Personal Finance

Your 401(k)/IRA VS Half As Much In Your Pocket

Expertise: Personal Development, Personal Finance, Mortgages & Creative Financing, Real Estate News & Commentary, Business Management, Real Estate Investing Basics, Flipping Houses
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Seems lately more and more people wanna know my take on real estate investing from their ‘qualified’ retirement plans. Frankly, it’s fairly cut and dried if the real estate is acquired inside the plan. You either buy for cash or use leverage to whatever extent you’re comfortable. However, what I tell ’em is this: They’re not asking the right question. The real question they should be asking themselves is . . .

Given a 15-30 year horizon, would I be significantly better off at retirement by exploding my job related retirement plan, paying the exorbitant taxes and penalty, and investing what’s left in long term real estate?

I’ve done the numbers back ‘n forth using several different scenarios. The bottom line? If you don’t think you can take 50-60% of the capital you currently have tied up in your qualified plan (after tax, cash out proceeds), and use real estate to demolish the returns you would’ve had over the next couple decades, even 15 years, inside the plan, you’re not tryin’ hard enough. On the surface that appears to be a bold, even somewhat extreme statement. But in reality it’s virtually akin to announcing you’ve done the testing, and yes, water’s wet, grass is green, and Grandma’s apple pie is the best.

Makin’ the Case

To keep things as real as we can, I’m gonna use the numbers from properties real client/investors are closing in a few weeks.

The investor is 48 and plans on retiring in about 17 years. His job pays roughly $160,000 a year. The balance in his 401k is about $560,000 give or take a few nights out at Sizzlers. He’ll take out half now, and the other half the first week of January so as to slightly mitigate the taxes by spreading them out over two calendar tax years. That’s not always super effective, but more times than not, it is. Check with your CPA, blah blah blah. 🙂

The assumption here is that their after tax/penalty net is about $295,000. It could be more, but let’s not count on it. Essentially, we’ve virtually halved his available capital. Ouch! Now let’s see what happens over the next 15-20 years or so with four properties worth a bit over $1 million.

They put 25% down plus closing costs, minus some seller credits. Their loans are 5% fixed rate for 30 years. The cash flow for the four of ’em is approximately $21,200 annually. It took ’em around $285,000 or so to close escrow, countin’ everything. For the sake of this example, we’re not gonna input any appreciation in value or increase the net operating income (NOI) ever.

The BawldGuy Domino Strategy

The investor is now saving the monthly investment into his now defunct 401k. He says his budget will allow him to add, from his paychecks, $800 a month towards his agenda of payin’ off the loans as quickly as possible. I’ve done the calculations, which show the following.

Takin' the monthly cash flow, a little less actually, plus his own $800 each month, he'll attack one duplex's loan till it's paid off completely. Then, he'll go to the next one, only with more income added to due to the newly debt free duplex. He'll do this till they're all free of debt. It will take him about 12 years give or take a quarter. (Things happen.)

This means in 12 years or thereabouts, he’ll have turned about $285,000 into approximately $1,050,000. (Assuming no increase in value.) His income at that point would be about $72-75,000 a year. Roughly 38-46% of which would be sheltered for the next 15 years. We’ll call it 40%.

With admittedly oversimplified numbers, his annual capital growth rate over the dozen year period was a couple sandwiches short of 11.5%. He accomplished that without increasing his monthly outgo, or not enough to matter. The assets’ cash flow did most of the work.

But wait! There’s more!

He’s not gonna retire for another eight years, give or take. His home’s loan balance at that point will be around $312,000. With the cash flow from his now debt free real estate, after taxes, he’ll be able to easily pay his home off in 5-7 years. Let’s say it takes six. That allows him to accumulate $144-150,000 in before tax cash flow in the couple years before retirement. We’ll call that around $115,000 after tax/after shelter. By payin’ off his home loan, he pockets around $30,000 a year thereafter. 🙂

What if he’d opted to maintain the status quo — keepin’ the 401k?

He has 17 years to grow $560,000 into enough to generate an after tax income of around $60,000. Let’s be generous and call that a gross of $80,000 gross annual income. If we go by Wall Street advisors who counsel retirees to project roughly 4% return on their retirement capital, that means they’ll need to accomplish the following. They’ll hafta end up with, give or take, $2,000,000 in their 401k at retirement. What does that mean in real world terms?

Here’s exactly what that means.

It requires him to average a growth rate of 7.75% for 17 years, without a losing year — ever. If he ever has a losing year, no matter how small, he’ll be forced to figure out how to yield far more than 7.75%. What do you think his chances are of having 17 consecutive years without a loss, while maintaining that rate of annual growth? Study after study shows two factors that bode against his success.

First, one of the most respected studies on Wall Street showed that over the last 20 years the typical 401k averaged around 4% growth a year. Our guy needs to almost double that, and for nearly two decades. Maybe he’s one of the smart ones, who knows?

Second, pick pretty much any 10 year period over the last 50. You’ll find a ‘2008’ in those 10 years. It’ll be more or less hurtful each time, but it will happen. It’s almost like clockwork — in any 10 year period, the market adjusts downward, and there goes your plan.

So I ask you again — Do ya wanna bank on never having a losing year, makin’ more than the average American does, almost by a factor of 2? 

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Our investor arrived at retirement, beginning with half the capital, and ended up in solid position, debt free, with no house payments, and completely free of the ups and downs of Wall Street. Even if his properties’ rents fall massively, he’s still ahead. He still has debt free income properties. If things went that badly in the stock market, they’d be greeters at WalMart for Heaven’s sake. Again, think of 2008’s adjustment, and how real estate investors fared, relatively speaking.

It’s a no-brainer — just like Grandma’s apple pie.

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.
    Replied over 8 years ago
    Amen to that. Our 401K isn’t nearly a big as your investor example–my husband got started late on his (emigrating to a foreign country will do that to you), and he’s only about 8-10 years away from retirement age. When we stopped contributing so much to it, the folks who manage his account asked to meet with him and see what’s up. They looked at his 401K and other things, which (at the time) was doing well. Then they saw the great returns I’m getting on the crappy little rental properties I’m getting–I average 18% ROI. They told him, “give the money to your wife to invest–she gets a better return than your 401K.” So, that’s what we’re gonna do. We’re going to cash out some this year and some next year, and dump it into real estate. We do pay all cash for our properties (which I know is a no-no in the eyes of some), so we don’t have to work on paying them off. We don’t have time for that. I need to get so many rentals under our belt, and then my husband can retire from his J.O.B. (early, I hope!) and join me full time. We’re very near our goal.
    Kevin Kaczmarek
    Replied over 8 years ago
    I love it Jeff. You have shared the a good piece of what a true retirement pie should look like. How do you go about finding the financing for the investors? Are they getting bank loans or borrowing from their life insurance?
    Jeff Brown
    Replied over 8 years ago
    Hey Teri — I’m here to tell ya that you CAN buy with a bit of leverage and still retire when you want to. I strongly encourage you to give me a call when you have some time. You can get my number on my blog which is linked to above in the “Article Author” box. I look forward to hearing from you. You have more options on your menu than you suspect. 🙂
    Jeff Brown
    Replied over 8 years ago
    Hey Kevin — Not sure I understand the question. Once they cash out of their plan, they have the capital to put down payments on properties. Getting loans for them from traditional lenders is not an issue for 90% of them. Make sense?