Why Your 401k Is A Retirement Income Loser!

by | BiggerPockets.com

A savvy commenter and a couple buddies made known to me that last week’s post at a sentence or two they didn’t quite grasp.

I read it myself, and calling that sentence the perfect example of tortured syntax would be straining the concept of kindness. 🙂 Here’s the offending prose.

If all you ever did was buy discounted first position notes secured by real estate, you’d surpass the after tax income from that significantly lower amount by double, at least in most cases.”

I wrote that in the context of what I call ‘gutting’ an employer sponsored 401k.

The consequences of executing this option are immediately felt in terms of hurtful income taxes and, to add insult to injury, a 10% penalty as salt in the wound. Don’t let anyone soft peddle this strategy to ya. There’s simply no way to sugarcoat the potential of having the impressive fruits of years of discipline cut in half — due to a decision YOU made.

In an event I recently hosted and at which I spoke, the tax expert in attendance who also spoke on the subject, backed up what I said about the brutal nature of the taxes and penalty. Please allow me to give an example of why I often say to pay the dang taxes and penalty.

It’s all about results, right?

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Here’s an Example for Ya.

The investor/taxpayer couple both have a relatively large work related 401k balance. The choice is whether or not to take the hit of taxes/penalty and invest in different vehicles for retirement than are available at work — OR — stay the course at work, grow it to an even bigger balance, and be happy with the 4% +/- that now huge amount would generate.

Related: How Has Your Retirement Plan Been Workin’ Out For You Lately?

They have a combined $700k 401k balance now, which in a horrible scenario will be cut in half by taxes/penalty if they ‘gutted’ ’em. We’ll assume they then put the now ‘measly’ $350k into a Roth IRA for the expressed purpose of investing in first position notes, secured by real estate. We’ll further assume their cash on cash return is 12%, which is at the bottom of the current range, 12-15%. That would then produce a tax free annual income to your new Roth of $42k. The cash on cash return doesn’t take into account the other, rather significant return built in to the various note purchases, the discount.

Let’s Assume they’re Say, 48, and will Retire at 65.

At the end of the first year their payments alone will buy another note. Using the same minimum return, that’s an additional annual income to the Roth of around $5k. Total Roth income is now $47k a year. Their payments keep buying notes — for 17 consecutive years. Each year the payments are a bit more than last year’s. For 17 consecutive years, year after year. 😉

Let’s circle back to the first big purchase of notes with the $350k. Just as likely as not, they acquired $500k in notes. ($350k = their combined balance at time of purchase) Who knows when those notes will pay off? I sure don’t, as it’s a completely random event. The latest data says 6-10 years. But that data and $10 will get us both some coffee and a cookie. 😉 Let’s be silly conservative and say that those original notes didn’t pay off ’til 15 years have passed. They’d still have a couple years before retirement, right? Let’s pause a second here, and begin adding up all the income your Roth would be collecting at that point, ok?

We’ve established the $42k/yr from the first big purchase, using the $350k. For the next 15 years they bought more notes with just the payments. The first year’s income from that approach yielded around $5k/yr additional income. Every year after that produced a bit more. Let’s arbitrarily say that the average for the 15 years was around $7k or so, a conservative amount. That comes out to $105k, which we’ll round down to $100k, just cuz we can. Again, let’s pause to appreciate what they’ve accomplished here.

Their initial purchase of notes produced about $42k in annual income to their Roth. Over the next 15 years they used that income to buy more and more notes, each year a bit more than the last. Those small purchases have now amassed an annual income — NOT COUNTING the $42k/yr — of $100k.

But Wait, There’s More! 🙂

The original notes have all now paid off at the end of the 15th year, a couple years before their retirement party. That’s roughly a $480k payoff, give or take. That capital is now put into more notes, again at the low end of the yield range, which results in approximately $57k/yr, which is a $15k/yr raise. Before continuing, their annual payments to the Roth have now reached $157k/yr. That figure is insultingly low, as in my 38 years of note investing experience, the vast majority of your notes woulda paid off sooner than this scenario assumes. But I digress.

The last couple years before they retire, and frankly many before that, but I wanna derail the naysayers before they start huffin’ and puffin’, each year will see them increase their annual Roth income by around $18.5k the first year, and about $21k/yr the second, and last year before retirement.

That means they’d begin retirement with a TAX FREE annual income of around $196k. 😉

Related: Investing In Real Estate Is Better For Retirement – PERIOD!

