Wondering if you should invest in a 401k or real estate? This reminds me of a post I did in 2017, titled In Defense of the 401(k). Real estate can be a good investment. In the 401k vs real estate “debate”, my answer is both. I 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 found on the internet and in real estate investing books, I think that's a little silly.
Should You Skip Investing in a 401(k) in Favor of Real Estate?
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.
Kiyosaki of Rich Dad, Poor Dad 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.
Medical 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
- Disability
- 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.
Bad 401(k)s
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) and Consider Real Estate
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.
If you are interested in learning more about real estate I recommend checking out WCI's No Hype Real Estate Investing course. It gives potential investors the foundation they need to learn about all the different methods of real estate investing. If you are not sure how to get into real estate, this course is a perfect starting place.
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!
While I follow this blog, enjoyed and read your book, I found your tone towards this student condescening and unnecessarily arrogant! One to one comparison of real estate vs IRA investment is a fair question I still debate in my mind and have elected to do both…. Tone down a little doc
Tone is always tough to get right, so apologies if it came across wrong. I’m not a taco; I can’t please everyone.
You also don’t have the benefit of seeing the rest of the exchange that went on for a few emails (and continued today after she saw this post) or even her entire email. I don’t think the student feels mistreated at all, so don’t worry too much about that. She can chime in in the comments if she wishes.
[Ad hominem attack deleted] So what it’s a little “edgy”. He gave constructive criticism that was written with some personality so it wouldn’t be boring to read. It’s sad people [Ad hominem attack deleted] get offended at something so trivial, [Ad hominem attack deleted]
Hmmm. Calling someone Snowflake. I think you seem more offended and please off with ad hominem attacks “Truth hurts”
I disagree with you, I think the tone Dr Dahle takes reinforces the prioritization of means through which doctors build wealth. The classic invest vs pay down debt debate. Unless real estate investing on a resident salary would yield income that offsets accruing interest on student loans and other liabilities, you might end up burning the candle at both ends. Realism and rationalization are fundamental to living and investing within one’s means.
its his blog not yours. who cares if you dont like his tone.
I think it is an interesting question. Real estate does have some major tax advantages to it, though I am not really involved in it at this point.
I do think this is a bit of a false-dichotomy, like you said. We don’t have to choose between real estate and a 401K. Why not do both? More diversification is usually a good thing, particularly if the real estate market doesn’t correlate with the stock market (though we saw that isn’t always true in 2008/2009).
Also, one major thing that real estate provides that a 401K doesn’t necessarily until 59.5 is passive income flow each month. I think you can achieve financial independence by getting to “your number” as a nest egg or through steady passive income flow. Investing in a 401K and real estate gets you a bit of both, and this “hybrid” model of financial independence is what I support. That passive income stream will help a lot if a bad sequence of return rears its ugly head.
Either way, interesting question.
TPP
Having “gotten to my number” both ways, bear in mind that it takes a lot more money to get there through passive income low, thus waiting until your passive income equals your expenses by definition means you are oversaving. That’s fine, it’s your money, but realize none of us are immortal and it is okay to spend some principal in retirement.
Completely agree. That’s why I take the “hybrid” approach I was alluding to. I want to get to financial independence using both savings/investing and passive income. I think they can work in a synergistic fashion.
I definitely plan on spending capital in retirement 🙂
TPP
Jim you touched on the great point that there is potential tax arbitrage for an attending who is contributing to a 401k and a higher tax bracket (in my case always the highest) and decades down the road can plan it to take out in a lower tax bracket. I feel that trumps the perceived loss of capital gains tax vs income tax difference mentioned. It swings it even more in favor of tax savings now via 401k contribution because today’s dollars will be worth far more than future dollars when you factor in inflation. So we are keeping more valuable dollars today by contributing to a retirement account and deferring taxes to hopefully a lower tax bracket which is a win win in my eyes.
The one thing that will be available to this particular individual that will quickly be phased out due to income is ROTH contributions. I would advise to fill up that bucket first because as a resident you will be contributing at a relatively low tax bracket and everything in future comes out tax free. I wish I had taken advantage of it while my income allowed me to qualify.
As far as real estate, I find it to be a great component of m portfolio and like you have both real estate and retirement accounts active to help diversify my portfolio.
You know about the Backdoor Roth IRA, right? The Roth IRA door doesn’t shut when you hit attendinghood.
True. But the beauty of the ROTH diminishes markedly at the higher incomes as now my contributions are after tax contributions with a 37% chunk taken out of it. In residency might be looking at 15-20% tax hit you pay now. So the tax arbitrage diminishes dramatically at higher incomes.
