Personal Finance

How to Use Real Estate to Retire MUCH More Comfortably Than Your 401k Would Allow

Expertise: Personal Development, Personal Finance, Mortgages & Creative Financing, Real Estate News & Commentary, Business Management, Real Estate Investing Basics, Flipping Houses
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Let’s create a very credible scenario today. Surely by now BiggerPockets is closing in on its gazillionth member, and most of ’em are regular folk like you n’ me. They go to work, and most get married and have a family. Furthermore, in far too many families, the economy for quite a while now has demanded both parents work to make ends meet and maybe get a teensy, weensy bit ahead. Here are the “facts” about our fictional couple. See if they don’t sound like you or many you may know.

Gary is 40, and his wife, Nicole, is 39. Married in their early 20s, they now have a couple kids, 12 and 9. Gary makes $48,500 a year before taxes. Nicole makes $16 an hour for 25 hours weekly as a bookkeeper, which comes out to approximately $20,000 a year pre-tax. They live in Texas, where they were both born and raised.

What They’ve Done So Far

For the last 15 years or so, they’ve each been putting $250 a month into their self-directed Roth IRAs. It’s what they’ve been able to afford. At first it was due to what they made at work, but then with the kids, well, I’m sure you get the picture. This has resulted in them having a combined balance of about $115,000 between the two accounts. Not a stellar return — about 3.5% a year average — but it’s nothin’ to sneeze at.

They also bought a modest home using FHA financing back when the prices were, um, “reasonable.” 🙂 They’ve remained there, as the home has three bedrooms and a couple bathrooms. However, they wish they could move to a home with more square footage. They have no other investments and pretty much live on a strict budget. They go out occasionally as a couple and as a family. The normal stuff. Over the last 15 years, aside from their separate Roth IRA contributions, they’ve been able to put away a bit over $25,000 — what they call their “rainy day” fund.

Though Gary gets small raises ever now and then, his income will be lucky just to keep up with inflation. The question begging to be answered is — Just what are they gonna do for a retirement income?

buy-hold-retirement

What Are Their Options?

They have many. Here are a couple.

  • Refinance their home loan to lower payments significantly. They'll cut their monthly payment down by $300. This is a Captain Obvious no-brainer and should be done regardless of anything else they may choose to do.
  • Put both of their self-directed Roth IRAs into discounted first position notes/land contracts, secured by real estate.

They can easily accomplish the latter through an investor group model. They have neither the knowledge, expertise, nor experience to invest in notes by themselves. In fact, investors moving into discounted notes without experience or professional advice are far more likely than not to end up with an advanced degree from Hard Knocks University. I’ve seen it far too often. Note investing shouldn’t mirror amateur night at the local comedy club.

Related: How Retirement Contributions Are Saving One Real Estate Investor $53K in Taxes

Note: Last month was the 40th anniversary of my first discounted note purchase. In that time, I’ve yet to have a note produce an overall yield — from day one in ’til last day out — of less than 10%. Every now and then, pretty rarely, I’ve had a non-performing note/land contract return less, even lose money. But the returns on non-performing are so much higher than performing that the occasional loser is less than a blip on the screen, relatively speaking. How high can the yields be on non-performing liens? Cartoonishly so. But the super high yields are just as much outliers as the losers are IF it’s done professionally. However, those of you wishing to get your foot in the door of non-performing notes/land contracts secured by real estate should always keep in mind that those much higher yields come with equally higher risk. Most folks don’t like talking about it, but there it is. The higher the risk, the higher the yield, and the bigger chance of failure. Don’t kid yourself. This is why using a pro to mitigate that risk, non-performing OR performing, is a necessity if you’re serious. This point cannot be over emphasized.

If Gary and Nicole keep putting in the modest sum of $250/month a piece into their Roth IRAs for the next 25 years and put that money into discounted notes  — performing — let’s see what happens. In order to make the point more compelling, we’re gonna assume they average a paltry 8% overall annual yield, something I’ve not seen in my professional career as it relates to discounted note yields.

