It makes me sick to my stomach whenever I talk with folks who were whipsawed in the latest stock market crash, describe having watched their retirement, just a few years off, as it disappeared like steam in the wind. I spoke with one such couple last week, and in the middle of our conversation the wife left the room. She simply couldn’t talk about it any longer. I could hear in her husband’s voice the reflection of his emotions, seeing his wife having to deal with such sharp disappointment. You could tell he was feeling responsible. Hell, my eyes got glassy.
Enough is enough already.
Here are some thoughts about A) Why 401Ks/IRAs are cartoonishly bad vehicles to use in your retirement plan B) How gettin’ bent over the bar now is infinitely better than later. C) How even with your employer match, you lose.
What’s wrong with 401s and IRAs for Heaven’s sake?
- One losing year and you’re on a treadmill playin’ catchup. Sometimes for much longer than it took to lose your place. More than one losing year? In a row?
- The tax deduction for contributing is nickels ‘n dimes — the income taxes paid for takin’ the money out is dollars. Why would you do that to yourself on purpose?
- More than 9 of 10 employees use mutual funds as their main 401k investment. Um, that’s less than 4% annual return based on 401k manager’s own 20 year study.
- Once retired, gov’t will force you to take more out annually if you’re not taking ‘enough’. It’s downhill from there. Oh, and they decide what’s ‘enough’.
Why pay taxes and penalty now instead of retirement?
- Do your own math. How much do ya have in there now? How much at retirement? What’s your income based on say, 6%? (Gettin’ nervous are we?)
- Pay now — then create retirement income not tied to asset appreciation — or derailed by decrease in asset value.
- Create both tax sheltered and tax free retirement income — not an annual skinny dip in the IRS pool.
Hey! I has a idear — let’s not just trash what people are doin’, let’s offer ‘em a, you know, solution.
Assumptions Used
- 30% down payments on all purchases.
- 5.5% fixed rate 30 year loans — fully amortized.
- NOI will never rise — as in never, ever.
- Investor cashed out 401K netting $600,000
- $100,000 will be used to purchase EIUL
- Investor is 45 years old when he starts down this path
To net about $600,000 the 401K owner would’ve had a bunch built up. I used a high number on purpose so as to demonstrate clearly that even payin’ up to or more than a quarter million bucks in taxes/penalties, you can still achieve a retirement income — after tax — that will shame what you might’ve done otherwise.
Hear’s the Plan in ‘Reader’s Digest’ form.
He takes a bit under $500,000 and buys six very well located duplexes, puttin’ 30% down plus closing costs. I’ll use what a client just closed on, so the numbers are not only real, but the ink is still dryin’. 
- Price — $252,500
- NOI — $18,360 — Yeah, professionally managed.
- Cash flow per duplex — $6,318/yr — 100% tax sheltered
- Total annual cash flow — $37,900
1. Take $3,000 from cash flow each month and add it to the monthly payment of just one of the duplexes. In just over four years, 50 payments, that puppy will be debt free.
2. Rince and repeat with newly increased income, gangin’ up on another duplex — which will take just 37 months to free ‘n clear.
Here’s the chronology of how the dominoes will fall.
50 months — 37 months — 28 months — 23 months — 21 months — 18 months.
In less than 15 years — 177 months — he will have created an annual income of just over $110,000. He’ll be 60 years old. Almost half of which will remain sheltered for the first dozen years of his retirement.
Wait just a doggone minute. I has a idear! Since he’s abandoned his 401k/IRA, and isn’t putting’ in the usual $5-10k a year, why doesn’t he take the after tax equivalent and also apply it to the monthly loan reduction process?!
Now you’re talkin’ ’bout gettin’ the same results in as quickly as 10 years,
But wait — There’s more!
Less than $500,000 was used to acquire the real estate, including closing costs. There’s about $115,000 left.
What to do?
He should take $15,000 and add it to his family’s existing cash reserve account. Then take $20,000 a year as an annual premium for the EIUL he’s now gonna buy. Five annual payments will take four years and a day. He just lets it sit ’till he’s 65 — five years after he retired. He then begins to take out $36,000 a year — 100% tax free — ’till he’s 99 — somewhat past his life expectancy.
