A short while ago I wrote a post challenging the notion that you should automatically plonk your money in your 401k, because:
1. It’s ‘forced savings’
2. It’s pre-tax savings
3. You get free money from your employer!
Yesterday I wrote a follow-up saying acknowledging that these are all good things to have in an investment.
But, not the only things … in fact, there’s only ONE THING that I want from an investment: that it gives me a return that supports My Life.
Not, the life that the investment is capable of supporting … not the life that I have … not even the life that I want … but, nothing less than the life that I need.
But, I expected to cop some flak, and here is some of it …
Traciatim said:
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.
In fact, this is a really common theme amongst the detractors (there were a lot of positive comments, too) … but, who ever said that you should invest in ordinary residential real-estate in ordinary locations?
Also, those who ‘remembered’ the costs of these direct investments (which I did allow for) , we tend to forget the hidden management costs and fees of the funds that your 401k invests in (which I did not allow for).
Curt said:
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.
This is the mistake of trying to time the market; this affects both the 401k ‘option’ and the alternatives, and probably requires a whole post in itself … if you are interested in the real-estate option (and, it is just one of many non-401k options that you could take) and you can find something that ‘works’ now, go for it!
Paul said:
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.
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.
Wise words, Paul. Of all the criticisms of my post that I read, Paul’s is most valid: I did not do an after-tax treatment (although, I did mention Capital Gains Tax); it’s just too damn complicated to run the numbers for a post like this … and, doesn’t change the relative outcome.
In fact, why do you think so many wealthy people invest in businesses and real-estate? It’s partly FOR the tax breaks! How much tax do you think that they legitimately pay per dollar earned compared to you, even WITH your 401k?
And, it appears that Pinyo of Moolanomey actually reran the numbers:
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.
Sorry, Pinyo, on this one we’ll have to agree to disagree … unless you want to share your numbers? Then, I’m happy to do [yet another] followup.
BTW: real-estate is not the only viable alternative to saving in your 401k; my arguments apply to any investment that has the following four characteristics: leverage, depreciation, other tax deduction/s, and inflation protection.
Guys, the critical difference is this one – hardly mentioned in the comments at all: Real-estate has an apparent risk … but, the 401k option has a hidden risk.
I think we all understand the apparent risks of alternate investments v the nice, safe 401k (if you were set to retire at the end of 2007 and you ‘forgot’ to shift the bulk of your funds to the bond market, you may have a slightly different view on this) …
I’ll leave you with one thought: when was the last time that 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” 
In the US, when an employer will significantly match funds contributed to a 401k it will usually make sense to invest in it up to the match, especially if you change jobs often (but not so often as to end up without the employer contribution vesting) as you can if you want cash out the fund at that point (paying the taxes and 10% penalty). I’d like to see the numbers to show that that isn’t the case – it would have to be a pretty good alternative investment. Now that is very different to “maxing out a 401k” or “salary sacrificing to super” in Australia (maxing out is hard in Aus when the annual limit is $200,000-250,000). Those are much more debatable things. The big question is: “should you contribute beyond the match?” in the US and “should you make any contributions beyond what your employer contributes (at least 9% of salary)?” in Aus. And these questions have different answers too depending on your age.
As a person who invests in both 401k and Roth IRA as well as residential real estate, I have to also add one other Major argument for real estate as a retirement strategy. That is, if investing right and long-term, real estate is much more of a sustainable investment. That is, if you have held it long enough to pay down the mortgage, you simply can live off of the rental income. After drawing out the rental income for one year—guess what? It hasn’t gone down in price but usually up—at least maintaining parity with inflation if not more (sometime much more if you invest right). AND…(the best yet)….you still have the same amount of money available to you as the year before plus a little more (if you haver raised the rent). The problem with 401K investments is that unless you have enough to live off of the dividends (out of the question for the vast majority of people), you are drawing down your investment every year. It is not sustainable like real estate. Granted, you must maintain your residences, which is an ongoing cost, but a smart investor always plans for the major repairs/renovations and has money set aside for the smaller ones. To be honest, I am so tired of the constant 24/7 blather of the stock market investment complex that has its tentacles in every media outlet. They want to keep spinning a song that hasn’t produced for most mainstream investors the past ten years (but has for their jobs and income). I am grateful for AJC’s contrarian and no-nonsense approach to most of their blather.