I also want to make a word of caution in terms of employee matches especially during residency programs if they are offered. Most require a vesting period that is conveniently longer (for them) than the residency. My training program had a vesting of 5 years (which I hit because of 5 year radiology training), but if I was in internal medicine, etc at 3 years and left, I may only have gotten 40% of the match (of course all my contributions are mine to keep regardless of when I left). But it is a point of consideration for 401k match investing for residents.
No it doesn’t. It might be worse compared to a tax-deferred account, but that isn’t an option for your IRA. It’s either Roth or taxable. So Roth is still great.
Your argument only works when there is a tax-deferred account available. Like when you are comparing traditional to Roth 401(k) contributions. This is not the case with the Backdoor Roth IRA. Since you don’t have the option to deduct a traditional IRA contribution, the Roth IRA is still a great deal. Because the only other option is a taxable account or a non-deductible traditional IRA. Roth IRA is way better than both of those.
That’s a dirty trick with the match, but I have seen it before. I don’t know that it is done on purpose, but it is very real none the less.
I was not paying enough attention when I started reading the post this morning. I thought this was a guest post. I only read the first 1/3 before my kids got up and I had to stop. I kept thinking that WCI is off his rocker. Why would he distribute such bad advice to his readers. This is so much different then the typical advice. Then I picked up where I left off and realized my mistake. Sorry for my temporary doubt 😛
It was a long “Q” section wasn’t it?
You need to warn us when linked material is that long…that roasting of Kiyosaki kept on going and I lost half my morning!
A lot of effort went into that eh?
Kiyosaki and all of his advisors hate retirement accounts and favor real estate. I have both real estate and stock market investments and do own apartments and single family rentals in a SDIRA. Is it more difficult to get loans for property in a SDIRA? Sure, but doable and prudent leverage is a huge advantage on investment returns. In my opinion the average doc is best advised to have the property professionally managed as that is not his/her expertise and a doc’s focus is better placed on the practice. My retirement income is from the real estate and I shouldn’t have to touch the stock portfolio until I may need to for RMDs. I feel balance with non-correlating assets is safer for long term results.
Interesting. To be fair, I’ve met more retired people who would much rather own 10 $1million homes (paid off) each generating $5-7k every month in rental income, than owning a $10million 401k portfolio that’s entirely in the hands of portfolio managers. When it comes down to it, Uncle Sam is going to take a piece of our pie no matter how we slice it, but real estate comes with greater tax advantages.
This is great for the intended target audience (professional clinicians, lawyers, etc.), but for those with very different outlooks in life (active investors/entrepreneurs)- some argue that they carry a greater advantage in real estate investments over 401k, given the leverage, risk control, and autonomy over their property/business.
Who wouldn’t want $10M post-tax instead of $10M pre-tax? I would. But $10M in taxable invested in rental property or $10M in a Roth IRA invested in mutual funds? I’d take the second, thank you very much. Worst case scenario, I pull it all out and invest it in rental property and I’m no worse off. Best case scenario, that tax and asset protection extends for decades into my heir’s life.
The net profit you may obtain with what you do with real estate may be far greater than how much your pretax dollars in a 401k is appreciating. To those physicians, with an investor/entrepreneur mentality, may find real estate to hold more value because of its tangibility, scalability, autonomy, and the potential of greater reward at a controlled risk.
In a 401k, you hold less control over your money. Pretax, who cares? Take inflation, management fees, expense ratios, and the fact that portfolio managers can not outpace the passive growth of the SP500, into consideration and your pretax dollars will start looking taxed. So not only do you have less control over what can be done with your money, but you may be losing optimal ROI. At that point, some might argue that you would be better off putting your post-tax dollars into the passive SP500 index, and not give your pretax dollars into the hands, and pockets, of a 401k portfolio manager.
Your heirs could benefit from real estate as well. In fact, Some would much rather give their child 10-fully paid-off $1M homes appreciating in value and generating income, than a 401k fund.
Just my thought
Sure. It could also be less.
Indeed, but it’s profit, nonetheless? This is the variation in mental outlook that is the basis of RKs book, which many educated professionals, like myself, tend to not have. I’m no RK fan, as I tend to take a hybrid approach, but to give credit where it’s due: at such late stages in life, the mindset of having net profit is always advantageous over having no profit, regardless of appreciation gains. A question of “how long will I last with what I have left in my 401k, and how are taxes going to alter my outcome”, is a question typically asked infrequently by those retired on RE.
real estate is likely heading for a correction, based on all the interest : )
Believe that tax advantaged accounts should take precedence over real estate investing
However real estate could be utilized in stead of taxable investing(with possible higher returns and tax benefits) – with the caveats the real estate is local and you need to have some real estate investing knowledge and that it can be part time job depending on how one structures their real estate portfolio.
