I received this email recently from a reader:
I am a fourth-year medical student applying to residency and my initial plan is to do a Roth IRA and invest in real estate during my training. My goal is to build wealth, pay back student loans, and establish financial independence. However, I am not sure what to do about retirement accounts like a 401(k) when I finish residency and get my first “real” job. I have been reading lots of information on tax efficient ways to build wealth and, ironically enough, much of the information I have read thinks that investing in a 401(k) is a bad idea, especially when there is no match.
Tom Wheelwright (the tax advisor to Robert Kiyosaki who is the famous author of Rich Dad, Poor Dad) is vehemently opposed to a 401(k). In his book “Tax-free Wealth” he states that investing into a 401(k) is actually unwise for anyone seeking to build wealth for the following reasons:
#1 Investing in a 401(k) causes you to pay a higher tax rate on the profits from your investments.
Outside of a 401(k), capital gains taxes from stocks are 15%, but if people retire rich, then their tax rate might actually be higher than 15% and their marginal rate might be over 20% as they withdraw money from the account. Since they deferred taxes by investing into a 401(k), once they withdraw money during retirement, they will not be able to pay the lower capital gains tax of 15% on their 401(k) profits. Instead, he/she will be forced to pay taxes on all the money they withdraw at the higher income tax rate.
#2 Investing in a 401(k) decreases your returns since you cannot invest using leverage.
Unlike investing in real estate, where people can use leverage in the form of a mortgage to purchase more homes or investing in a business where people can use debt to purchase equipment or leverage their time by hiring employees, a 401(k) doesn't offer that flexibility. He states that it's much harder to invest using leverage inside of a retirement account and this limits the types of investments one can make and thus lowers the returns they could have otherwise received. The example he uses is the limitation on what real estate deals one can purchase inside of an IRA vs outside of one.
#3 Investing in a 401(k) decreases control.
Investing in a 401(k) decreases the control you have on your investment since there are so many restrictions associated with them. The government has many rules on how much you can put in it, when you can take the money out, and what types of investments you can make inside of it.
To summarize, he recommends against putting money into a 401(k) since it only offers temporary tax savings and has many negative consequences such as the three listed above. He states that those who are seeking to build wealth and permanently lower their taxes should instead invest in things like businesses, real estate, commodities etc.
What are your thoughts? If you still advise that people invest in a 401(k) (even when there is no employer match), what is your reasoning? How do we combat the higher tax rate, the government restrictions, and the inability to use leverage to realize higher gains? I understand that this email is quite long, but I would love to hear your thoughts.
Should You Skip Investing in a 401(k) in Favor of Real Estate?
This reminds me of a post I did in 2017, titled In Defense of the 401(k). I hope nobody thinks the title of this new post means I think real estate is a bad investment. I do not think that and have plenty of money invested in real estate myself. However, I also max out my 401(k)s.
It seems the tax-advantaged investing account is a frequent boogeyman for real estate investors. Like many of the arguments in this email, I think that's a little silly. Like I defended 401(k)s in 2017, I'm going to deconstruct the arguments, point out where they're wrong, where they're right, and where they're simply a half-truth.
Kiyosaki Is No Real Estate Authority
Let's start with the obvious, at least obvious to those who have been in the personal finance sphere for a while. Robert Kiyosaki wrote a best-selling book(s), but it was based on a lie and has been heavily, accurately, and appropriately criticized. Every Kiyosaki fan should be aware of these criticisms, probably best expounded by John T. Reed. Needless to say, once you read that, you'll be far more skeptical of anything and everything Kiyosaki says, much less his tax advisor. It's not that there is nothing useful in his books, but don't treat it like scripture.
Residents Make for Lousy Real Estate Investors
Let's go ad hominem (just a little). You're a fourth-year medical student and sent me this letter in November. Now I'm all for learning some finance and investing in medical school, but my recollection of November of MS4 was that it was all about matching into a residency position. You've already invested 7+ years into becoming a doctor, and have at least 3+ ahead of you. A career in real estate is very much a viable path to wealth, but it doesn't seem to be the path you are on. A typical resident has neither the time nor money to be a successful real estate investor and I worry that spending a lot of time on that goal would affect what I think ought to be your primary focus — becoming a good doctor. Tell you what, come back in a half decade or so after you have completed residency, paid off your student loans, and built up a little capital to invest and let's talk.