@ Moom – The underlying point is this: as for ALL investments, do’t just blindly plonk your money in … run the numbers first! It is my theory that if you do, for many people the 401k will NOT be the answer that they thought it was … wow! Then what??? Keep reading this blog …
@ Timmers – you have just outlined a GREAT Making Money 301 (keeping your money once you’ve made it) strategy and helped to explain the old saying: “… the rich may make their money elsewhere but they KEEP their money in real-estate”.
To agree with the premise that RE is the best investmentment, I have made over $350,000 tax free profit in fifteen years selling only 2 primary residences. I have paid about $450,000 in mortgage interest, taxes and maintenance fees (it’s a co-op) over those years, but I consider that “rent” and not necessarily the cost to make $350,000. In fact, not included in the $450,000 I spent is about $150,000 in tax refunds due to mortgage interest and RE taxes paid. Another way to look at it is I’ve made $50,000 in 15 years AND lived rent free the entire time! Contrast that with my 401k, while contributing about $225,000 pre-tax, I’ve lost about $100,000 in value. Thus, my 401k has “grown” $125,000 in 15 years, but at a cost of $225,000 pre-tax dollars. But, I write all this because I want to state that the 401k losses were my laziness and idiocy, specifically: I was too highly invested in corporate stocks. I think as anyone understands, to remain diversified it is ludicrous to sell your 401k and bet it all on real estate. Similarly, you should never be more that 40% invested in stocks, and that is combined 401k and personal holdings. The rest should be RE, bonds, cash and/or commodities. As it turns out, my 401k is only 11.5% (as of today) in stocks, the 88% bonds and cash. Honestly, I have been moving money since early June and losing a lot less on my 401K than those who keep the “recommended” 70-90% stock allocation. Anyway, I also want to emphasize the RE market has TANKED and my current residence has lost about $60,000 in value in the last 2 years – a MUCH BIGGER LOSS THAN MY 401K! Further, my 401k losses would have been even less had I diversified sooner. You would be a complet and utter fool to be solely invested in RE the last 2 years. In fact, since Jan ’08, gold, oil and/or sliver would have been the best bets of all.
My conclusion is that you are giving terrible advice to invest in RE instead of 401K. But, to recommend a 401K, I would also recommend to be heavy in bonds and cash, especially during this bear market. If you don’t own real estate, at all, do what I did. Withdraw $50,000 from your 401K and use it for the downpayment on something nice, that is how to diversify!!! This reduces your 401K exposure and gets you into RE with no risk, since you have to live somewhere!
@ Andrew – actually, I am not recommending ANY investment … if you look closely, you will see that I NEVER do. What I may do, from time to time, is ILLUSTRATE using RE or stocks, or bonds, or business, etc. But, that is a far cry from RECOMMEND.
In this series of articles I am specifically NOT recommending RE over 401k, what I am saying is that diversifying and solely relying on your 401k will NOT make you rich. A more active investment (for EXAMPLE real-estate, or could just as easily be stocks, bonds, business, etc., etc.) MAY make you rich.
Finally, on the subject of timing: if the market is down this year, buy MORE not LESS … and, WAIT: 20 or 30 years should cure any small 2008 problems.
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I will believe 401K/IRA mutual fund investing is the way to go when the data for the wealthy tells me that is where they made their money. So far, the people with the highest percentage in mutual funds are the least wealthy of the folks with a net worth of $100,000 or more (I know that is a laughable amount to call people wealthy, but that is where the mass afluent category starts). And when you get to the wealthy $1M or more or super wealthy $10M + their mutual fund ownership is tiny. I am always amused at how Wall Street interests always point out that the market returns 10%-12% or more when in reality folks that invest in mutual funds get 7-10% below market (Dalbar studies indicate an average return of 4.4% for the years 1987-2007 for example!)
Start comparing oranges to oranges instead of one theory (demonstratably false) to real estate.