One other point that WCI has said before but bears repeating: Real Estate SHOULD pay better – it is actual work compared to index fund investing. RE is an inefficient market where you can spend time to develop special skills or knowledge to get an advantage. However I personally didn’t have that time in residency.
Armydoc is correct. The best way to make $ in real estate is buy a “value add” property where you can make gains via better management. We now have an apartment under contract that has been self managed by the seller and the rents are 20% below market. Another we took over in 2007 was badly mismanaged and is now 250% more valuable than when we bought it and cash flows well. It takes work but the rewards can be awesome.
I agree real estate is not a very efficient market and those who can buy, manage, and sell well can add value while those who do it poorly will subtract value. The smaller the properties and the less professional the average investor in that market the larger the effect.
Oh boy. The average question is from someone who is looking for an introduction to personal finance and hasn’t read any finance-related books yet. Based on this question, it seems that reading the wrong personal finance book is worse than having read none at all. I cringed when I saw the Robert Kiyosaki’s book mentioned.
I don’t think WCI was too hard on him at all. As mentioned in the post, there’s nothing wrong with investing in real estate AND a 401k, but real estate is ultimately a higher risk/reward investment and an optional asset class.
It’s frustrating how often the “lower” capital gains tax line about 401(k)s is rolled out. You’re right about bracket arbitrage, but the bigger point is that, mathematically, taxable accounts are hit by both income tax and cap gains. 401(k)s are only income tax. By avoiding a 401(k), you’re not swapping regular ordinary income tax for cap gains, you’re incurring both!
People get confused by the timing, characterization of a portion as “gains,” etc., but the math is simple:
Pre-tax retirement accounts: Value = (initial cash * growth) – (initial cash * growth * ordinary income tax)
Post-tax retirement accounts: Tax burden = (initial cash – (initial cash * ordinary income tax)) * growth
The mathematically minded readers will recognize that due to the distributive property of multiplication, these are identical. The only way to win is to complicate things by fiddling with the income tax rate–the arbitrage example given above.
But compare this to post-tax accounts, where:
Value = (initial cash – (initial cash * ordinary income tax)) * growth – (cap. gains tax on growth)
If you accept that pre- and post-tax treatment is the same (without fiddling with the income tax rate), then it’s easily seen that the cap. gains tax on growth of a taxable account is simply an additional drag on taxable accounts relative to tax-advantaged accounts. You’re not saving any money at all.
Invest in your tax-advantaged accounts people.
Brilliant point – missed way too often. Obviously depends on “401K growth” vs “RE” growth, but everyone forgets that the initial investment amount is lower (post-tax dollars) if outside of the 401K.
also – nail down all the other financial fundamentals (insurance, written plan, cash reserve if you believe in one, primary career learning) before getting too much in the weeds.
So this is an interesting discussion to have. Many make this mistake but the reason why is subtle. The argument works when you are discussing an annuity vs a taxable account. In that situation you are weighing the value of the tax-protected growth against the value of paying on the gains at a lower rate instead of your ordinary income tax rate. With enough time, the tax protected growth usually wins out but with a very tax efficient investment it is possible to never come out ahead with the annuity.
The 401(k) versus taxable is a different situation, however. The gains coming out of a 401(k) are not taxed. Now bear with me here so you understand what I am saying. In a situation where you save 37% going in and pay 37% going out, what you essentially have are two accounts. One account is yours, the other is the governments. Your account is essentially the same as a Roth IRA where the gains are not taxed at all. The government account grows at the same rate as your “Roth IRA account” but all goes to the government in the end. So it looks like this:
You earn $10K at your job. Let’s say you’re in the 50% tax bracket and always will be. In situation 1, you put that $10K in the 401(k), no taxes are paid. It grows and grows and grows and two decades later is worth $40K. You pull it all out and pay $20K in taxes and are left with $20K.
Essentially it is like you had two accounts- your $5K account and the government’s $5K account in the beginning and your $20K account and the government’s $20K account in the end.
Alternatively, you could have just invested it in the taxable account. However, you must first pay taxes. So you invest $5K in the taxable account. It grows a little slower due to the drag from the taxes on dividends and capital gains distributions an after two decades is now worth $18K. Plus, you have to pay capital gains taxes on the $13K in gains. Let’s say that’s another $2K. So you’re left with $16 instead of $20K. That’s the value of the using the 401(k) even without a match or any tax rate arbitrage.