Let’s pause again to reflect on what their choice was 17 years earlier. Let’s say they opted to stay the course with their employer sponsored 401k plans. Let’s further assume they grew the $700k balance to $2 million. Don’t laugh, I’m not. 🙂 It’s laughable, but let’s assume they were able to generate a 10% annual return ’til they died, never ever missing a year. That’s $200k/yr pre-tax annual income. However, their federal income tax liability will be about $43k/yr. Let’s say their state tax is from California and takes away another $14k. That leaves them an after tax annual income of give or take $142k/yr.

Remember now, that figure assumed they’d never ever miss generating a 10% yield on your capital.

Meanwhile, back at the ranch, the other ‘them’, the ones who paid the horribly high taxes and penalty 17 years earlier, are enjoying their first year of retirement with roughly $5k a month more after tax income than the 401k ‘them’. But wait, it gets worse, far worse. But before I outline those factors, let me tell about the real killer surprise the feds have in store for you guys.

About 5.5 years after you retire, 70.5, they’ll knock on your door and begin FORCING you to take more out each year than you wish. You won’t have a choice. I have a way around that that’s wickedly simple, but it also requires the taxpayer to pay, you know, taxes. However, cuz they opted for their approach instead of mine, those taxes will be horrifically more in terms of dollars, than if they’d bitten the tax/penalty bullet when they were much younger. In other words, pay ’em now or pay ’em way more blood money, later, when they need it the most.

1. The almost $200k/yr TAX FREE income the brave ‘they’ generated the first year as a retiree, is mostly likely to be, in real life, more like $250-350k/yr.

2. Furthermore, whatever the figure is will in fact be the lowest retirement income you’ll ever receive, as long as you live.

3. Why? Cuz notes don’t know you guys retired so they keep on randomly paying off, TAX FREE, so that you can then rinse ‘n repeat, creating ever more TAX FREE income in retirement. You keep getting raises while on your latest cruise. Who knew? 🙂

What I was trying to say, though not very well at all, was that when I suggest folks might consider gutting their employer sponsored 401k, I’m offering an alternative approach. That approach is to move the before tax capital into a Roth ‘envelope’ and begin buying first position notes secured by real estate.

I know, I know. Boy do I ever know how emotional this decision can be. Why on earth would anyone purposefully cut their retirement (401k) nest egg in half?!! I just told you guys why, and was conservative to a fault in how it was done. Here are the facts to remember.

  • You’re definitely not gonna grow today’s $700,000 (or whatever) into $2 million in the next 17 years. The unspoken assumptions there are that you’ll never have a losing year; and that you’ll average roughly 35% greater return than Americans have over the last two decades.
  • Does anyone think they’re gonna keep investing in the same vehicles available in their 401k and make 10% a year once they retire? Really? That return is nearly triple what Americans have been able to generate in their 401k plans the last 20 years.
  • If you overcome the very real emotions attached to ‘gutting’ your 401k, you’ll live to laugh out loud at your initial anxiety, which was indeed just as real.

Always go with the empirical evidence!

Be sure to leave your comments below!

About Author

Jeff Brown

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.


    • Sure thing, Adrian. Financial advisors advise those nearing or already in retirement to become more risk averse. This results in the qualified plan generating far lower yields. Generally speaking, the advisors predict 4%, give or take. That’s where it comes from. Considering what woulda happened to their capital in market crash of 2008, being mostly outa the stock market appears to be solid advice indeed. Make sense?

    • You can’t compare stock market returns to employer sponsored mutual fund returns. Historically, the S&P 500 outperforms those funds by 80%!! I think Jeff’s 4% might be generous 🙂

      • Every employer I have been with offers their own brand of mutual funds that basically mirrors the S&P 500 and usually at a lower expense ratio with the plans offered through an employer sponsered plan…

  1. Charles Williams on

    Thank you for the scenario explanation, very fascinating. I’ve been considering this strategy for several months, but haven’t felt comfortable pulling the trigger. You’ve indicated early note payoff would boost the profits, but didnt share your opinion on impact of any note defaults. Would you mind sharing your thoughts/analysis on the numbers for this scenario given the average default rates for these notes? As a follow-up, care to share the best/reliable source of purchasing performing first lien notes to purchase at 12-15% that havent been cherry picked? Thanks!

