I’m on David Phelps’s email list. He’s a dentist who has freed himself from his clinical practice not once, but twice (there was a divorce.) He does this primarily by bringing in associates to work for him and investing his earnings in his real estate side business. The purpose of his email list seems to be primarily to pitch his “Mastermind Conference” where you meet with other dentists interested in freeing themselves from their clinical practice (which I actually think would be really interesting to attend, but haven’t had the chance yet to do it.)
There is usually a fair amount of hyperbole, hype, and appeal to emotions in the brief emails, so I’ve gotten a bit used to it. However, the latest one was a little bit over the top to the point where I thought talking about it in a blog post might be interesting to readers. Here’s the email in its entirety.
Let’s start by pointing out the falsehoods in the email, and then we’ll finish by pointing out some actual issues with 401(k) investing.
401(k)s Aren’t a Bad Idea
First of all, 401(k)s aren’t a bad idea. That doesn’t mean they’re the best possible option in every situation, but to paint them broadly as a bad idea is just foolish.
Second, “financial advisors” (typically salesmen masquerading as financial advisors) don’t typically recommend investing in a 401(k) because it is not money they can control and make commissions off of. In fact, real financial advisors being paid an Asset Under Management fee might not even advocate for them if their definition of assets doesn’t include the 401(k), but most of them will if they take their fiduciary duty seriously.
Third, your 401(k) money is neither safe, nor useless. 401(k)s aren’t investments. They are an account in which an investment can be held. The investment itself is either safe or risky or somewhere in between. The account has nothing to do with it. The money is not useless. It is being invested to meet real future financial goals. If useful means “I can spend it today without taxes, expenses, or consequences” everything outside of a banking account is also useless.
Fourth, your money is not locked away until you’re too old to enjoy it. This seems to be an odd way to refer to the Age 59 1/2 rule. Let’s start with the fact that I know plenty of people in their 60s, 70s, 80s, and 90s who are “enjoying their money” just fine. But beyond that, the age 59 1/2 rule has so many holes in it that you can drive a truck through it. Check out some of the reasons you can use to pull money out of an IRA (to which a 401(k) can be converted as soon as you leave the employer providing it) without paying the 10% penalty.
- Unreimbursed medical expenses > 7.5% of your adjusted gross income (which may not be that high if you’re retired)
- Pay for medical insurance
- Inherited IRAs (if your father leaves you his IRA, you can take out the money before you get to 59 1/2)
- Qualified Higher Education Expenses- for you, your kids, or your grandkids
- A First Home. Keep in mind the IRS definition of a “first home” is that you haven’t owned one for the last 2 years. Also, it doesn’t have to be YOUR first home, it can be your kid’s or grandkid’s first home too. See how this works? You pull out $10K from your IRA to pay toward their home, and they gift you $10K for Christmas. No 10% due. Ethical? Perhaps not. Legal? Certainly. Keep in mind there is a $10K limit.
- IRS Levy
- Reservist Distribution. A military reservist can withdraw money while activated without paying the 10% penalty.
Don’t forget the really big one either- early retirement. That’s right. You can retire early and spend your IRA money penalty-free. That’s called the Substantially Equal Periodic Payments (SEPP) Rule. Basically, you can start taking it out any time you like but you have to take the same annuitized amount out each year from the time you start until you turn 59 1/2, at which time you can turn the spigot off until RMDs start at age 70. Or just pay the penalty if you want a little more once or twice.
Now, if you want to buy a boat with it at age 45 the IRS is going to have a problem with that. 401(k)s are for retirement. That’s why you get such a HUGE tax benefit out of it. Let me remind you again of that tax benefit in case you’ve forgotten:
- Every dollar going in is pre-tax. If your marginal tax rate is 40%, contributing $50K to a pre-tax account knocks $20K off your tax bill THIS YEAR.
- Tax-protected growth. There are no taxes due on dividends and capital gains on the investments in the account.
- Tax arbitrage between contribution and retirement. A typical doctor saves money at a 40% marginal tax rate, then pulls most of the money out in retirement, filling the brackets as he goes, at 0%, 10%, 15%, or 25%. Contributing at 40% and withdrawing at perhaps 15% is a winning strategy.
In addition, most 401(k)s have a loan provision. While I’m not a big fan of taking a 401(k) loan, most 401(k)s allow you to borrow up to half of your 401(k) balance or $50K, whichever is less. Plus, with a 401(k), the 59 1/2 rule doesn’t even apply. It’s an Age 55 rule as long as you’ve separated from your employer.