Seriously though, all a doctor has to do to become wealthy is learn to practice good medicine, live like a resident for 2-5 years after residency, save 20% of gross for retirement the rest of her career, and invest it in some reasonable mix of stocks, bonds, and real estate. That doc is highly likely to retire with the equivalent of a mid-7 figure portfolio today, which will provide a physician level of income throughout retirement. Anything above and beyond that is a bonus. Lots of docs have done just fine with real estate and I don't want to discourage you (probably couldn't even if I wanted to). It's great. But it's not a reason to hate on 401(k)s. There are many roads to Dublin. If you prefer real estate to stocks and wish to make your portfolio 80% real estate (the opposite of my 20% position), I think that's fine. If you want to buy one property a year after finishing residency, I think that's fine. But I see little reason to take an extreme position in the stocks vs real estate debate.
Real Estate Investors Don't Like 401(k)s
If the authors of all the books you're reading don't like 401(k)s, maybe you're not reading the right books, or at least not all the right books. If all the books you read say the same thing, you probably ought to broaden your perspective a bit. May I suggest a book or two from a Bogleheadish perspective? Maybe something that talks about the benefits of retirement accounts and index funds?
The Tax Advantages of a 401(k)
I've been surprised at the pathetic understanding of the tax code among many real estate investors. Somebody in some seminar or book somewhere told them that real estate is awesome for taxes and retirement accounts suck and they just believed it without actually learning how the tax code works. Let's talk for just a minute about the tax benefits of a 401(k).
#1 Tax-Protected Growth
The investments in the 401(k) kick out income and you occasionally sell something with a gain and buy something else. You don't pay taxes on any of that as it grows.
#2 A Big Tax Break
The second benefit is a big fat tax break the year you contribute to the account. In fact, this is the biggest tax break available to a doctor. My practice has offered a 401(k)/Profit Sharing Plan (PSP) ($56K in 2019) and a Defined Benefit (DB)/Cash Balance Plan (CBP) ($5-120K in 2019) allowing $61-176K to be protected from taxation. At my current 42% marginal tax rate (2019), that could knock as much as $73,920 off my tax bill once I am old enough for that $120K/year contribution. For each year I contribute. That's hardly insignificant, but wasn't even mentioned in your email and presumably in Mr. Wheelwright's book.
#3 Withdrawing at a Lower Tax Bracket
Another benefit is the opportunity to do Roth conversions or withdraw money in your lower income years. The idea here is to defer taxes from high-income years to low-income years. For most docs that aren't super savers, they're going to be able to withdraw or convert money at a lower tax rate than their rate at contribution at some future date. That might be as they phase out of their career. It might be in early retirement before they start taking Social Security or have to take Required Minimum Distributions (RMDs). It might even be in later retirement. Most docs drop a couple of brackets or more when they retire, so even if the brackets inch up a bit, they still come out ahead.
In addition, especially before taking Social Security or for someone without a pension or a bunch of rental income, they can use those tax-deferred withdrawals to fill the brackets. $24,800 standard deduction (2020)? That's $24,800 that comes out tax-free. Contributing at 42% and withdrawing at 0% is a winning combination. The next $50K comes out at 12% and nearly $100K comes out at 22%. Win, win, win. This dramatically trumps the benefit of the lower capital gains rate (which isn't always 15%, by the way. For me in my state, it's 28.8%. Lower than 42% yes, but not quite as awesome as it sounds, especially since it is also applied as the investment grows and not just at the end).
Okay. Maybe you're a super saver. You probably are given that you're thinking about this stuff as an MS4. You could potentially be withdrawing at the same or higher rate in retirement, especially with a lot of rental income. So is the answer in that situation to avoid the retirement account? No way. The solution is to make Roth contributions and conversions at every opportunity. Or is there something I don't know about investments never being taxed again that is bad? I can't think of anything. I mean, if you like the lower long term capital gains rate, you're really going to love 0%.