Hope that helps.
I am glad you put it to words. I knew that the benefit existed but this clears it up so much. It is hard to clarify this point when someone uses the argument that their taxes will be the same in retirement. Even tho that is unlikely for most.
The only other factor is fees. I would hope in most taxable accounts people are using very low cost funds. If you use your example above and compare a taxable with very low cost to a 401K with only high cost funds or a high management fee that might negate the tax protected growth. It would have to be some awful fees to make that much of a difference so this keeps with your point that maxing tax deferred accounts during peak years.
Yea, run the numbers. We’re talking 2%+ or over a decade before it’s really worth skipping the 401(k).
RE is powerful in the right hands.
1. Leverage: Yes it cuts both ways. Folks who don’t overleverage do well. Learn to use it not be afraid of it. This effectively eliminates majority of physicians (more worried about debt pay off, which is fine, but the psyche and skills don’t match risk taking)
2. Control: Understanding banking, interest, refi, cash out, flip easily puts your RE returns in 18%+
Arguments can be made about how “passive” this can be, but with practice, it is fairly passive. Read white.beard.doc posts if you don’t trust a “newbie”.
But yes, don’t skip 401k. Thats not smart. However, it is possible that if I didn’t have matching or employment as a doc, I may have skipped 401K and gone all RE and down the road from the RE business MAY have done solo-k. The returns are just greater in the way RE is done the way I know. Also there is not tax arbitrage for me: I’ll be in high income bracket even if I quit medicine the way things are.
Still, for vast majority of employeed or PP partner 401K the benefits of matching (free money) can’t be ignored.
I don’t think 18%+ long term returns should ever be called “easy” and I think most experienced real estate investors would agree with me. Possible? Sure. Risk free? Nope. Easy? Certainly not.
Nothing is risk free.
WCI network isn’t risk free yet it comes “easy” to you.
Investing passively in RE you can earn 8-10% so not much different than your 401k
But with your own property you gain control of financing, leverage, etc to boost returns. 18% would be low end actually.
At 18%, investing $50K a year for 20 years and then letting it ride another 40 would give you $200M. Given how many doctors I know worth $200 Million, I’m left to conclude that 18% is not easy. If you can reliably get 18%, you should be gathering assets like a madman and scaling up.
Ha! The good old if you can do this become an asset manager. This is possible on smaller capital and so far it’s 20% for me but I can’t sustain it at larger capital as deals don’t come by and you hit a break point at financing.
Btw that’s exactly what these sponsors are doing – using OPM and skimming off fees while taking much less risk.
What you are talking about is static 50k per year…RE deals in CRE aren’t 50k but much larger capital at stake.
Still since you mentioned , I do have other people’s money …that is the reason I have boosted returns. Don’t I can scale but I’m growing that way.
Btw I’m just showing what is possible with RE and realistic. More realistic than starting another WCI. Doctor’s usually don’t have the skills or tempremant to pull this though and hence…stick to 401k.
Another thing as a counter point to 401k is that it’s locked sans penalty. In RE – like any business – you can move money. Not an apples to apples comparison but something to consider.
Surely you could do it with $100 million though. That’s not that much is it?
My point is you probably can’t sustain this over the long run. Congrats on your success, but please don’t make your financial plans dependent on sustained 20% returns. You are likely to be disappointed.
That’s a dumb counter point too. There are many ways to get to 401(k) money prior to age 59 1/2 without paying the penalty and there are significant liquidity and transaction costs involved in getting to money in real estate. You can do better than that.
I was trying to make a point of how RE with direct ownership coems with higher returns. Stock market may or may not sustain 7% … I may or may not do 20% in my RE business but I can assure you my overall portfolio is not jsut RE , it’s small businesses and RE and I’m confident I will sustain 20% and more on that for a looong time. I can’t tell you if you can sustain WCI success, similarly you’d be dissapointed that I won’t be disappointed in my success. We both know what our business can and cannot do.
Those methods of getting prior to 59.5 is getting it at what like 55 on equal payments or loans from 401k that you have to payback ? Big whoop. Something few people use or want to do. You are locked till 55 let’s say or else pay penalty. RE can lend it self to leverage and banking from it that allows cash out and money movement you cannot do with 401k. It’s difficult to show or explain to passive RE investors but it’s alright. I’m not here to do a tutorial. Seasoned RE businessmen are essentially walking banks. Not a “dumb” counterpoint. It’s very real.
I am not a real estate investor because my understanding is that if you want returns that good(18%) you need to be quite skilled (which I am not) and spend a lot of time(which I do not have). I do not need another job managing property. I am looking for passive investing. Just keep shoveling into VTSAX. I would be psyched with 7% over the next 20-30 years. It would easily allow me to achieve my goals.
