Set for Life question: using Roth as savings location

16 Replies

I just finished @Scott Trench 's Set for Life (as you can no doubt tell from how often I reference it) and I had a thought/question I'd like to put to everyone. What do you think about using a Roth IRA as a component of the savings vehicle for the $25K-$100K initial steps? Any of your contributions can be withdrawn without penalty, the money would have an opportunity to grow, and there would be a tax advantage to your contribution. I know the limits are fairly low per year, but the rest of your savings could go elsewhere.

As long as I'm aware of and accept the risk, is there a downside to doing this I'm not considering? 

@Shawn Q. Great Question! 

Let's overview this real quick. Most people save less than 5-10% of their take-home pay. At this rate, and achieving a 7% return, they will accumulate enough wealth to "retire" in just over 50 years. For this person, a 401(k) is a great way to save, because they will retire on much less income than they earn today, and therefore likely be in a lower tax bracket. If you earn a high income, and plan on retiring poor, the 401(k) is designed for you. Sadly, this is what most Americans think is good financial planning.

Let's take it up a notch. Suppose instead that you are better than average and save 30% of your take-home pay. You will accumulate the same amount of assets as the guy above in just about half the time, and by the time you hit 59 and a half, likely be very rich. So rich that you will likely have substantial investment and business passive income, even if you aren't all that great of an investor. As a result, you will be in a higher tax bracket than you are now. If you earn a low-moderate income, but plan on acquiring assets and getting rich over a long career, then a Roth IRA is designed for you. Sadly, too few people take advantage of this.

Now, let's kick this thing into high gear. Suppose you read Set for Life, agree with me, and decide that it is actually quite feasible to save more than 50% of your take-home pay starting out, house-hack, take direct responsibility for all of your financial and investment decisions, and otherwise rapidly accumulate a lifetime of wealth in less than a decade. A side effect of this is that you will create passive income very quickly, which accelerates your savings rate (because you have more income on the same level of expense). Therefore, you can accelerate very quickily towards this point of financial freedom. If done proractively, you might spend most of your adult life in a state of financial independence. 

The stakes are very high for achieving this goal very early in life, as the opportunities to try and fail numerous times at entrepreneurship will present themselves. Additionally, a state of financial independence does not preclude us from returning to wage-paying work at any point we so choose. The point is that if this is your goal, then not being able to access the gains from a Roth IRA IS A BIG DEAL. It may preclude you from pursuing the opportunity that could accelerate your progress. It may slow you by months in hitting some of the big milestones, like a house-hack, in good times, and produce no real advtantage in bad times.

The Roth IRA at first glance seems like a great vehicle for folks that might read Set for Life, as it allows you to set aside money to grow tax free over time as you start out in a low (median) tax bracket, and expect to create investment and business income such that you wind up in a higher tax bracket later in life. 

I actually DID contribute to a Roth IRA when I was getting started, and did empty it out (my contributions) when buying my first House-Hack. I remember getting up early on the first business day of each calendar year, heading on over to Scottrade, and putting in the $5,500 maximum contribution as early in the year as possible so that it could compound throughout the year.

Here's the thing - it didn't matter, and would have been slightly to my advantage/comfort to just keep the money in an after-tax brokerage account. Why? Becuase I was not able to access my gains when buying my first house-hack. The point of Set for Life is to achieve early financial freedom. If you are going to invest your savings in pursuit of early financial freedom, why not invest them in a place where you can take advantage of gains, should you see gains?

There is no tax advantage to your contribution (you can only defer taxes on pre-tax retirement accounts like the 401(k)), it's just a bit more complicated to withdraw/access the money, and the only advantage is that you will be able to harvest the gains tax-free at the age of 55. 

Personally, I subscribe to the belief that as a young, ambitious hustler that sustains a high savings rate and invests systematically, that I have a far greater chance of compounding my returns and seeing outsized yields on my own business (real estate) right now, in the prime of life, than I will by allowing my investments to grow tax-free in index funds inside a Roth or 401(k). 

That said, this is MY opinion. And I'm sure that smart, reasonable people can disagree on this point, and contribute to a Roth to advance their position!

@Scott Trench - I think (maybe!) I'm getting what you're saying. I'll paraphrase, and please let me know if I'm close - ultimately you're saying the Roth's limitations increase opportunity cost risk because you don't have the freedom to deploy the gains in the Roth toward anything that has a chance of radically increasing your returns. So a Roth only allows a negligible increase in investment gains over a brokerage account (investment choice remaining equal), but you sacrifice the ability to use those gains for anything that can make a meaningful improvement to your life right now (at least until 55)? 