  2. Jeff, You will need to excuse my ignorance but where does the 12% cash on cash return really lie on possible returns on notes..Meaning how many of these can be found . I think this is an important distinction.

    Great Article by the way.
    I am that 48 yr old…. well maybe a little older:)

    • They can be found in note funds, various note websites, etc. I have a note fund that specializes in 1st position notes. The range of cash on cash ‘yield’ these days is 12-15% for the most part, which doesn’t count the profit. We currently own more than 100 of ’em, though by the end of the year that could come close to doubling.

  3. Hey Jeff – Great article. I am 100% in agreement. Another angle on this is that if the couple in the example has a rollover traditional IRA form a prior employer. It makes sense to take the tax hit now and convert it to a SD Roth IRA, where the income from note and RE investments is tax free.

  4. Can anyone tell me if the laws permit converting a 403b to a Roth. The people from the provider of the 403b tell me no, but I wanted to get a second opinion since they have a vested interest in keeping me paying their fees. By the way, I am in total agreement. I have considered cashing out and paying the taxes and penalties even if I cannot convert it to a Roth because I know I can easily outperform the long term returns (past 20 years) that I have seen in the stock market with real estate investing. Notes sound like a much better alternative within a Roth though. Great article!

    • Matt DeVincenzo on

      Yes you can…

      A 403(b) is an educator/teacher version of the 401(k), if I recall correctly. I had a TSP (military/federal employee version), which I believe is a 457(b), Anyway point being they all “behave” similarly but are specifically established through different sections of tax code.

      In order to rollover one of these other types of plans you have to do the same thing you would with a 401(k) to roll it to a ROTH IRA. With all of them it is a two part process. First you roll it into a traditional IRA, once it is an IRA then you can convert it to the ROTH envelope. So your administrator is telling you the truth, you cannot roll into a ROTH IRA…they’re leaving out(or don’t know) that you can get it there through the two step rollover.

      (I’m not a tax professional but have have a SD ROTH for close to 10 years so have a pretty good grasp on the ins and outs of them)

    • Michele — You can contact my ‘in house’ expert on the subject of self directed plans, John Park, via his website. pgiselfdirected.com

      Please tell him I sent you. The next sound you’ll hear will be the red carpet rollin’ out. 🙂

  5. Great article, Jeff! In this, combined with couple of previous articles, you prove beyond doubt that how superior is Notes investing (in Roth) compared to typical employer sponsored 401K. I would love to get your take on Note investing vs buy-and-hold income producing real estate (in the same Roth setting). For an investor like me, and I am sure for most BP readers, the real dilemma would be whether to buy more RE in that Roth account or discounted Notes.

    • Thanks so much, Sandeep. In my view there’s no ‘either/or’ with real estate and notes. It depends wholly upon each investor’s unique circumstances. There are literally no set formulas involved, either. Also, I’m definitely NOT a fan of buying real estate in any ‘qualified’ retirement plan. It’s better than nothing, but the short version is that for roughly the same money to buy one in your plan, you can almost buy two in your own name.

  6. Hey Jeff,
    Love the writing style as always. And, as always, questions. That’s what engineers do, nothing against the Bawld Guy, I’m one too.

    I appreciate the tax free income end game. I do have to question why not invest in the notes in a self directed 401K. This way ya have double the initial resources, double the compounding and hopefully, in my case a lower bracket in retirement, unless the gubberment adds another higher bracket.

    The note income will be the primary source of income and the first 225K will be taxed at lower rates, and every year I get a do-over from the tax man on the first 225K (today’s bucks).

    The 350K becomes 700K and blazin’ thru da math and just doubling the end 196K puts us at about 390K with the first $225K taxed at the graduated 10%, 15%, 25%, 28%, etc. Total tax for a married no kiddies is 98K in fed and another 40K in CA state (move to FL or TX) for 138K in tax and a take home of $240K and change.

    Not as much flexibility as the Roth, admitted, but if you have political ambitions, you could show what a good citizen you are and paying plenty of tax .

    Either way, I like the end result, and I love the idea. I’ll PM ya about the fund of first positions ’cause I’ll have lots of questions.

    • Muchas thankias, Joe. I couldn’t agree more about the 401k vs the IRA. This is especially true as it relates to small business owners who qualify for a Solo 401k. In fact, I have one.

