to think in unconventional ways at times, you better make sure you are accurately looking at these scenarios before you risk your entire future on them. While it could pan out, it could also blow up in your face.

  7. @ Fiscal – nothing wrong with that … it’s called ‘hedging’ and I highly recommend running the ‘slow path’ and the ‘fast path’ in tandem.

    @ Traciatim – yours sounds more like Australia’s Superannuation scheme that Moom refers to: if you can take your retirment plan money and use it to invest outside of the typical funds on offer then we can have a different discussion!

    @ Moom – I like the way that you think; anyone know the cost/benefit for Fiscal to slip his (exceedingly generous) 8% @ 100% match out?

    @ Paul – unfortunately the world splits into those who don’t believe that real-estate outperforms all funds, and those who are rich 😉 Not an easy thing to demonstrate in a short post for all the reasons that you mention (most of which I can counter with the words: leverage, depreciation, tax deduction/s, and inflation).

  8. I agree, the 401k is a 30 year trap and the tax laws favor real estate investing. But… real estate is about finding a ‘good deal’ and ‘timing’. We are in the middle of a national real estate correction, therefore this is not a good time to invest in real estate – although it is possible to find a ‘good deal’ if you know a market and are constantly looking for a ‘good deal’.

    But, researching for a ‘good deal’ is an investment in itself. There are better investments today, like gold and oil. If you wait three years, real estate ‘good deals’ will be everywhere and you won’t have to invest the time to find them. That will likely be a better time to move money back into real estate.

  9. @ Curt – If you can make more money in gold and oil over 30 years than in business and real-estate, more power to you … and, if you can’t, why wait to get started?

    BTW: the point of the article is not really to invest in real-estate, althought I think the principles that I outline are valid, rather it’s to encourage people to ‘think outside of the 401k box’.

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  11. AJC – Interesting post, but I have to agree with the naysayers. Your analysis in scenario 1 didn’t include mortgage and other expenses. In part 2 of scenario one where you actually account for expenses and deposit everything into CD, the true advantage is only $63,000 over 30 years and this is before tax — after tax it’s virtually wiped out.

    Granted, your 401k matching is a lot more generous than real-life situation.

    Again, interesting angle that worth exploring.

  12. @ Moolanomey – Always good to have you on-board 🙂 Unfortunately, in this case, and presuming that your objective is wealth, I am correct and have put my own money (in fact $1 mill.) where my mouth is … I’ll save this for a follow-up post.

    In the meantime, can anyone tell me what happens if you DO take the employer match and then pull the money out (yours + ‘theirs’) a year or so later? Is there a way to have your cake and eat it?

  13. I agree with others who have pointed out some of the errors in your calculation. The big one is clearly the tax treatment of the 401K contributions. $30K in a 401k is substantailly more than that once your take into consideration the tax savings.

    Not taking into consideration additional payments you will be making on the house over time is another error you are making, and ignoring the many costs of home ownership is a third (insurance, maintenance and taxes).

    Many people leave their employers after a relatively short time of 3 to 4 years. When you leave your employer you can roll-over your 401K into an IRA. If you don’t like your investment options in your 401k you can always push to have them changed – I have successfully done so in my previous company. If you are not successful, once you leave your employer you can invest the money as you please in your IRA.

  14. @ Shadox – reread my post [“assume that 25% of rents will go towards expenses (other than the mortgage) and vacancies (a useful Rule of Thumb)”] …. I have dealt with mortgage, costs, and interest-only. I have not yet dealt with tax benefits of both (that requires a more complex set of calc’s to deal with depreciation and after-tax benefits which greatly favor real-estate).

    But, for those who still think the 401k is the ‘be all and end all’ on the basis of tax, stay tuned …

    In the meantime, when was the last time you read this headline:

    ‘Multimillionaire thanks the tax system for favoring his 401k … says” “without it, I would not be sitting in my beach house in Maui sipping Pina Coladas today” …’ 😉

  15. AJC – I fundamentally disagree with your advice, because I think you’re confusing two different investments with two different purposes.

    A 401(k) is designed for those who work for a living in order to save for a retirement in a tax-preferred manner. Real estate investing is another thing entirely. Maybe the best advise is to do both – designate an appropriate amount to each.

    As for having your cake and eating it too, the answer is a qualified “Yes, you can.”

    Assuming you are vested in the employer match portion (vesting schedules vary by plan), you could separate service and roll the 401(k) proceeds into a self-directed IRA at a place like Northern Trust.

    You could also potentially do this without separating service if the plan allowed for in-service withdrawals. (If its your company, and therefore your plan, you can arrange for this simply by making the correct election on your plan document).

    SO yes, you can make a contribution, capture the employer match, and then once vested roll the money into a self-directed IRA and buy real estate (investment property) inside of that IRA.

    Not a solution for most, but possible.