Also I have no liquidy issue. I can pull from my 457 whenever I leave my employer and from my brokerage anytime. Most that are planning on early retirement should have planned a way to have accessible money. Other wise they are poor planners.
You can invest more passively in real estate, but you have to pay someone to do that work which lowers returns all else being equal.
Real Estate investor
I’ve been a real estate investor for 20yrs exactly and am now 43yo.
Here’s the problem 401k people keep missing. Real estate has INCOME while 401k Has 0 Income.
THATS THE PROBLEM!!!!
I’m 43yo and am earning $180,000yr solely off of real estate income. In which I’m netting over 130,000 and am no longer working.
A 401k could never and I repeat never retire me at 43yo with that type of income. Instead I would make $0 in liveable monthly income and would have to wait until I’m a geriatric nearing death or age 59 1/2 to hopefully live off money from what was saved. By the time I reach 59 1/2, there no telling how many millions I would have made and spent as a young man while having the millions in equity to go with the crazy cash flow.
INCOME , INCOME and Financial Freedom at a young age comes through real estate not 401k because there is NO INCOME!!!!
Great example of the mistakes one makes when they don’t know about the exceptions to the age 59 1/2 rule outlined here:
https://www.whitecoatinvestor.com/how-to-get-to-your-money-before-age-59-12/
I can also introduce you to a lot of 59 1/2 year olds who would feel insulted to be called “geriatric”, especially since most feel that term only applies to AT LEAST 65+ and most “geriatrician patients” are 70-80+.
Income and assets are fungible as discussed here: https://www.whitecoatinvestor.com/the-pros-and-cons-of-income-investing/
The last thing I need right now is more income.
I agree higher returns are possible when you pay no fees to anyone else. Risk and hassle also higher of course.
Be sure, of course, to count the value of your time into the equation when calculating returns. Lots of real estate investors fail to do this.
I think you’d benefit from reading this post about exceptions to the 59 1/2 rule:
https://www.whitecoatinvestor.com/how-to-get-to-your-money-before-age-59-12/
Basically, you can do the SEPP rule at any age. You could start at 25 if you wanted to.
But anyone who has enough money to retire before 59 1/2 probably has a significant taxable account anyway.
There are many paths to a successful retirement plan. My father was a self-employed dentist in SoCal, but his passion was real estate. So much so that he obtained his real estate license, and eventually his brokers license. He loved to develop commercial and multi-unit apartment buildings, allowing him to retire at 55. He has lived off the rental income for the past 37 years, and actually continues to generate savings in retirement. However, it was not without significant stressors, with an occasional deal gone bad. And, it was a lot of work. Kiyosaki would have been proud of him.
We took the opposite path. As two employed physicians who maxed out 403b, 457, and 401a accounts, in combination with state pensions, we also can retire comfortably at 55. Kiyosaki would be disgusted with us. I don’t think it matters which path you choose. Just don’t dabble at it.
Good advice. Many roads to Dublin. Good warning about dabbling too. If you’re only going to dabble in real estate, you’re far better off with a passive option like the Vanguard REIT index fund or a private real estate fund or teaming up with a good syndicator etc.
You wrote: “Most doctors don’t need to take on much leverage risk in order to meet their reasonable investing goals.” I think this about sums up the philosophy difference between doctors and (some) real estate investors on this.
Of course Kiyosaki was a BS artist, but interestingly John T Reed himself agrees w/ him on the Pension Fund=Bad thing. Reed himself has no 401(k)s etc. They both give the same reasons, and in addition Reed emphasizes the threats of hyperinflation/deflation wrt such a centralized system.
As high-income professionals, we can afford the luxury to invest rather conservatively if we like. I think many beginning real estate pros/investors have less to invest and so feel the need for more leverage and more flexibility w/ what stash they do have. And Kiyosaki’s arguments might make more sense for someone in that context. But I agree, 401(k)+CBP is great for all the above reasons as well as one real simple one: it forces me to not touch my money for a decade or more. If I could touch it I’d probably spend it or lose it somehow.
BTW, my absolute favorite post on the math behind all this that completely convinced me to max out my pretax space:
https://www.madfientist.com/traditional-ira-vs-roth-ira/
Reed has a few wacky, conspiracy theorist ideas too for sure. Like anything, take what you find useful from Reed, Kiyosaki, this blog etc and leave the rest.