The Benchmark
$110,000 a year from his debt free real estate — $36,000 a year from his EIUL. Total annual retirement income from Plan: $146,000 — $36,000 of which is always completely tax free. About 45% of the $110,000 RE income will be tax sheltered ’till he’s about 73.
Ask yourself a few simple questions:
1. How much will your 401K/IRA hafta have in it at retirement to generate $146,000 a year? If you assume a constant, never-ending (as in uninterrupted) return of 7% from retirement ’till ya die (Please! Stop laughin’.) you’d need about $2.1 Million in your 401K or IRA. And all of that income would be taxable. Not to mention you’d be tax-naked every April 15th.
2. (In Clint Eastwood voice/tone.) Are ya feelin’ lucky? You gonna arrive at retirement with over $2 Million in your plan’s account? Really?
3. Let’s assume you do, which is highly improbable for 95% of Americans. If you’re retired for a few years and another crash takes place, in either or both of stocks or treasuries etc., what then? You lose, that’s what.
Remember now, the income at retirement from the guy’s real estate was from the same NOI as when he bought them 15 years earlier. You really think that’s gonna be the case? Do you think that figure is more likely to go up, or down?
And finally, if it does go down a bit, the income still rocks on, albeit at a slightly reduced rate. A reduced annual income from your 401K plan will most certainly remain forever decreased due to the need for you to then gain access to your principal. Oh yeah, the government might make ya do that anyway — against your will.
Don’t be the couple I spoke to last week. There are 10′s of thousands of them in the making.
Tell me again how much confidence you have in that silly employer match? Please…pretty please with sugar on top.
Note from the Editor: Please check out Jeff’s follow-up post, “Back To The Future – Wicked Cool Retirement – OR – “Sorry, We Can’t Afford To Go…“
Related posts:
- Tell Me What Your Retirement Looks Like – Are You Smiling?
- Your Retirement – What’s It Look Like and How Ya Gonna Get There?
- My Accountant and Retirement Secrets
- Your Retirement — 19th Century — Back To The Future
- A Tax Free Retirement
Article Author: Jeff BrownJeff has written 110 articles for us.
Visit Jeff's Website: http://www.bawldguy.com
Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.
Joshua Dorkin
{ 32 comments… read them below or add one }
Always enjoy your posts, Jeff. Insightful, with humor, and most of all, based on actual data.
Great examples, as always, Jeff. You continue to be one of the brightest lights in the REI space.
Thanks Alex — it’s a challenge to present comparative data in a way that illuminates reality.
Very much appreciated, Josh. Always nice to hear.
Jeff – You’re usually more balanced than this. I really like your posts, but the advice that 401k’s are cartoonishly bad is dangerously bad advice, even if we both agree that real estate (today) is a better place to be.
We all know people who were badly hit in their 401k’s, but I know far more people who have been FAR more badly burned in real estate by buying over-leveraged properties at a time when prices were absurd, with just as many silly tax rules, because so many were playing the ‘greater fool’ game.
401k’s are a tax advantaged was to invest money in chunks that can’t effectively be done in real estate. Yes, the rules are a bit silly, but it is better than a savings bank. People got damaged in 401k’s not because of the 401k’s themselves, but the underlying investments which were over hyped, over speculated, and over sold – just like real estate and mortgages were at the time, but which THEY chose! As a matter of fact, there are so many parallels between the equity markets and real estate, it’s eerie.
Lastly, telling a reader to unilaterally dump an employer matched 401k, pay taxes and penalties, and plow it into real estate, without a thorough and careful analysis is not necessarily good advice.
All that said, I have done some analysis and have determined that today, real estate is indeed one of the better ways to build wealth. I will NOT be liquidating my 401k’s to do it, just because of the emotional pull of some lady in San Diego, however wonderful a person she may be.
I have a friend who’s wife demanded a bigger place in 2005. I too am so emotionally involved that I can’t even tell the story (no, it’s not me). Let’s leave emotions out of it and stick with the analysis part – that’s where your story really shines.