The Analysis

Present value = $115,000

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Annual investment (payment) = $6,000

Time (n) = 25 years

Interest/yield (i) = 8%

They’d end up when Gary turns 65 with about $1.25 million in their two Roths combined. If we extend the lousy 8% example annual return ’til they both die, that’s a tax-free income BEGINNING at around $100,000 a year — wait for it — tax free. Why do I say “beginning”? Simple, cuz their portfolio of performing notes/land contracts will continue to do what they do, which is to pay off early in a totally random manner. (Most pay off in a 3-9 year range.) Inside the Roth, there’ll be no taxes on the profits. The money will be reinvested in larger liens with slightly larger monthly payments. This means, in essence, that they’ll forever be getting random “pay” raises their entire retirement. How freakin’ cool is that?!

retirement-goals

Related: How to Retire in 3 Years Through Real Estate Investing

Can they do other things? You bet. But considering they have a couple kids and haven’t yet figured out how to print $100 dollar bills, this will have to do. They can do other things. But given the cost of living for a family with this income, regardless of the fact they live in a relatively low cost-of-living state like Texas, this plan is eminently doable.

Let’s compare this approach to the typical family with their 401k plans. I’ll make this short. 🙂

If this same family across the street from our couple ended up with a work-related 401k balance at age 65 of $1 million bucks (make-believe at its best), then made the same 8% return (another delusion), they’d be living on $80,000 yearly — BEFORE taxes. In other words, they’d be grossing far less income than Gary and Nicole will be netting. The neighbors’ net income would be around $67,000.

The kicker? The neighbors can’t even come close to achieving that in their work related 401k. It’s a fantasy to say the least.

The Takeaway

Getting ourselves to a very nice retirement, one allowing a full lifestyle with travel and whatever else makes your day, doesn’t hafta be super complex or sophisticated. It does require a cogent plan and for that plan to be executed on purpose. Gary and Nicole will retire with more tax-free income than they likely ever made pre-tax in their lives, combined. All they did was what they could do and what they could afford. Imagine if somehow they’d been able to shoehorn in a rental or two? 🙂 When the smoke clears, the truth is that none of this, assuming there’s a pro in the mix, is rocket science.

Investors: What does your retirement strategy look like? 

Let me know with a comment!