I agree that leverage is a risk that is more worth taking when you have less/make less.
nothing could be easier than becoming wealthy by passive long term investing in a d iversified portfolio of index no load mutual funds
almost a guarantee of wealth at age 65-70 with very very little time and effort
why take on the risks of RE and all the time and problems
It really comes down to philosophy about how you want spend your time and mental/physical resources. Some don’t want to bother with real estate, whereas I like it and it’s become my retirement “hobby” plus I love having the tax advantaged cash flow that keeps me in a lower tax bracket. I also am loathe to sell assets to live in retirement. You have to sell index funds and “cannibalize” the asset to live so you have less and less assets over time.
Not a fair characterization. Even spending principal, so long as you do it at a reasonable rate, you are likely to have more and more assets over time. SWR studies show that on average people die with 2.7X what they retired with when following a 4% withdrawal rule. That’s hardly “less and less.”
I mean, you’re fine to only spend income, but that means you left a lot of money on the table that you could have safely spent to make your life better. It just means you’ll leave more behind to charity and heirs.
I agree index fund investing is easier than doing real estate right. The main reason one would take on real estate investing are for potentially higher returns, low correlation with a stock and bond portfolio, some unique tax advantages, and the fun of owning stuff you can put your hands on.
Since we’re discussing 401k I figured i’d ask this question: What is the difference between a solo 401k and an individual 401k? How much are you allowed to contribute to either one? Thanks
It’s the same thing. Max contribution is ~55k combined I believe.
$56K this year. Solo = Individual. Two words for the same thing. Also sometimes called a Self-Employed 401(k), an i401(k) or even a self 401(k) or even a self-directed 401(k) (although that last one has a slightly different meaning, they’re usually also individual 401(k)s.)
Oh ok. I saw a post somewhere that was comparing the two so I was a little confused. If you currently have a 401k from your employer, leave that employer and open a solo 401k after starting a locum tenens gig where you receive a 1099, would you recommend moving the your 401k money from the former employer to the new solo 401k?
Sure, why not? You probably get lower fees and better investment options. If nothing else, you only have to manage one account and not two.
I did keep one of my old 401(k)s though, the federal TSP. With its rock bottom prices and the unique G fund, it was worth the additional complexity to me.
If a High Income Investor (HII) knew they could lose up to 40% of their investment to fees and taxes, would they invest in a 401k?
If an HII knew that, over time, all-in 401k fees could eclipse an employers 401k match, would they invest?
If an HII does not want the following in their wealth building portfolio, why don’t they have what they want?
– High taxes
– Excessive fees
– No guarantees
– Legislative risk
– inflation risk
HIIs demand the following when investing:
– Control
– Certainty
– Consistency
– Clarity
How does a 401k offer any of the four C’s? Of the four C’s, a 401k can only offer certainty and consistency. A certainty in paying high taxes and consistently paying fees that, over time, may exceed the HIIs contributions.
Additionally, the medical student states, “My goal is to build wealth, pay back student loans, and establish financial independence.” How is this student going to build wealth when the interest paid on his debt is greater than the net return on his 401k?
You’re trolling, right? “Lose up to 40% of their investment to taxes and fees?” First off, you’re paying income tax when you invest anywhere–it’s not like investing in RE “saves” you a ~40% tax bite. And fees? Mister HII, open a solo 401(k) at Vanguard and put all your money in VFIAX. Total cost? $20 a year.
Taxes are lower than any comparable investment, since you’re always going to pay income tax one way or another. Of course there are “no guarantees”–you want guarantees, open a savings account. I bet that the S&P500 companies are just at good at finding ways to beat inflation as real estate. (Don’t like it? Invest in a REIT ETF!). As to legislative risk, the 401(k) is literally the most widely used investment vehicle in the country. I would bet tax laws go after real estate way before 401(k)s.
If you don’t think a 401k gives “the 4Cs,” get a better 401k.
(And yeah, if you’re paying high interest on student loans, pay those off first.)
Are we buying diamonds here? 🙂 I thought the 6 Cs were Cut, Color, Clarity, Carat, Certification and Confidence.
It’s totally misleading to characterize 401(k)s as “losing 40% of their investment.” Even if you are in the 37% bracket at contribution and at withdrawal (rare for most docs), you got the same deduction up front that you paid in taxes at the end. It’s like 63% of the money is really yours and 37% is really the governments that they allow you to invest for 30 years on their behalf. If you buy real estate outside of a retirement account, you do so with after-tax money. That’s a silly argument.
As far as the 4Cs, I’m a hgh income investor and I require neither control nor certainty from my investments. Consistency is nice, but I’ll even give that up for a higher long term return. Clarity? I have similar clarity in my retirement accounts as my taxable accounts and in my stocks, bonds, and real estate. So not sure where you’re going there.