Tax-free gains, compounded over the long-term, are HUGE.

I'll take that over whatever (potentially taxable) returns I could enjoy on $5,500 per year in the short-term.

But to that point, if $5,500 a year is going to make or break an investor's ability to execute their investment plan in the short term, then they should probably be looking for ways to maximize their income rather than figuring out how to maximize their return on $5,500 a year in the short-term.

And you can self-direct a Roth mind you.

Mine has been invested in stocks (during the Recession), then notes earning 12%, and now a beachfront project in Orange County, California.

The ability to snowball TAX-FREE WEALTH in such a vehicle is a significant financial boon.

I mean we're talking about the ability to grow 7-figure wealth tax-free here over the long-term.

I'll take that over the ability to deploy an extra $5,500/yr in "non-Rothable" assets.

It's not like one is looking to deplete all of his wealth early on in life, so why not grow a portion of it tax-free over the years?

Originally posted by @Logan Allec :

I mean we're talking about the ability to grow 7-figure wealth tax-free here over the long-term.

I'll take that over the ability to deploy an extra $5,500/yr in "non-Rothable" assets.

It's not like one is looking to deplete all of his wealth early on in life, so why not grow a portion of it tax-free over the years?

Could a similar argument be made for company match of pretax 401-k retirement contributions? Say if you have a match of 5%, shouldn't you put in at least 5% because you automatically start with an instant 100% ROI on the 5% you do contribute? I feel like you can just earmark that small "un-accessible" amount of your net worth for later years when you have access to it without penalties.

Originally posted by @Logan Allec :

Tax-free gains, compounded over the long-term, are HUGE.

I'll take that over whatever (potentially taxable) returns I could enjoy on $5,500 per year in the short-term.

But to that point, if $5,500 a year is going to make or break an investor's ability to execute their investment plan in the short term, then they should probably be looking for ways to maximize their income rather than figuring out how to maximize their return on $5,500 a year in the short-term.

And you can self-direct a Roth mind you.

Mine has been invested in stocks (during the Recession), then notes earning 12%, and now a beachfront project in Orange County, California.

The ability to snowball TAX-FREE WEALTH in such a vehicle is a significant financial boon.

 I could do 4 direct mail campaigns with that $5500. Each one may net me a wholesale deal that earns me $5000.

@Logan Allec So I understand your thought process here. But here's the thing -- that FIRST $5,500, that FIRST $25,000, $50,000 in investable liquidity is absolutely precious and hard-won. It's not as simple as "earn more income" for the median income earner seeking early financial freedom. You have to have some cushion that enables you to take risk. That cushion needs every dollar that you can come by in the early stages. I believe that a capable twenty-something, with an eye open for opportunity, is going to find a better use for that $5,500 than putting it in a Roth and indexing it over 30 years. For me, that money went to a house-hack, and then real estate investments. On a house hack, if I leverage 19:1, then I can produce nearly 200% annual ROI in the first few years, and still harvest nearly all of the profit with heavy tax advantages if I play the game right throughout my life.

There is virtually no way that keeping the money in my Roth IRA would have produced a higher ROI than my first house-hack, or even my ensuing other real estate investments following that. Nowadays, I enjoy a hefty surplus in cash flow. Since I have more cash than profitable ways to deploy that cash, a Roth would make more sense were I eligible to contribute.

 But, the good news is that this is a topic where reasonable people can disagree. Folks should get a variety of opinions on this subject, like any others. And, at the end of the day, this is a secondary concern. What truly matters is the savings rate, and the willingness to deploy those assets in investments that produce returns of at least those of the long-term stock market average. If you just do that, you have a great chance at ending up extremely wealthy by age 59 and a half. 

The years in between now and then might be a bit different though, particularly the first few years starting out, depending on how and where you accumulate your wealth.

@Shawn Q. That is exactly what I am saying. In the initial years of wealth building ($0 - $100,000 in investable liquidity), that opportunity cost can be precious, in my opinion. So, it will be up to you to decide if you will meaningful deploy that capital (will it be the "cushion" or "financial runway" you need to change jobs, buy a house-hack, or otherwise make a move sooner than you might otherwise?) or if you won't. If you believe you might, then the opportunity cost of putting it in a Roth and being reluctant to withdraw it might be very large. If you believe that unlikely (for example, you already house-hack and plan to stay at the job for many years), then the Roth may be advantageous.