But wait, there's more. In most states, retirement account money is also protected from your creditors. While you'll likely never need that asset protection, it's nice to have it. Investments in your taxable account do not have similar protection. Sure, you can put a real estate property into an LLC, but that's not quite the same thing.
Okay, I think we've addressed your/Mr. Wheelright's first point.
What About Leverage?
It is generally true that it is easier to use leverage outside of a retirement account than in one. Brokerage firms don't allow margin to be used in a retirement account like you can use it in a taxable account. But there are plenty of situations where leverage can be used in a retirement account. You can buy a leveraged hard money loan fund with a self-directed IRA, for instance. You can even put equity investment property in a self-directed 401(k) and use leverage on it. Yes, Wheelright is correct that it's a significant hassle. But it can be done.
Now, I don't necessarily recommend you put investment property into a retirement account. But neither do I recommend you try to leverage up all of your investments. Leverage introduces additional risk, and it is a good general principle of investing that you avoid taking more risk than you need to take. Most doctors don't need to take on much leverage risk in order to meet their reasonable investing goals.
I think we've now addressed your/Mr. Wheelright's second point.
Are 401(k)s Inflexible?
There's no doubt that 401(k)s are less flexible than investing in a non-qualified account. That much is true. There is a price to be paid for those awesome tax and asset protection benefits. However, they're not nearly as inflexible as the typical real estate investor thinks. Consider all the possible exceptions to the 10% penalty for withdrawing money before age 59 1/2:
- Unreimbursed Medical Expenses > 7.5% of your adjusted gross income (which may not be that high if you’re retired)
- Payment for Medical Insurance
- Inherited IRAs
- Qualified Higher Education Expenses — for you, your kids, or your grandkids
- A First Home — for you, your child, or your grandchild
- IRS Levy
- Reservist Distribution
- Early Retirement via the SEPP rule
What exactly do you think you'll need to tap your retirement money for that isn't on this list? Besides, if you're such a super saver that you're worried you might pay more on withdrawal from a tax-deferred account than at contribution, you're almost surely going to have investments that are outside retirement accounts anyway.
In addition, you can borrow up to 50% of a 401(k) or $50K, whichever is less. [Editor's Note: The CARES Act of 2020 has temporarily changed this amount for those affected by the coronavirus and will allow withdrawal up to $100K without the 10% penalty applying.]
I think we've now addressed your/Mr. Wheelright's third point.
Another issue some worry about is lousy 401(k)s. Some 401(k)s have tons of fees and have lousy investments. Even in those cases, the 401(k) is probably still worth using. First, because you probably won't be in it for long before your employer changes it (especially with all the lawsuits going on against employers for neglecting their fiduciary duty) or before you change employers. But second, the overall tax break is so large that it will overcome even moderately high fees over the long run.
A Reason to Avoid a 401(k)
Can I imagine a scenario where it might make sense to skip a 401(k) contribution in order to invest in something else? Sure. This would be a situation where I either had very limited investment dollars or exceptionally large retirement account availability AND a particularly attractive investment that could not be placed into the retirement account. I mean, if you can buy a surgical center likely to provide 30% returns going forward, then you can probably justify skipping the 401(k) that year if you absolutely have to. But I don't think you should put all of your money into real estate, and if you're going to invest in stocks and bonds (and even REITs), you might as well do it inside retirement accounts and enjoy the tax and asset protection benefits.
401(k) Vs Real Estate — I Invest in Both
As you can see, while there is some truth in what Mr. Wheelwright is saying, it can be very misleading. You owe it to yourself to understand how a 401(k) works and then make an informed decision about it. I suspect that, like me, you'll choose to max out the 401(k) and then invest in real estate above and beyond the 401(k). You'll notice I haven't even talked about an employer match. I've never actually had one, but I've been maxing out a 401(k) (or two, or three) every year since I left residency. A match makes this all even better. A match is best thought of as part of your salary that you're leaving on the table when you don't contribute enough to the 401(k) to get it. That would be really stupid. I invest in real estate. I also have four 401(k)s. They don't seem to be slowing down my wealth creation one bit.
I invest in real estate. I also have four 401(k)s. They don't seem to be slowing down my wealth creation one bit.
What do you think? Would you skip a 401(k) in order to invest in real estate? Do you invest in both? Why or why not? Comment below!