Tom — I get where you’re coming from, and frankly, we don’t disagree much. With respect though, your arguments are specious as it relates to my post. Let’s take ‘em one at a time. I won’t even address in depth the comment about the ‘emotional pull of some lady in San Diego’. The emotion was mine. I’m the one who became a bit emotional at yet another couple who bought into the whole ‘qualified plan’ sham, and now has no retirement. If anything, my counsel is consistently objective in nature — or as you put it, balanced.
“Jeff – You’re usually more balanced than this.”
1. Thank you, I appreciate the thought. But please, tell me where my numbers or concepts are mistaken. Lord knows I’m not protecting a perfect record. If we went back 20 years from today, and compared notes, my way vs the 401K approach, my folks would cry alright, but outa pity for the horrible financial state the 401K people would be in. This has nothing to do with ‘balance’. Wanna know what a person would be doing now if they’d followed my advice 20 years ago in San Diego?
Their real estate income alone would be roughly $165,000 a year. Their EIUL income would be about the same $36,000/yr — tax free — as in the post. Wanna talk about where their co-workers are today?
“We all know people who were badly hit in their 401k’s, but I know far more people who have been FAR more badly burned in real estate by buying over-leveraged properties at a time when prices were absurd, with just as many silly tax rules, because so many were playing the ‘greater fool’ game.”
2. Let me ensure I understand this. What the post said was bad advice cuz you know so many who’ve been burned by horrible prices at the top of the market, a wife who wanted a bigger house, and morons who decided 0% down was the way to go? On the scale of ‘bullseye’ that argument isn’t even aimed at the right target. Of course, if the definition of ‘over-leveraged’ includes putting nearly 1/3 down, I plead guilty. There are many cases, (workin’ on one now with a new client) in which I’m counseling 50% down. 30% down is overly leveraged in a market having lost 30-40% of its value? Really?
Oh, and for the record? The duplexes of which the post speaks, would literally cash flow a few bucks a month with 0% down — so I guess 30% down wasn’t over-leveraged.
“401k’s are a tax advantaged way to invest money in chunks that can’t effectively be done in real estate. Yes, the rules are a bit silly, but it is better than a savings bank.”
3. True enough, but how in Heaven’s name is that related to this post in any way, shape, or form? I was talkin’ about folks who already had 100′s of thousands of dollars in a 401, not a fast food cook with a year on the job. I was talkin’ to folks who’re down an abandoned well and don’t know it yet. I was offering them a rope. I don’t care how those just getting started save money, with the exception of telling them, as I have my own 26 year old daughter, to contribute to an EIUL instead. She’ll end up at 55 with just well over $75,000 a year in tax free income. Imagine what else she’ll have as retirement income, as she’s well connected to the real estate investment world.
401Ks are ‘tax advantaged’? Really? The average employee saves roughly $1-3,000 yearly in taxes via their contributions. They do this for maybe 30 years. Then in the first 2-6 years of retirement they pay more taxes than they saved in the previous 30. If that’s ‘tax advantaged’ count me out. Sounds like ‘new math’ to me.
“Lastly, telling a reader to unilaterally dump an employer matched 401k, pay taxes and penalties, and plow it into real estate, without a thorough and careful analysis is not necessarily good advice.”
4. Again, I was addressing the vast majority out there who’ve seen their retirements crash and burn. It matters not a whit WHY they invested in a particular Wall Street vehicle. The fact is, most Americans never expected anything but growth and a solid retirement income from their 401s, cuz that was the line they all heard. Over-hyped etc.? You bet. It doesn’t change the fact over 4 outa 5 got nailed by the crash.
I was addressing the post to those among the 90%+ who listened to ‘pro’ advice at the office and are now wondering when they can retire, much less what cruise to take when they do. The employee who was hardly damaged, and now whole, is rare indeed. It was made abundantly clear to anyone reading carefully, that the post’s target audience were those 90% or more who listened at work to their ‘plan’s’ advisors and found themselves wondering where their money went and why.
Next week I’m gonna continue this discussion in my next post. It will give an historical comparison of how two couples would’ve fared if they’d started back 20 years ago. One will execute my plan, the other a 401k. I’ll even rig it in favor of the stock market crowd. I’ll assume in those 20 years there was not one losing year, ever. The real estate investors will still crush ‘em like grapes. It’s not a fair fight, Tom. And the thing of it is, I think you already know that.