I feel each situation may differ, I would argue it depends on 1. Your employer 2. Your income 3. Your position. My example would be myself, I work for a public company that matches my roth contribution of 100% up to 6%. 

For me this has been roughly $3,500 combined with a 'free' $3,500 from the company, on top of being in the company stock plan which has went from $150 to low 400's in the last 5 years. The retirement account I have I am able to take a loan out on up to half, from what I read about the plan is that you potentially can use a penalty free withdraw on your home purchase if it has been invested for 5 years. 

I would say it is all relative. If you make enough money to save for a down payment by practicing frugality as Scott's book preaches, this shouldn't be something to lose much sleep over. I would also say for someone unable to save, this is a good option that forces you to. If you spend a year in the position and have 7k after year one, you could easily loan out $3,500 and FHA a 100k property. Or 203k an 60k forclosure and 40k of rehab.

In short I think if you are talking about being self employed then yes the $5,500 lump may mean more at that time. I would say someone with a steady job/income with a match plan is giving up free money, on top of what they are able to earn and save. The other thing to think about, and what I am researching is when you have enough property to eventually escape your job, you can take that roth and roll it into a self directed to avoid the tax on profit (I believe). 

In short, I believe it is relative to the situation you are in, if someone has a job that is matching a Roth, there is no way you shouldn't be putting the $100-$150 a check in that is getting matched imo.

@Shawn Q. the single largest expense you will incur in your life is taxes, so any method to reduce or avoid taxes should be utilized. In a Roth IRA your money has already been taxed and grows tax free. That means no matter what your tax bracket is in the future, the money can be withdrawn without paying taxes. The other advantage is asset protection. Money in your Roth IRA provides some protection from bankruptcy and legal settlements. There is a reason they set contribution limits and income limits - it is a good deal.

Ask yourself, will my taxes be higher or lower in the future? 

With the current tide of taxes going lower, many are speculating on large budget short falls, which would imply taxes will need to increase in the future. As the baby boomer population ages with dwindling tax contributions, it will continue to put a larger burden on younger tax payers. My prediction is that taxes in the future will be significantly higher and real estate investors will be hit hard. 

If you can protect some of your money in a Roth IRA, that is a win. At the end of the day, it is only a few thousand dollars. Put it in a low fee, whole market index fund. It will be hands off and you will see a conservative compounded return. At the end of 30 years you will have a nice little nest egg. Assuming you are successful in real estate, this can be your fun money. If something goes wrong in real estate, the Roth IRA may be your food money.

I kind of in different cam on the 401 k saving. read the book really great contents but it can not be apply to everyone. if you live in high tax rate like California maxing out 401k might not be worst idea . if you are here than you are earning more anyway just to survive.again everyone and there life circumstances are different. coming back to your question. I would rather keep them in cash of some liquid stable instrument than roth IRA.

@Scott Trench

"...a better use for that $5,500 than putting it in a Roth and indexing it over 30 years."

So don't index. I can self-direct my Roth into incredible, tax-free real estate deals.

Having house hacked a 4-unit in Los Angeles that cash flows and has appreciated marvelously with only 3.5% down, I agree it's an incredible strategy that you can't do in a Roth.

But if $5,500 a year is the difference between being able to put 3.5% down or not, then I would maintain that income is the fundamental issue.

"...a Roth would make more sense were I eligible to contribute."

You're an employee of BP, right? Why aren't you eligible to contribute to a (backdoor) Roth?

@Logan Allec You know what? When I hear from a smart guy, I pause and reflect. I thought about this a lot today and last night. And I'm going to qualify my statement somewhat. 

I stand by what I said earlier, but I think that this is only true in the initial years of wealth building. So, in those first few years, I think that it DOES make sense to avoid the retirement accounts and build up a "runway" with after tax savings that you can spend. But, the purpose of this (as I write at length on in Set for Life) is to exploit a few key opportunities - namely a house-hack (which you cannot purchase with funds in an IRA, even a self-directed plan), and to fund your lifestyle as you begin looking for work with greater opportunity.

Much of the time, higher paying work is commission or performance-based, and the tradeoff is often a reduction or outright loss of base salary. So, having an after-tax, spendable nest egg that you can use to offset your lifestyle expenses opens up these opportunities to you and makes them approachable, instead of non-starters. The guy with $25,000 in after-tax cash is more comfortable starting a new career as a real estate broker than the guy with $45,000 in lifestyle expenses and $10,000 in cash. Make sense?

