Can someone check my math?

13 Replies

I was trying to run some numbers through a spreadsheet to see what the effects were

of cashing out a 401k to invest in vs. leaving it in a self-directed IRA/401k.


1. Starting value of 300k in 401k

2. Lose a third of that by cashing out

3. Lose about 20% by converting to Roth

4. All cash (reserves required + net rents) is deposited in an account and just held there.

5. Rents are 1.3 percent of total purchase price of property

6. Expenses are 50% of rents.

7. Cashout option allowed to invest with 20% down and 5% reserves

8. Retirement accounts required to invest with 40% down and 10% reserves.

9. All had 30 year mortgages at the same rate.

10. Cash option paid 25% tax on net rents (may not have done this quite right)

11. Very simple monthly appreciation and increase in rents based on 3% for inflation

and for appreciation (I know this isn't realistic, but it made the calc easier)

So, for example, the SD Regular IRA would be able to purchase $600,000.00 property

because it has the full 300k to work with, but must use 240k for a down payment and keep

the other 60k in reserve. The Cash Option was able to purchase $800k of property

even though it only had 200k to start with.

This is what I found after 30 years (end of loan):

SD Normal IRA:

Gross Rents - $ 19,100.00

Property Value - $1,470,000.00

Cash Account - $1,629,000.00

SD Roth IRA:

Gross Rents - $ 14,600.00

Property Value - $1,127,000.00

Cash Account - $ 948,000.00

Cashout Option:

Gross Rents - $ 25,400.00

Property Value - $1,960,000.00

Cash Account - $1,378,000.00

What strikes me is that the cash account in the cash option is after-tax money. No

more tax gets paid on that. Also, the gross rents are much higher because a larger

amount of property was purchased.

Now....did I go horribly wrong somewhere? Because by these numbers, I should

dissolve that retirement account tomorrow.

Thanks in advance for any help in figuring this stuff out. I'm sure that I

must have missed several pertinent pieces of info.

You have $300K in the 401K. The CAGR of the stock market over the past 50 years has been 10%. If you use a 10% CAGR for 30 years you get $5.2 million ... drop that down to 7% to account for inflation, you end with $2.3 million. Just roll the 401K money over to a Vanguard IRA & put it in VTSAX. Then start building savings to invest in real estate outside of retirement. This way you have a diversified portfolio of both equities & real estate.

@Gregory Hiban  

While I am not opposed to diversification, I wasn't trying to compare stocks vs REI. This example ignored reinvestment. Actual returns in either example would have been much more. I am really wondering if, specifically for real estate, the retirement account structure works.

Also...those 30 year average numbers don't help much when you retire into a bear market.  I like the idea of having at least some control of how investments perform.  Maybe I'm just a control freak.

If you have your spreadsheet in Google Docs or can transfer it there then post the link here, it would be much easier to check the formulas than trying to replicate all the different moving parts & assumptions (like what interest rate you're using).

Hey Shawn, this will be long ... so here it is:

As far as your calculations, I don't see any errors in the traditional IRA or Cashout sheets. For the Roth, if you're losing 20% in the process of rolling it over, that should leave you with $240K, not $230K. Also, since the real estate is held within the Roth account and has already been taxed, I am not sure you need to take 25% off the net rents for income tax as long as it stays within the Roth (though don't quote me on that, haha).

Regarding your underlying assumptions. For all three of these, you need to take into account closing costs on the initial acquisition of the real estate, which will decrease the amount you can buy. Another thing that is definitely missing is the effect of depreciation. I am not sure how depreciation is handled within a retirement account versus a taxable account. Also, everything in these spreadsheets is highly contingent upon the accuracy of the rental rate, expenses % and interest rate since they have various levels of starting debt to amplify the returns. Additionally, as you mentioned when I brought up equity investing, all of that cash building up can be put to use, and will perform differently in the different accounts as well.

Specifically with the retirement accounts, there are a few extra things you have to consider. First, self-directed IRAs that own real estate will need a custodian institution that does all the legal & administrative BS ... they'll be charging you to do all this. Second, I believe debt financing within a retirement account may be subject to UBTI. Third, not a numerical consideration, but if the real estate is in a retirement account, you won't really have access to the real estate or cash until retirement without significant penalty.

Also, please sit down with a GOOD financial planner & tax accountant before you do ANYTHING. If you clear out your entire 401K at once for either a Roth or to cash it out completely, that is ALL recorded as taxable income. With an additional $300K in income on top of your salary, you will be bumped up into the top tax bracket for 2015 & unnecessarily pay tens of thousands in extra taxes (I'm assuming, unless you are already in the top tax bracket). If you go Roth or cash out, most likely you should stage it over 5+ years to save on taxes. Also, you can sit down with an accountant who can get your taxable income as low as possible on paper so you can decrease the tax cost of the Roth conversion / cash out. Sitting down with an expert on this stuff is well worth the $500-$1,000 fee.

One more thing to consider is the source of the return. The cashout return is more reliant on equity which is a much less certain return than cashflow and has a higher degree of risk since there is a higher percentage of debt on the properties. Also, since the buildings will be fully depreciated after 30 years, you either have to keep it forever or pay capital gains on the full $1.9 million minus the cost of the land.