      In the post’s example, both spouses were employees, therefore no solo possible. True, max contributions are much higher for 401k plans, about triple, give or take. Here’s a suggestion. What if they diverted the difference in contribution limits towards an EIUL? Over a 20 year period, they’d be 68, $1k a month premium would likely get them roughly $6k/mo tax free. What we must remember, Joe, is that, especially in high tax states like CA, the taxpayer must generate pretax income of around $1.40 or so just to EQUAL a tax free dollar. Over time that becomes an incredibly tall order. Your point though is very well made.

      The other caveat concerning 401k plans on the Roth side, is that before the taxpayer(s) turn 70.5 they’d need to roll the balance into a Roth IRA. For some reason the gubmint doesn’t force that plan to increase distributions. Don’t know why.

      I’ll be on the lookout for your PM.

  7. I went back and looked at my annual returns. Not that I am against any note investing, in fact it intrigues me. I average significant above 4%.

    2014 YTD 6.37%
    2013 33.15%
    2012 16.30%
    2011 -3.38%
    2010 8.08%
    2009 12.81%
    2008 -15.16%
    2007 1.82%
    2006 13.58%
    2005 8.97%

      • Hey Eric — They are bought at a discount for sure. It varies by individual note. Also, the market dictates the yield at any given time. They are liquid, but that’s a relative term. Compared to real estate they’re WAY liquid. 🙂 Not as liquid as stocks though. Most can be sold pretty quickly, however.

  8. Jeff your math is impeccable … but I think your analysis suffers from a GIGO problem.

    Primarily your results hinge on the rates of return that you assume on the 401K investments and the discounted notes.

    You noted in your response to Adrian Tilley that “Financial advisors advise those nearing or already in retirement to become more risk averse. This results in the qualified plan generating far lower yields. Generally speaking, the advisors predict 4%.” But the stellar returns that you assume to earn from the discounted note purchases all come from one asset class. Hardly a move towards less risk.

    You also assume that asset class will always generate that “12% to 15%” return. What happens when the US economy hits another recession? What happens to those returns when interest rates hit a roller coaster? What happens if and when the inflation rate hits double digits? Would any of these events affect the value of the discounted notes? Is there any chance that even one of the notes that your hypothetical couple purchases becomes a slow pay or even defaults? Remember Will Barnard’s ongoing adventure in California.

    What happens when one of the purchased notes gets paid off and when the couple looks for a replacement, there are no notes available with the same 12% yield? The only notes available pay only 8%? Could that happen?
    What is the minimum required distribution from a retirement account for a 71 year old? Is that distribution “horrific” especially since the return for all those years was only 4%?

    You also assume that the worker stays in the same job for many years – hardly a realistic assumption in today’s workplace. Every time a worker switches jobs, he or she has the opportunity to move the retirement funds to a self-directed IRA and then invest in a large universe of investment – stocks, bonds, mutual funds, notes, gold, and other investments. He or she could also examine converting all or part of his/her IRA to a ROTH IRA. Such a move should be carefully considered and probably discussed with an advisor and a tax accountant. Rarely does it make sense for someone in his/her working career to convert ALL of his/her IRA to a Roth in one year. This is especially true if he/she has no plans to work until age 65 or at least work full time.

    I agree with your premise that greater returns are available is the investor takes ownership in the investment selection especially if he/she invests in a company over which he/she can exert some direct influence.

    The funny thing with investments though … no one really knows the outcome … that is why they are called “investments” and not “certainties.”

    • Good hearin’ from you again, Kevin. You generally pose the best questions, the answers to which require serious thought.

      Frankly, I don’t disagree with any of your statements or the implications inside your questions. It is all relative. As I’ve promised in a few comments above, I’ll be addressing most of the questions on this thread, and ALL of yours. 🙂

      For the record, I bought my first discounted note in 1976, during a hugely inflationary period. The cash on cash was higher than 12-15% back then. Also, in my 38 years of note investing and brokering, I’ve yet to buy/sell/broker a discounted not yielding less than double digits. Are they out there with smaller yields? You bet they are. But if I want decades of relatively smaller yields, I’d be in the stock market instead of real estate and notes. Sorry, I couldn’t resist. 🙂

      • Jeff, who is SELLING these notes that yield 12% or more …. and WHY would they sell a note with such a high yield when the alternative investments offer much lower returns (1% on CDs, 3% on Treasuries, 4% in the stock market (your number), gold has tumbled as of late, etc)?

        If these notes are such a great investment, why does ANYONE sell them?