Fifth, Phelps argues there are better ways to protect your money from taxes. The only one I can think of is a Health Savings Account (HSA), where you don’t pay any taxes at all when the money comes out so long as it is used for health care. Certainly his favored investment of real estate does not have better tax treatment than a 401(k). Does it have some nice tax advantages? Sure. Are they better than those in a 401(k)? If you think so you either don’t understand how real estate is taxed or you need to read that list above again.
Sixth, Phelps talks about how awesome it is to invest in real estate in a self-directed IRA. Where does he think an IRA big enough to purchase properties comes from? $5,500 a year isn’t going to cut it. So it doesn’t seem he is so much against retirement accounts as he is against non-real estate investments like mutual funds. He might be amazed to learn of the existence of self-directed 401(k)s.
Finally, Phelps is obviously an advocate for entrepreneurship and taking control of your destiny. I have no problem with that. What I do have a problem with is that he doesn’t mention a rather obvious fact- that someone with a physician (or dentist) level of income can free themselves from their practice in just a decade or two by simply controlling their lifestyle, saving a bunch of money, and investing it in some low-cost, broadly diversified index funds, both inside and outside retirement accounts. The reason dentists are coming to him at 55 trying to figure out a way off the hamster wheel is because they spent all that money they made in their 30s and 40s and let their lifestyles get so big that they can’t ever afford to let the wheel slow down, much less get off it. It doesn’t matter what you invest in if you don’t have anything to invest. Phelps is right that his pathway (business ownership and real estate ownership) takes work. If you’re not interested in that type of work, realize it isn’t mandatory if you’re willing to control your lifestyle.
Exhibit A: The Physician on FIRE, who reached financial independence a decade out of residency while never having owned a practice or been a real estate investor.
Some Reasons to Actually Hate 401(k)s
Now, let’s talk about some points that Phelps maybe should have included in his email.
A 401(k) is Not Enough
Some doctors think if they just throw some money into their 401(k) that their retirement will be covered. Investment gurus claiming they should expect 12% returns on that money don’t help. First, you have to actually become financially literate, learn about what you’re investing in, and create and follow a reasonable investing plan. Second, chances are that even a maxed out 401(k) isn’t enough savings. I recommend a 20% savings rate for someone who wants a full career, and if all you can get into a 401(k) is $18K a year, that’s only 9% for a doctor making $200K, and 4.5% for a doctor making $400K. You’re going to need to invest somewhere else too such as Backdoor Roth IRAs or even a taxable account (which is a great place for those real estate investments Phelps loves.)
Some 401(k)s Do Suck
I’m lucky in that I have a pretty good 401(k). The account fees are very low, the investment options are all low-cost, broadly diversified Vanguard index funds, and if you want to do something else you have a brokerage window option where you can buy just about anything else. But there are still plenty of 401(k)s out there with egregious fees and bad investments. They might even come attached to a salesman masquerading as a financial advisor. While it may still be a good idea to contribute to a bad 401(k), (particularly if you won’t be there long or if you have some hope of getting it changed), it does make it a less attractive option.
You Can’t Add Value
The public equity markets might not be perfectly efficient, but they’re efficient enough that you can’t monkey around with your 401(k) in a way that will add value. In fact, studies show the less you touch those investments, the better off you’ll be. That’s not the case when you’re a small business or income property owner. Your time and work can actually add significant value to those investments.
You Have To Cover Your Employees
If you are a practice owner with employees, using a 401(k) comes with some additional costs, like the match for the employees. That amount could be so high that it essentially eliminates the benefit of using the account to you, at least if you don’t reduce their other compensation enough to make up for those costs.
Business Ownership is the Pathway to Wealth
This is a good place to acknowledge the truth of Phelp’s main point. If you want to get really rich, really fast, be a successful entrepreneur. Investing in mutual funds in a 401(k) is likely to get you a 5-10% nominal return. That’s a slow, steady path to wealth. If you’re already burned out of your clinical practice, you’re going to need something with higher returns that works faster. It will require significant risk and even more work, but it is a viable, and perhaps even preferable pathway to wealth, depending on your goals. If you have an investment available to you that will give you 15%, 20%, or 200% returns such as improving your practice, and you cannot make that investment AND max out your 401(k), obviously making the investment is the smarter move.
In conclusion, what I really hate about that email is the “either/or” nature of it. There is no reason you cannot invest in stocks AND real estate. There is no reason you cannot max out retirement accounts AND be an entrepreneur on the side. Both approaches have advantages and disadvantages. Moderation in all things.
What do you think? Do you think entrepreneurship and real estate investing is a viable path to wealth for the majority of physicians and dentists? What did you think of the email? Comment below!