This is gonna be fun. Again, Tom, I think for the most part we’re pretty much on the same page. Your points of contention however, were aimed at targets I never supplied in the post. Thanks again — especially for next week’s post.
Jeff,
“Cash flow per duplex — $6,318/yr — 100% tax sheltered”
Last week we discussed how some of the taxable gain on a property can be tax sheltered on sale. How can cash flow be tax sheltered and not considered income?
oy, I have much to learn.
Jason
Bilgefisher — Never a problem.
Depreciation is, in its simplest form, a ‘paper loss’ that real estate investment owners can use to offset cash flow generated by income property. There are various rules/regs governing how much per what kinda property. But the thing to remember is, that it’s an ‘expense’ you never had, but get to claim against cash flow. Cool, eh?
Don’t get too excited, as in the end, the same gov’t regs allowing such a thing, tax you for it down the road if you don’t use proper strategies to avoid such taxes. It’s called ‘recapture’ tax. But that’s a different story altogether.
Bottom line is, depreciation ‘shelters’ a property’s cash flow so that all or part of that cash flow isn’t taxed as income.
So, Jeff – Here is where I must call you out:
“401Ks are ‘tax advantaged’? Really? The average employee saves roughly $1-3,000 yearly in taxes via their contributions. They do this for maybe 30 years. Then in the first 2-6 years of retirement they pay more taxes than they saved in the previous 30. If that’s ‘tax advantaged’ count me out. Sounds like ‘new math’ to me.”
Yes, they are. You are posturing to make a good deal look bad. You are!
Here is the truth. By not paying 37% tax on your 401K, you effectively have 37% more to compound (assuming you choose the right vehicles – which can be real estate) over X number of years. You are forgetting to consider the interest on that in your statement. The fact that I have to pay huge taxes on withdrawal is because I’ve made so much darn money to be taxed. If I didn’t – I wouldn’t be taxed so much, would I?
Again, for the most part I am agreeing with you and really respect all you’re doing for the community, for retirees, and for the real estate business. It’s clear that you care, but if I don’t point out this obvious disconnect and allow you to reconcile it, some, maybe many, might feel uncomfortable, and that would be very bad indeed.
Tom — I’m posturing? Gimme a break. Seriously, let’s hit the road with this circus act of ours.
We’ll pick 100 401k owners at random, and you and I know that they absolutely are not using their annual tax savings for anything but everyday living, walkin’ around money, for Christmas, or their trip to Hawaii. What you say is absolutely true — except it’s not cuz the only people doing it are exceptions proving the rule. What you’re talkin’ about is the weakness of IRR (internal rate of return) which makes a false assumption, i.e., that cash flows gain the same rate of return as capital still inside the investment. When I used to teach it, we joked about how a particular property would sport a 12% after tax IRR return, but would yield demonstrably less when cash flows were dealt with honestly.
In this case, the employee’s tax savings each year are ‘cash flows’. What sorta after tax annual return are they gonna get in your world? In mine, it won’t be all that much.
“…posturing to make a good deal look bad.”
Geez, Tom, the typical employee is lucky to put in $5,000 yearly. They’re not gettin’ a 37% tax break. But, for the sake of this discussion, I’ll stipulate they are.
Are they gonna make 5.5% year in, year out, without one losing year? Even allowing for big upswings, are they gonna average 5.5% on their tax savings over 15-30 years? They haven’t so far. In fact, let’s use some real numbers.
Let’s say they make $80K/yr. they put in $5,000 + $1,850 (tax savings) + $2.400 (3% employer match) That’s $9,250 a year invested. Let’s say they do that for 30 years. Let’s say they make far more than 5.5%. Let’s use 7.75% a year — for 30 years — and we’ll grant them the fantasy of never ever having a down year — no playin’ catch-up just to get even, which would necessitate a much larger annual return.
In 30 years they’ve still not amassed a million bucks — (just over $956,000) but let’s say it end up as $1 Million. If they live another 25 years or so, what return is that million bucks gonna give ‘em? What dividend will they enjoy? For what treasury will they opt?
The folks in my post ended up with almost $150,000 a year. On what income will your folks retire?