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.
    Justin Fraser Rental Property Investor from Milltown, NJ
    Replied over 4 years ago
    Jeff, where could this couple go to find this “investor group model”?
    Jeff Brown from San Diego, CA
    Replied over 4 years ago
    Hey Justin — I don’t know of any personally. However, we both know there has to be a bunch of ’em around the country. There’s no way I’m the Lone Ranger with these type groups. Notes in the last few years have become more of a topic than in the previous 30 years. The demand is, and will continue to increase for at least the next 20 years. Boomers will be a huge factor in this growing demand.
    Paul MacInnis Investor from Windsor, Nova Scotia
    Replied over 4 years ago
    My favourite part of real estate investing……..how truly diverse it is! This is awesome! Thanks, Jeff!
    Jeff Brown from San Diego, CA
    Replied over 4 years ago
    It is diverse, isn’t it?
    Paul MacInnis Investor from Windsor, Nova Scotia
    Replied over 4 years ago
    Jeff, it really is and what i’m starting to learn is that once you get comfortable with one ‘area’ of investing it could be time to start looking into another ‘area’. I’ve been exclusively purchasing small multi-family properties for buy and hold, but recently i’ve been getting into private lending. Cheers for the article!
    Jim C. Investor from INdiana
    Replied over 4 years ago
    I guess I’m confused…. If a note can almost guarantee 10% returns, then why don’t all stock and bond investors invest in these exclusively??? And, wouldn’t you find “NOTE” shops on every street corner like all other investment companies? You mentioned “Investor group model” but then in the comments said “I don’t know of any personally”…. Does this mean they are elusive?
    Jeff Brown from San Diego, CA
    Replied over 4 years ago
    Hey Jim — I missed where the post says the returns on notes are guaranteed. Your premises about a note shop on each corner are pretty funny. The fact I’m thinkin’ there are many private note investment groups doesn’t mean I know where they are. I imagine a simple Google search would unearth many from which you can choose.
    Christian Thompson Investor from Denver, Colorado
    Replied over 4 years ago
    Hi Jeff, great article. How can I get started investing in discounted notes. I have a self directed Roth IRA in place.
    Jeff Brown from San Diego, CA
    Replied over 4 years ago
    Hey Christian — The answer depends heavily on whether or not you’re an accredited investor; if you’re interested in group investing; and a few others. Reach out to me and I’ll be happy to show you your options.
    Frandy Ho Investor from Union City, California
    Replied over 4 years ago
    Hi Jeff- Its interesting, I would like to look into your options. How to contact you.
    Jeff Brown from San Diego, CA
    Replied over 4 years ago
    Hey Frandy — Please email me at: [email protected]. I’ll be looking for it. 🙂
    Aaron Sauceda from Placentia, California
    Replied over 4 years ago
    Hi Jeff — thanks for the post. I enjoy reading your retirement-related pieces. I know it’s different for everyone, but in the average “ideal” case, how does note investing fit in with EIULs, rental properties and other supercharged investment vehicles? Which should be the priorities, or put another way, what’s an “ideal” powerful mix/portfolio you’ve seen?
    Christina Welch Investor from Lakewood, Washington
    Replied over 4 years ago
    Jeff, I really enjoy reading your articles. How much does one need to initially get started in note investing?
    John Humphries Investor from Courtenay, British Columbia
    Replied over 4 years ago
    Hi Jeff. Another interesting article. If a person (such as myself) does not qualify as an accredited investor, is it still possible to invest in note funds? Also, just caught David Greene’s BP Podcast #169 that mentioned a strategy that you had put together with him. I’d be interested in more info about these types of strategies if you have anything that you can pass along.
    Danielle Levins Real Estate Broker from Tampa, FL
    Replied about 4 years ago
    Great post Jeff!!! Way to make a person like myself think about alternative retirement options!!
    Eric B. Homeowner from Hopkinton, MA
    Replied about 1 year ago
    While the information about buying notes in the article is great, there are a few big issues here. The comparison to the 401k is a bit absurd considering that the hypothetical couple #2 could have contributed to a ROTH that invested in stocks as well. It also means that you aren’t comparing apples to apples (post tax vs pre tax dollars going in). I am also wondering why an 8% return is a delusion, considering the S&P averaged 9.8% over the last 90 years. I am all for comparing different investment approaches, but lets at least look at them objectively.
    Joseph Walsh from Brookfield, Wisconsin
    Replied about 1 year ago
    It’s even better than that, the WHOLE 90 years is ~10%, but any 20 year window is closer to 12%!
    Johnny Sooc
    Replied about 1 year ago
    This article lost all credibility when he said 8% return on 401k is a delusion. Either he doesn’t know how 401k works or he thinks the readers don’t know how 401k work.
    Donald Choi
    Replied about 1 year ago