I am going to stick with my original recommendation of leaving your retirement funds in equities. If you want more control over it than dropping it all into an index fund, use a self-directed IRA through a brokerage firm like Scottrade to build your own fund of 20-30 stocks you personally choose & invest in some REITs you like to get the real estate exposure. However, if you are hell bent on investing in individual pieces of real estate, sit down with a financial planner & tax accountant before doing anything.

Hope this helps, as long-winded as it was.

@Gregory Hiban  

Thanks! You are right that I was probably incorrectly taxing the roth version.  I'll fix that and see how it looks.  So, many of the issues that you discussed will actually put more weight on the cashout option.  The issue with depreciation I didn't address, but that would have offset some of the 25% tax on the net income. 

I guess the biggest questions I have are:

1. Is the assumption of the disparity in leveraging power accurate or close to accurate?

2. Is my assumption of 30% loss way way too low?  I live in TX, so no state income tax.

There have been many debates on this forum over using the self directed retirement accounts for real estate investing.  I haven't seen the leveraging issue directly addressed (but maybe I didn't dig deeply enough)

Maybe some of the people who have exercised one option or the other could weigh in.

Hi Shawn,

I cannot give you advise about cashing out or not but I can say something about your assumption of owning for 30 years. This might be simpler for calculation sake but you are leaving a great deal of money on the table by such a long term buy and hold. Just consider the equity build up over 5, 7 or 10 year periods that you could extract from your property and re-position into a larger property or several smaller properties. This is only one example of strategies that are available in real estate that are not available in securities. Your two million of equity could be double that or more depending on external factors. 

1. I would say the disparity in leveraging power is pretty accurate. Leverage sacrifices current cashflow for higher overall ROI & appreciation. Assuming you are investing relatively nearby to the town on your BP profile, long term real estate appreciation will probably be quite heavily tied to the long term health of Houston's energy sector. If you think the energy sector will be booming for decades to come, you could experience much greater than 3% appreciation which means the more leverage (within reason) the better. However, if Houston's buoyant energy sector becomes relatively short-lived, your appreciation many not even keep up with inflation. I'm not an expert on Houston (besides thoroughly enjoying my Kinder Morgan capital gains & dividends), so this is not a topic on which I can give an educated projection.

2. Yes, I think you are pretty significantly underestimating taxes if you plan to do a Roth conversion or cashout all at once. If you cash out, you get hit with the 10% penalty automatically. The income tax portion will be the same whether it is a cashout or Roth. With the $300K in income from this move, you are looking at a marginal tax rate of between 33%-39.6% depending on your marital status & current salary. You may also get hit with some of Obama's new high earner taxes as well. I wouldn't suggest realizing $300K in income in one year. As much of a broken record as I may sound, I can't stress enough how important it is to take this to accountants & financial planners where you can divulge your entire financial situation & they can layout multiple tax-efficient solutions.

@Greg Hiban

Yep...I was looking for inputs here since there are some pretty smart folks in these forums, but I've already sent an email to my accountant to ask for some sit-down time to seriously discuss options and strategies.  I'm just tired of what seems to be lackluster growth that is probably the result of my own negligence.  But, the current valuations in the stock market are making me very skittish about jumping in deeper.

@Howard Abell

Oh, absolutely, Howard.  I was merely trying to show the difference in outcome with less money but greater leverage.  I would be extremely foolish to leave that money untapped for 30 years....Hey, I'm not sure if I even HAVE 30 years left.  Thanks, for your input.

If you take the 401K all at once, your loss could be as bad as 125K - 40% by the time you factor in the 10% penalty.  You likely have to put down 25%, so your remaining 175K can only be leveraged into 583K which is less than keeping it in a traditional retirement vehicle.

Also in practice it gets challenging to finance properties after the 4th or 5th property.  

I think the better high-leverage strategy, would be to get a loan on part of the 401K balance to acquire under-priced properties.  When the properties have seasoned, they can be cashed out and the 401K loan can be paid back.  You will need some actual cash reserves, but the 401K balance can help with qualifying for loans.

In practice I would recommend getting properties outside of a tax shelter first. Then once financing became more difficult, I might consider a self-directed IRA at that point.

@Jesse T.

That's great info.  Thanks.  So, the drawback to what you are saying, though is that I can't take a loan against a 401k that I have from a former employer, can I?  That's where the money I am talking about currently resides. I do have a much smaller balance in the 401k at my current employer.

Originally posted by @Shawn Root :

@Jesse T.

That's great info.  Thanks.  So, the drawback to what you are saying, though is that I can't take a loan against a 401k that I have from a former employer, can I?  That's where the money I am talking about currently resides. I do have a much smaller balance in the 401k at my current employer.

Most 401ks will allow a roll over into the plan.  So you can do a roll-over to get your balance up to 100K.

You can rollover into separate retirement accounts, so you could create an IRA also that could eventually become your Real Estate IRA if you want to go that route.

Ehhh, I wouldn't advise using a 401K loan to finance real estate. If you leave the job for any reason, the loan must be repaid in full within 60 days or it is subject to the 10% penalty and income taxes. So if you were to get laid off, you would have no income coming in and then have to choose between finding enough money to pay off the loan or eating the substantial tax bill.

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