HOWEVER, I see your point, and agree with you. Once you have a high income, a large amount of after-tax wealth and cash flow, AND can max out your retirement accounts and STILL have a large after-tax surplus to invest in assets outside of those retirement accounts, it definitely makes sense to invest through retirement accounts. 

If I am already financially free or close to it, and do not plan to draw down on my portfolio to live my lifestyle in the near future, then yes, of course we should invest in retirement accounts. In fact, since this is my position right now, I am going to reconsider my stance at this time, and consider maxing out my employer retirement plans, including my 401(k) and Roth 401(k). (I have always taken the match).

So, you've literally changed my perspective with your post! Thank you! Do you see, on the same lines, why that $5,500 might be a huge difference to a median income earner just starting out in life, or the guy that is desperate to achieve early financial freedom so as to start a business? In that case, it might make sense not to contribute. But, in cases like mine (and yours) it may make a lot of sense to contribute, especially in self-directed plans. 

@Joe Splitrock - I can see your point, but taxes aren't much of a concern for me at this point. I think Scott's point (now that I get it) is a really good one. Until you're at the point where you have $100K in financial runway, you don't need to worry too much about taxes, you need to worry more about being nimble enough to take advantage of opportunities. 

Like the example in the book I make $50K a year. If I can live off $25K I can have $50K available savings in two years. If I contribute fully to the Roth, I'll have $39K. That $11K can be a down payment in my area (or whatever example of an additional income-producing opportunity you'd like). It's more important for me to be able to use that $11K (plus whatever I earn on that $11K over the course of saving it) to further grow my income. After all, at $50K if I double my income I still fall below the limit for a single person investing in a Roth, and I know there are many ways I can earn much more than $100K and still manage the tax bite. If (when!) I get to the point where I'm stable and in financial freedom, then I can decide to manage tax risk for the future. 

The other point, which I think is a subtext to Scott's reply, is one of focus. This is a very One Thing idea, but if your goal is financial freedom as Scott describes in the book, then Roth investing before you've achieved that goal is a distraction. And anything that distracts from your goal should be eliminated. 

Seems like the answer in this case is one of balance: how are you balancing your progress toward your goal against your tolerance for risk, or at least that's the way I'm currently thinking about this thanks to this thread. Very glad I asked the question!

@Shawn Q. Very well said! Great points! Let's use the Median income earner as the example, I still think the Roth IRA is a great vehicle for wealth building. The Median income earner can use the Roth IRA as a self-directed and trade options with it and earn 70-80% returns pretty easily year after year, yes it may be more risky but you rarely get that kind of return in real estate and never without alot of WORK. I also know someone who buys non-performing notes in their Roth IRA, and easily gets 100-200% returns, all tax-free! Yes you can't access the money until 59.5, BUT it's delayed gratification.

$5500 at conservative 50% return over 5 years (stocks or options trading): $41765. Income = 0

$5500 outside of a Roth IRA same 50% return but you get hit with 25% federal income tax + state (lets say 0% as in the case of NV): $27032. Income = $2062/year (after taxes)

$5500 into real estate, generous 20% COC return (deferred tax from depreciation and other write offs, so no tax for 1st 5 years) = $13686. Income = $1100/year.

The numbers are overly simplified but my point is, tax takes a huge chunk out of your compound interest equation. So the question becomes what are you after? Cashflow (income) or equity (wealth)? And someone mentioned asset protection, everything inside your Roth IRA is protected whereas your real estate outside of a retirement account is not.

401(k) is different story, most company 401(k) is managed by large mutual fund companies with very limited fund options and high fees, mine averages 4-8%, it's pathetic. My stance on the 401(k) is: if your income is below $75k, do not contribute to your 401(k), take the money pay the taxes & invest it elsewhere. If your income is higher than $75k, you are in a higher tax bracket, and at that point it's a way to offset your taxable income to a lower bracket. Just know at some point, when you leave your job, you can transfer to self-direct, or convert to Roth, or better yet, borrow against it and invest in something with much higher return. BUT @Scott Trench is absolutely right, no income until 59.5. NOTE: Tax bracket is extremely important once you pass $100k/year income, your write-offs get phased out starting at the $100k mark (means less deductions), so you pay even MORE taxes.

My strategy is invest in real estate with savings for passive income and some level of wealth building. Roth IRA for high risk, high reward vehicles such as stocks, small caps, and options trading - wealth building only. 401(k) for lowering tax brackets only, not as an investment vehicle, at least for me. If someone else has successfully used 401(k) as an investment vehicle, I'm all ears.

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