    Hey Jeff, It’s an interesting thought on notes investing. There is always credit risk and I wonder what the credit risk is associated with the return and yield. As for the Roth math, on a 401K you would have to account for the tax equivalent investment because it’s pre tax. Because Roth is after tax, you would have to show the tax equivalent math to show the true yield, and compounding effect for future value.
    Matt Dobroski from Stroudsburg, Pennsylvania
    Replied about 1 year ago
    I’m curious too how the couple making $68,500 and 100 something thousand in Roth’s are considered accredited……pro status for a reason i suppose.
    Michael Walton Rental Property Investor from Tallahassee, FL
    Replied about 1 year ago
    I think he mentions "group investing" as a work around the accredited investor. Not sure if that's what's happening in the example Jeff provided, but I can only assume as the couple clearly doesn't meet the criteria.
    Joseph Walsh from Brookfield, Wisconsin
    Replied about 1 year ago
    Sigh, It’s blog posts like this that actually do more harm than go. The author creates unrealistically “bad” scenarios for the “don’t do this” and unrealistically “ideal” conditions for “do this instead” While RE is a good option, so is the 401k, particular with a match, and low fee index funds. Also, you are asking this couple to invest 9% of their post tax income, whereas, apples to apples, if they could afford the same take home pay, they could invest ~13% of their pre-tax income, with the same take home pay, PLUS any employer match they might get. Yes, they are taxed on it in retirement, etc. The point, be real. Compare apples to apple, or at least apples to oranges, not apples to fords.
    Susan Maneck Investor from Jackson, Mississippi
    Replied about 1 year ago
    We’re forgetting a few things. 1. Always contribute to your 401K up to your employer’s match. Otherwise you are leaving money on the table. But if you are only getting 3 1/2% on their retirement moneys, they need to look more carefully at what they investing in. 2. Is this hypothetical couple self-employed? If so why aren’t they in a solo401K rather than a self-directed IRA? The former have far fewer restrictions and costs. I own three houses in mine.
    Rick Harmon
    Replied about 1 year ago
    He did not mention that most if not all employers offer a 100% match of investments up to a certain amount, making your returns even higher.
    Joel Morton
    Replied about 1 year ago
    Also, most 401k’s nowadays have a loan feature. If you can get 6% and borrow at 4.5% inside the 401k, then buy real estate and use the cash flow to pay off the loan like a mortgage, then you get uninterrupted compounded interest on two fronts and essentially a negative borrowing cost. So why not do both 401k and real estate? Also, you can contribute more to a 401k than an IRA and the match makes it a a no brainer.
    Timothy Bundy
    Replied about 1 year ago
    Hi Joel, I am curious about the 401k loan. Isn’t there a relatively shallow limit to loan that you can withdraw from a 401k?
    Michael Walton Rental Property Investor from Tallahassee, FL
    Replied about 1 year ago
    It's typically limited to 50% of the balance in your 401k. I think the thing no one talks about w/ a 401k loan is that you also halt receiving any employer match during the period in which a loan is outstanding (since you are typically restricted from making contributions to receive said match). Results may vary and I can see the case for folks that don't receive a match, have a moderate salary, or the match is pretty low. But, I also know some fortunately individuals that make $100k+ salaries that receive 7% matches. Very rare I know, but I would have to think that a person like this can't really consider a 401k loan as it's hard to pass up an immediate 100% return on 7% of your contribution.
    Jason Oberweis from Atlanta
    Replied about 1 year ago
    I am sorry to throw shade on your post, but the title doesn’t make much sense to me because of the hypotheticals you showed. I thought the post would be about why real estate is better than a 401k, but that’s not really what you demonstrated. Both couples started with about $1 million nest egg. Both couples made 8% on their investments. The only difference is that one is invested in a tax deferred account (the real estate note couple) and the other is in a taxed account (401k). What if the 401k people were in a Roth 401k? Then it would all totally be the same if we use your other numbers, right? Conversely, what if the real estate people were in stocks returning 8% dividends a year? It would still be a Roth account, so it would be no difference. In my opinion, the title should be Roth vs. Traditional. Then the rest of your post makes sense.
    Alan M. Rental Property Investor from San Francisco Bay Area
    Replied about 1 year ago
    I’m not sure it’s a fair comparison. Against a 3.5% return, almost any other option will be better. A diversified stock/bond portfolio should return 7% annually without much risk. Self directed IRA usually come with much higher fees and most 401ks wouldn’t be sitting in a SDIRA anyways. That being said, i’m sure note investing can be lucrative, but for the average joe-shmoe, especially one that’s not accredited, diversification through index funds will be the most sure way to secure their retirement.