The 401(k) is useful even without a match (I’ve never had one), but I agree that minimizing fees is an important aspect of all investing, qualified and non-qualified accounts, stocks and real estate.
Tax, legislative, and inflation risk are concerns of both stock and real estate investors. No difference there.
If you knew that you would get back less than what you put into an investment, would you invest?
Just like any other investment, an investor wants to get back more than what they put into their investment.
When employees 401k contributions, all-in fees, and taxes on the distribution are added, the employer match and stock market gains will have a difficult time equalling or exceeding the aforementioned Cap Ex, Fees and Withdrawal Taxes.
Would you invest not knowing how much of a tax bite you may incur when you sell or liquidate your asset?
Smart investors want to know or control the amount of tax exposure they may face down the road. You cannot do that with a 401k, but you can have more (not complete) control of this issue with RE. The whole idea of investing is to limit the downside (taxes and risk), and keep more of what you make.
I disagree that fees in a 401(k) are likely to wipe out the tax advantages. If you want to count the taxes at withdrawal, you must count the taxes at contribution.
If you’re really worried about future tax rates, then do Roth contributions/conversions. But don’t skip out on using it at all unless you have a very attractive investment that you can’t put in there.
Don’t disagree. Know for sure. For starters, run a cost-benefit analysis only on the accumulation side. It only gets worse on the decumulation side.
Question – Would you go into business with someone that does not put up any seed money or additional funding, is not involved in the day-to-day operations of the business, and yet demands a large share of the profits when you sell? How is a 401k any different?
Fact: Tax deferral does not mean No Tax. Tax deferral means that your contribution, employer match, and any market gains are subject to the internal compounding effect of taxes. In short, a 401k plan takes an investment that would be taxed at capital gains tax rates and turns it into an investment that will be taxed at ordinary income tax rates. Perhaps 401k plans should re-named as Tax Delayed Plans and Not Tax Deferred Plans.
At the end of the day, there is only one 401k question that needs to be answered—Will you get back more than what you put in? All of the other analytical gymnastics are secondary because of the assumptions used to support 401ks.
No it doesn’t. You’re misunderstanding the math. Think of a 401(k) as two pots of money, one yours and one the governments. With a tax rate arbitrage, you get some of the government’s money. But even if there is no arbitrage, you’re not paying anything in taxes from your pot.
Yes, I fully expect to get more out of a 401(k) than I put in on an after-tax basis. Probably much more. But that by itself doesn’t make it a good idea. It’s important to do at least an analytical cartwheel so you understand how the thing works.
I can’t figure out what TonyO is selling, other than bad math and willful ignorance.
Many physicians in a practice can create very large tax deferred savings especially if they are self employed.
401k $56k
HSA $7k
Backdoor Roth $12k for MD and spouse
If a doc is making $300k that is a 25% savings rate
Some can do defined benefit plans worth over $100k/yr
Some can put their spouse on the payroll and defer more in the spouses 401k.
When you add it all up one can find their tax deferred options to take up all of their savings. In this scenario if one was to start investing in real estate would you recommend cutting down on the tax deferred investing to make room for real estate?
“With a tax rate arbitrage, you get some of the government’s money.” Your argument makes sense if an investor participates in 401k while in a higher tax bracket and takes distributions while in a lower tax bracket. However, it does not make sense to contribute while in lower tax bracket and take distributions while in a higher tax bracket.
With the current workforce-to-aging population trends, pressures from social security expenditures, unfunded wars, and other unfunded government (taxpayer) liabilities, where will the money come from?
I agree if you are contributing in a lower tax bracket and taking distriubtions in a higher one that tax-deferral is a bad idea. One should do Roth contributions/conversions in that situation or avoid the retirement account completely.
Where will the money come from? Probably mostly inflation, the stealth tax.
Say for a current resident with no debt, making 50-80k/year, with no 401k match, and anticipated future retirement income higher than current income, is it likely best to hold off putting funds into a 401k until becoming a higher earner?
Thank you.
Roth would be great in that situation. Also if you had a better place to use your money like paying down loans. If there was a match though I would at least get that.
Why not use the Roth 401(k) or convert to Roth as soon as you walk out of residency. Do a Roth IRA too and a spousal one if eligible.
Thoughts on RE vs 457? I know, a little redundant but when you max out the other tax advantaged accounts and you like the idea of “buying one property a year” …which I’m trying to do in cash… Which way do you stear? Or does it matter if you still end up in Dublin?