  16. @ csrt8 – This is a great summary … might put it in my follow-up post. The point here is that once you move the money OUT of your 401k you need to decide how to invest it:

    To get rich: I maintain that (a) self-directed AND (b) leveraged is the way to get there … (c) tax-advantaged is great if you can get it, as well …

    Trouble is, most people focus on the cream (c) and forget the meat-and-potatoes (a)-and-(b)! I do the exact opposite …

    Of course, if you have the luxury of both 401k and alternate investments, you should do that … in fact, the 401k can be your ‘untouchable safety net’ in case your get rich(er) quick(er) plain fails!

  17. Thanks for this fascinating post. I have recently been thinking about my 401k as I have changed jobs. I now have the option of rolling my previous 401k into an IRA and have considered a self-directed IRA which I could invest in rental property possibly? I also am very concerned that the rate of US national debt growth is going to force our tax rates to be much higher during retirement than the pre-tax savings are worth now…

    [link deleted]

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  19. @ Joe – Real-estate was only an example; I wouldn’t dream of telling you how to invest your money … but, if I’ve got you thinking enough to consider your options (all of them) then I’ve done my job 🙂

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  21. Owning rental property is asking for a way more complicated life then I’d like. But for some, I think it’s a viable option worth exploring. My first step, if it were me, would be to get a good accountant. There’s a lot of potential expenses one could overlook in either direction. For those of us not interested in dealing with rental property, the 401K tax break, and company match if you have one, is an easy alternate investment vehicle. The key to me, is choosing the best funds you can.

    Nice post- I like the detail, even if i might not exactly agree with your assumptions and your math.


  22. @ Greener – real-estate was just an example of an ‘alternate investment’ for the purposes of this post, however, if you ARE going to invest in real-estate (and, it sounds like you are not) you will definitely need an accountant BUT one with experience in that area – as you say, there are a lot of tax-breaks that you might otherwise overlook.

  23. AJ

    Are the laws in Australia much different from the ones in the US regarding property? From what I’ve studied, property rights vary between many countries, but since we both are generally outgrowths of the English laws, I would think we have many similiarities. Do you mind sharing where your real estate investments have been located? I assume these are assets you can visit and walk through, not assets on paper in some office (like REITs). Would that be a correct assumption? My former father-in-law was into ranches in Montana (beef) and strip malls in the Fort Lauderdale FL area, tho I think he took a $1M hit one year…maybe also orange groves for a while. And he did have an accountant, as well as property managers I would assume. Partners as well. Would you tell more about the kind of RE investing you do, and how you started? – Another post of course.

  24. @ Di – all of my investment real-estate is in Aus; not that I am sitting on very much right now, having sold one commercial property. I have residences in US and Aus. Stocks on London, NY, and Sydney stock exchanges. Rest is just cash; but it is currency hedged against US and earns nearly 8% Tier 1 bank interest … so this is one time that Cash Is King!

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  28. AJC,

    I appreciate your attempt at explaining why Real Estate investing should at least be considered over equity investing in an employer-matched 401K. I ran the numbers using your assumptions (adding in tax consequences–property and income–and cost of property insurance) and, although the annualized return was much closer, your Real Estate investing scenerios came out slightly ahead. I expected this result as investment property investing usually carries increased risk (and hand holding) and thus should provide increased reward.

    In going through the process of comparing investment options, I was suprised by a few things. 1) the Real Estate investment option, according to your scernio, suffered from 8-15 years of undiscussed or accounted for negative cash flows after costs, such as property tax, insurance, mortgage payments, and your 25% unrealized income either due to maintenance or unoccupancy, and 2), more importantly, the overall outcome (equity v. real estate) varied drastically based on 2 assumptions: estimated appreciation of real estate over 30 years and estimated return in the equities market over 30 years. Even a 1% point swing in either of these assumptions made a huge difference in projected outcome, i.e., which investment option was better.

    I looked through your blog (not exhaustively) for a post discussing your reasoning behind these 2 estimates, but failed to find one. Since it seems that the accuracy of these estimates (best and worst cases scenerios over 30 years) is essential in determining if either investment option has a clear advantage, I was hoping you could either point me to a post of yours discussing them, or let me know of any books, articles, etc, that led you to your estimates.

  29. @ Jeff – Aha! My point is proved (at least to you) … you shouldn’t just AUTOMATICALLY assume that the 401k + employer match is the bee’s knees right? You need to investigate ALL the likely options for YOU (which may, or may not) include real-estate ….

    Worth another post, then? Stand by 😉

  30. @AJC
    Looking forward to another post. I can see how some people couldn’t stomach the additional risk of Real Estate investing…and thus the decision to get a company match in a 401K is an easy (near automatic) choice. For me, I want to determine a return that is reasonable for each option, and then compare it to the associated risk before I make a choice.

  31. @ Jeff – There’s a question that you need to ask first: “what return MUST I get?”. Only after you answer that can you can “determine a return that is reasonable for each option, and then compare it to the associated risk before [you can sensibly] make a choice”.

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