None of the above is gonna happen. There will be losing years. The average employee just isn’t a stock picker. Even with a million bucks, the average person will be lucky to generate a 7% return using Wall Street products — assuming they’re interested in protecting their capital and not wanting to swing from the chandeliers.
Manipulate the numbers any way you see fit, Tom. Please show me how your folks end up with nearly $150,000 a year in retirement income. While your at it? Please show me how you allow for the down years in the market. What average return are you gonna impute to your analysis?
I had my post’s example begin by bending themselves over the bar by paying massive taxes and a penalty. They made more money than $80,000/yr. Yet by ‘gutting’ their plan, they were able to generate a retirement income that is not only tax sheltered (45% of the RE income) for a dozen
years, but a lifetime of tax free income in the amount of $36,000/yr.
All that with not an inch of asset appreciation, or a hint of an increase in any property’s net operating income. Sorry, Tom, there’s no posturing here — of course if there was, I’d be the one standing straight and tall, as Wall Street wouldn’t have the chance to endless bend me over their bar.
Be my guest, take me to school. Show me how all these folks who’ve had to postpone their retirements are wrong. We’re listening.
Great discussion… everyone reading this post are getting PHD level insights… all for free.
How cool is that?
Keep them coming.
Pete
I agree with Pete. I know the constant arguments get frustrating, but I rather like them. It tests points of contention that many of us are wondering. Seeing the cold hard facts is extremely helpful when understanding several vehicles and making life changing decisions. I appreciate the level of detail in your responses.
Jason
Hey guys — So often it becomes somewhat tinged by emotional response. It’s about numbers, analytical assumptions, and most importantly, the ability of the analyst to do the analysis for each vehicle, compare them, and do it all letting the chips fall where they may.
It’s been fun though, hasn’t it?
FYI, Dalbar’s data has come out for investors in mutual funds. Dalbar, Inc. studies are the gold standard and come out annually. Their results are matched by internal results from the mutual fund companies. According to their research, the average investor in mutual funds averaged 3.17% annual return over the last 20 years. Just thought some facts on real returns would inform the discussion!
Jeff,
I would like to do a post request. Often times you talk about clients that have bundles of cash from 401k’s or other income properties. What about folks who have less then 5 figures to invest with? They simply can’t put 30% down on a 250k duplex. What do you tell folks who are just starting out?
Also, one other small question. What are your assumptions when you determine NOI. (Ie maintenance expenses, pm fees, taxes, taxes insurance) Do you use the often touted 50% rule or another set of criteria? I’m just trying to see how the numbers are derived.
Jason
Jason — Go to my blog. Get my cell number at the bottom of any post. Call me after 9 AM.
Like the post suggestion, btw — thanks.
Why would you not do a self directed IRA? All the benefits, none of the BS…
Lee — What would your plan be, exactly?
The general plan would be similar to what you outline minus the cash out piece. Just move the money every so often into your self directed IRA. You could contribute to get your employer’s match. I realize this is plan dependent as many plan admins won’t let you play this game.
Jeff great article.
I would tend to agree with Lee.
Why not roll it over to a truly self directed IRA – where you can buy real estate inside your IRA?
Lee & Taylor — I get where you guys are going, but doin’ it inside a self-directed IRA or a Solo 401(k) means you’ll be subject to higher down payments (not always) and for sure, much higher interest rates. This will tend to limit the investor sometimes by eliminating that extra property they might’ve been able to buy, but for the increased upfront capital required.
Still, if the money’s there, and ya don’t hafta take the taxes/penalty hit, it makes sense, though not nearly in in all cases. That said, it’s still, IMHO, a better way to go outside of gov’t plans. For example, what if you died and your kids were your heirs? They’d be far better served if you’d have owned the properties outside the plan.
A Roth, now that’s a different story altogether…
Make sense?
Sure. It all makes sense. I’m full time self employed so I can’t contribute to all these plans anyway and have embraced a similar strategy on my own. That said, I do contribute and max out a Roth every year as you can’t beat tax free income (though the gamble is the politicians may go after the money).
Jeff, this article is great and has given me a glimmer of hope. I’m currently working for a Real Estate Investor and have learned a great deal from her and BP. My wife has a great job, but is likely to get layed off within a year. We’ve seen our IRA lose nearly half it’s value in the last two years, and we’re tired of watching the stock market and getting that sinking feeling.