A 457 is a little less attractive than a 403b or 401k. Ideally, you can do both. If you really have to choose, it’s a tough choice.
@ Complete_Newbie – “Investing passively in RE you can earn 8-10% so not much different than your 401k.”
Are your 8-10% 401k numbers reflecting the performance of the fund or investor returns?
@ Bryan – “You’re trolling, right? “Lose up to 40% of their investment to taxes and fees?”
Since not every 401k investor invests in index funds, I suggest that you consider the following research paper in the Financial Analyst Journal, Volume 70.Number 1 @ 2014 CFA Institute: The Arithmetic of “All-In Investment Expenses, John C. Bogle. The author of this paper, the late John C. Bogel, says;
“Here, costs (including taxes) consume 43% of the returns for the active funds, compared with 5% for the index fund. “
That’s an indictment against high load, high fee actively managed funds, not a math-based argument against against using your 401(k) with low cost index funds.
Seriously, make a math-based argument with specific hypothetical numbers for why real estate investing is better than a traditional or Roth 401(k) contribution.
I appreciated your description of how the progressive tax applies to retirement withdrawls. For someone who is both a high earner and a high saver, they are still likely to get a tax benefit from the 401k. For an MD making $600k, every dollar that goes into retirement gives them around a 40% savings on their current tax bill. If they have enough in retirement to take out $600k/yr from that 401k, the effective tax rate based on the current tax structure is guaranteed to be far less than that–even without deductions because the first 250k is taxed at a lower rate. Of course, we can’t predict what major changes there may be to tax law between now and retirement.
There was a post a while back in which you described a 401k as essentially being two accounts in one–60% which you invest for yourself and ~40% which you invest for the government. In this way, the 60% functions almost like a Roth IRA in that it grows tax free. The 40% that would have otherwise gone to taxes now also grows tax free but a portion (most) of it will ultimately go back to taxes. Applying this understanding of a 401k, I fail to see how paying the ~40% taxes now and investing only the 60% gives any benefit at all. Using the OP’s reasoning, you pay 40% taxes now and invest only 60%. You then have to pay 15% (minimum) capital gains taxes on the money you’ve already paid taxes on.
Real estate investing using debt in which you can claim depreciation and take out tax-free loans makes sense but is a different ball of wax and doesn’t take away from the benefit of a 401k.
My wife and I put $112k/yr in a 401k and I wish I had even more tax-deferred space.
Two things:
1) The leverage in real estate is not really leverage. It comes with a set of assumptions.
a) you will be able to find a tenant.
b) You did not include the maintenance costs which fall on you as a landlord.
c) Liability costs – tenants, property.
d) Time involved in managing the property.
e) Real estate is a depreciating asset
f) If there is a boom in a market, be extremely cautious because it will be followed by a bust as the affordability will go down and so will your ability to find a tenant for the property.
g) Your down payment is ‘stuck’ in a fixed asset. To me, that is no longer your money because you do not have immediate access to it.
Lastly, one does never really ‘own’ real estate. The land is owned by the local government. You pay taxes on it.
For these above reasons, I stocks would win over real estate. Stocks (index funds) require minimal work, and over 30 years (length of a mortgage), if you had invested 100K and left it vs. 100K as a downpayment, you would find that you would get a higher return compared to a property.
I don’t agree that one needs immediate liquidity for it to be your money. Even my stocks and bonds require a couple of days to be turned into the green stuff.
Those issues you list are real issues with real estate, but they have nothing to do with whether it is levered or not.
I mean one or two days is not the same as possibly 6-8 months, or selling at a loss. It’s funny all the proponents talk about how amazing real estate investing is, but there are huge failures also…
In my spare time, I like to spend time with my kids- not worry about another property. Sometimes I find my own home to manage difficult with all the maintenance.
One demanding career isn’t enough of a challenge?!?
At least the person asking the question already has some RE background and RE mentors. For anyone else thinking about using real estate to fund retirement, be aware it’s a F/T profession for 2-3 years to learn enough to not hurt yourself too badly. It also isn’t a get rich quick scheme. 10-20 years is a reasonable timeframe to generate equivalent cashflow and equity vs. doctor income plus 401K portfolio income. I doubt even 5% of the real estate investors in my circle will even come close.
Conversely, it didn’t take me three years to learn how to invest in index funds using a 401K. 😉
This strikes me simply as a grass is greener outlook. Sign of the times, I guess since no one – much less a doctor about to become fully employed – would be asking this question in 2008 or in the following years. Diversification through REITs, private lending, etc. isn’t too difficult – actively acquiring and managing a significant RE portfolio is an entirely different commitment to generating wealth.