        • Kevin, discounted notes were way old when I acquired my first one, back when Ford was in office. They’re not new by any means. Why would anyone sell a 30 unit apartment building with a white water view of La Jolla Shores Beach? For the same reason any investor sells anything. They perceive the sale will improve their investment portfolio’s status quo. I’ve sold ’em/traded ’em to acquire more real estate.

          They’re not different than any other investment as it relates to investors’ goals. Some folks like stocks/bonds, some like precious metals and/or diamonds, etc. It’s not that complicated.

    • Sorry, Branden, I can’t. One of the main reasons I opted for a private offering note fund, governed by the SEC is that those note sites aren’t my cuppa tea. It wasn’t that I didn’t like the site owners, cuz virtually all of ’em were highly knowledgeable and honorable folk. It was the notes themselves for which I had no confidence.

      On my own website you can click on ‘audio’, then listen to Dave Van Horn and I discuss the ‘behind the curtain’ stuff that goes into the making of the ‘sausage’ so to speak. You’ll have to register your name/email to get content access.

  9. Hey Jeff
    Long Time
    I have been away for a while because I have been frustrated chasing REOs and foreclosures. guess what brought me back to reading BP? 1st position note investing. How timely that you are on this subject. I am 17 months from being 59 1/2. I have a 401k at the JOB plus a traditional IRA and a ROTH. I plan to convert the ROTH to SDI now and the traditional when I become of age. What do you think?


  10. Great article, Jeff. I’m looking forward to your next post where you address some of these very good questions people have asked. You definitely have my piqued my interest for doing something with my dismal 401k. One thing that I’m interested in is how moving money from a 401k to a Roth can affect personal liability. As I understand it (and I definitely may be wrong), a 401k offers way more asset protection than a Roth if you are ever found liable in a lawsuit. I don’t think your 401k can be touched. But they can take your Roth (again, I could be wrong). So just something to consider. And if I am correct, I wonder if there are ways to do this within the structure of a 401k or other retirement vehicle that can shield you from liability?

  11. Jeff, The basic premise that folks can do much better for their retirement future by A) switching from the limited, market-based investments most employer plans offer, and B) converting their retirement savings from tax-deferred to Roth status certainly has merit. Many of my self directed IRA & 401(k) clients at Safeguard Advisors (ira123.com) are doing exactly this,

    My problem is the use of the term “gut” with respect to the 401(k), and the assumption that anyone can do this – and should do so all in one shot. If one can “migrate” from a traditional 401(k) to a Roth IRA or Roth Solo 401(k), great. Gutting your 401(k) implies taking the funds as a fully taxable distribution, which is not something that can then be rolled over or converted in many cases. Not everyone can remove funds from a current employer plan, however, as most 401k style plans do not allow for arbitrary distributions other than for hardship (which cannot be rolled over to an IRA), termination, or after age 59 1/2. Generally speaking, this path of changing one’s investment platform and strategy is more suited to a former employer 401(k) or an IRA.

    The “ripping off the band-aid” method of converting a large sum of your tax deferred savints to Roth status is also a double-edge sword. Sure, there is the benefit of putting that Roth money to work in notes or any other investment that performs better than the stock market, but the cost of getting there can be very high, especially if you do not happen to have the liquid funds available to pay the taxes on a Roth conversion. If you are taking early distributions from an IRA or 401(k) in order to pay for the tax on the Roth conversion, you are effectively paying your marginal tax rate twice on those funds used to pay for the conversion. There will be less than 50% of the initial value left to invest with. A gradual approach from tax-deferred to Roth status can be much more beneficial. Keep in mind, you can invest in 12% notes with a tax-deferred self-directed IRA too.

    For those considering a transition from tax-deferred market based investments to Roth investments in alternative assets such as notes, the bottom line is that you need to do considerable research on the plan options before you, and speak with your tax advisor to fully understand the implications specific to your situation.

    In summary. Absolutely consider allocating at least some of your retirement portfolio to non-traditional assets such as notes or real estate. Go ahead and take a hard look at a Roth conversion, but do so with expert guidance. And keep in mind, these two shifts in strategy do not need to be done at the same time or all at once. I personally would not shift the entirety of my portfolio to a new type of investing I was unfamiliar with, nor would I recommend that for most of my clients.

    Consider Jeff’s writing a good kick in the pants to get out and do some serious homework, but definitely, absolutely,and without cutting corners, make sure you understand your options and the tax implications.

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