My Point: before reading your article, that account was kind of a sacred cow. We assumed that gutting it would be far too expensive to consider. I’m with Bilgefisher above and would like to see your thoughts on what we could do with considerably less than the half mil in your article. Could we reasonably expect to start our own RE business that would provide income both now and later with around 200k seed money?
Fantastic post Jeff! I am on the same page as you 100%. When listening to my friends, colleagues, associates speak about their stocks, mutual funds, company-matching plans, I can’t believe how many of them have lost thousands upon thousands of value in their “professionally-managed” accounts. I explain the positives of investing in real estate (not being highly leveraged) or even becoming Lenders and using their funds in their RRSP’s (registered retirement savings plan here in Canada – just like 401ks) to hold mortgages. Yet, they keep on using the HAP strategy (Hope and Pray) with their Advisors. Do individuals not understand that if you do what the masses do (invest in IRA’s, 401k’s, RRSP’s, mutual funds, or even speculative real estate purchases – aka lining up for pre-construction condo’s), that they are going to get the average returns? If they’re lucky! Thanks for providing an actual well thought out (and realistic!) plan.
I sincerely appreciate the effort you put into your writing and calculations. Keep up the great work. Investing in the format you suggested above will kick the crap out of any employee-matched plan or even bank Advisor’s suggested 60/40 equity/fixed income plan.
Cheers
Thanks Dave — Once emotions are set aside (pun intended), the numbers comparison becomes overwhelming to say the least. Also, your point about ‘average’ results is very well taken. It points to the mistake of blindly following the herd, assuming the rest aren’t, or wouldn’t do anything that would endanger their own retirements.
Wrong, Wal-Mart breath.
Thanks again, Dave.
Edward — The short answer is yes, but the caveat is that we’d need to talk. Everyone is different.
Unless there’s something in your financial status quo that would act as a virus of sorts, you should be able to use $200k ‘seed money’ to your very positive advantage.
Contact me. Have a good one.
Jeff-
Definitely an interesting article and some interesting thoughts. However, I think some of your assumptions are a bit off. If you really want to net $600,000 from a 401(k) you’d end up pay almost 1/2 million in taxes and penalties. You’d be in the 35% tax bracket + a 10% penatly. Your beginning value would have to be $1,090,909. I can’t see how that could really be worth it.
Jeff B — It wouldn’t IF you could convince yourself you’d be able to produce the income they did, and structure it to be as stable. Also, remember that a large chunk of their retirement income is tax free for life. If you can duplicate the after tax income, and structure it be that stable, you’d be a fool to move.
Can you?
OK, this one gets bookmarked. Your message goes against everything I’ve been taught and told about investing. It makes me nervous and yet piques my interest.
Thank you,
Elisha
Found this article while researching IRA management. Incredible, thanks for the analysis and advice.
What would you recommend for someone currently earning less than $20K/year with less than $2K in a trad IRA who is faced with rolling it over to another broker? Does it make more sense to pay the penalty and taxes now and drop the remainder into a savings acct or CD? Or is it better to roll it into another traditional IRA? $2K isn’t a whole lot to do anything with, so it’s tough to discenr which path yields the least amount of hassle and or taxes.
Bill — gut it. Stop contributing to it. Call David Shafer. He’s a contributor on my blog. In fact, he’s gotta post of today. There’s a link to his site in his name at the top of the post. Good luck.
Bill: I have been retired for 3 years with a monthly pension. My wife currently works. Our combined income is about $95,000 per year. I have a 401k sitting with about $18,000 in it (used to be $35,000 before the crash) and eligible to withdraw without penalty. I never intended to use it as monthly income, per se. We have some debt and eligible to purchase a home and considering the advantages or disadvantages of withdrawing 401k money and using a portion towards a down payment and/or pay down debt and to put at least half in savings. I am concerned about the tax rates this year compared to next (which are currently unknown) and wondering whether you would recommend withdrawing those funds this year, as opposed to next, in terms of tax consequences. I realize the 20% fed and 10% state tax consequences now, might they be worse next year? I’m inclined to pull it out and put it to use now, even if it goes into savings (realizing I must use the funds wisely). Any thoughts?