Real Estate Notes vs. 401k: Which Investment Wins Out Over 30 Years?

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Having fun conversations all day is what consistently turns my work into play. Even on the franticย days, when at the end of the day I can feel my IQ begin to drop precipitously, these conversations remain as a fix for the shameless addict I am.

Every now and again, I run into a whippersnapper who is wicked smart — and disagrees with me.ย It rarely gets better than that.

This guy was plainly smarter than I am, and that’s not false modesty. I may be smarter than the average bear, but I promise M.I.T. never recruited me. ๐Ÿ™‚ Our discussion ended up in a very interesting debateย about the relative merits of his company sponsored 401k, their generous matches, and me with notes inside a Roth envelop.

It was a fun debate, especially given this guy was still under 30 and already had amassed a hair under $200,000 in his 401. I liked him even more due to his clearly world class upbringing — highly respectful, without the superior attitude many youngins, including me at that age, bring to the table. A very cool guy.

It’s even better that he’s on the East coast and printing $1,000 bills at his job โ€” wait for it โ€” as a financial whizkid. He pays far more in income taxes than the median household gross income. And, boy, did he ever know his stuff, big time.

Related: Questions! Questions! Questions! There Are So Many Questions On Why Your 401k Is A Retirement Income Loser!

Let’s look at his position vs mine to see what’s what over the next 30 years.

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A Comparison of Two Investment Approaches Over 30 Years

He says that since he gives about $16,000/yr with an additional company match of the same amount, that he’ll end up with a dump truck of cash at 60. (We agreed to round up from 59.5.) That’s $32,000/yr in the stock market. He says letting it ride has historically resulted in 7% average annual return, even counting all the crashes and bull markets. OK, I accepted that as the Lord’s truth.

Let’s see what happens in 30 years. Remember, he’s already beginning with a $200,000 balance, so I’m including that at the start. Here’s how I’m figuring.

N = 30 years; I = 7% annually; PV = -$200,000 current balance; PMT = -$32,000/yr total ‘contributions”; And finally, FV will equal what he has as a lump sum 30 years from today.

Does that work for everybody? Cool, let’s get cookin’.

This shows that WhipperSnapper will indeed have kicked some clearly major league booty. He’ll end up with just over $4.5 million in his 401k, just in time to be able to take it out however he sees fit. He lives in New York, so the taxes will be onerous, to say the least.

Let’s say he continues getting 7%, which ain’t gonna happen, but let’s play pretend, ok? That yields a pre-tax annual income of around $315,000. Given the fact he’s paying taxes in one of the two highest income tax rate states in the nation, his taxes overall will be painful. Counting state and federal taxes, he’ll be billed for at least $100,000 a year, and those living in NY know already that I’m being generous. Sad, isn’t it?

His Approach’s Results

This leaves our guy with approximately $215,000 a year in spendable after tax income. Better than a kick in the head, right? Who wouldn’t sign up for that retirement?!

But What if He Opted for My Approach?

In a nutshell, I proposed he blow up his 401k — IF the company would allow it. Some do, most don’t. That’s the reality. We’ll act here as if they allowed it. After all income taxes and penalty, even if spread out over 2014 and 2015, which would only be a week or two in this case, let’s assume he netted just half of his money, $100,000. He’s a W-2 employee, so a Solo 401k is outa the question. That’s too bad, seein’ that he would’ve been able to contribute so much more than a Roth IRA allows. For the sake of this post, I’m giving all the advantages possible to WhipperSnapper. ๐Ÿ™‚

He now has his lousy after tax $100,000 in his Roth IRA. He can no longer contribute more than $5,500/yr. In the last 10 years, that will go up a whole $1,000. Woohoo!! His investment vehicle of choice will be discounted notes in first position, secured by real estate, and with warranties. We’ll use the bottom of the yield range, 12%. Even though it’ll be significantly higher than that when cap gains are realized along the way, we’ll assume those notes NEVER pay off early. Yeah, that’s a joke to be sure, but I’m tryin’ my hardest to make this comparison less brutal than a Christians vs. lions affair. ๐Ÿ™‚ If I’d included early payoffs, which would indeed be the case in the vast majority of notes, his actual annual yield woulda been somewhere in the 15-20%/yr range.

NOTE: For those somewhat unfamiliar with various terms, here’s what matters. I’m using a conservative 12% based upon “cash on cash”ย yield only. The formula used is simple: Cash flow received from note per year/price paid. So, if his Roth paid $100,000 for a note and received $12,000 a year in payments, his “cash on cash” yield would then be 12%. The capital gains would come into being if any note paid off before it amortized itself to zero. That happens, as I said earlier, most of the time. However, I’m not incorporating that into this comparison, at least at first. ๐Ÿ™‚ I’m assuming every single note his Roth buys will simply make payments to the Roth ’til it’s paid.

I computed the results using the exact method as we computed the results using his method. The only difference was that I had to do a couple separate calculations. The first one was for 20 years utilizing the $5,500 contribution limit. The last decade I continued, but boosted that to the over 50 $6,500 limit. I hope you’ve mentally noted that not only did my approach begin with only half the beginning balance of his way, but that the annual total contribution was barely 17% of his. Every year in his way, there was over $26,000 more a year in contributions than mine enjoyed. Quite an advantage, eh?

My Approach’s Partial Annual Income So Far

The balance in 30 years is just over $4.3 million. The income from that figure alone will be roughly $520,000 yearly โ€” tax free. But wait, there’s much, much more.

Did you really think I was gonna let the money from all those years’ payments just sit there? Here’s what I did. I took all those payments, and bought more notes. It started with the second year. It’s been goin’ on every year since.

Now, I’m not gonna go through almost three decades of payments buying notes and the results. I will say that there’s simply no way that the income doesn’t provide an additional $200-400,000 a year in annual payments, all of which, of course, would be tax free. Being generously conservative, let’s just say those payments bought notes generating at least another $200,000 a year in tax free income.

How is that even possible, you ask? Simple arithmetic. After 20 years, his absolute minimum annual income from notes is somewhere in the range of $150-250,000/yr. I simply took the bottom end of that and brought it forward the last 10 years. Even that was sabotaging the real life outcome quite a bit. But you get the drift, I’m sure.

The Tally So Far

If WhipperSnapper opts for my approach, he’d end up with a tax free income at 60 of around $720,000 a year. In other words, my way, in terms of after tax annual income, can buy his way 3 times a year, with enough money left over to buy a new Lexus. ๐Ÿ™‚ These numbers are real. They’re handicapped by never having any note pay off early, which is a patently ludicrous assumption. If I hadn’t hobbled my approach in that way, what woulda been the result?

There’s no way on God’s earth he wouldn’t have ended up with $1 million a year in tax free income. That’s nearly quintuple when compared to using his way. His way is like coming to a gunfight with a rubber knife. It simply cannot compete on any level. But let’s try just for fun, ok?

What if his yield wasn’t the 7% they tell us to expect on the stock market? What if it was the same 12% my approach generated? Let’s see.

N = 30 years; I = 12% annually; PV = -$200,000; PMT = -$32,000/yr total ‘contributions’; What will the FV (future value) be? Turns out it would be WAY impressive, around $13.7 million.

Let’s see how that comes out at 12% annual yield in retirement. That figure is about $1.6 million a year before taxes. His combined state/federal tax bill would be around $700,000 or so. Still, that leaves him about $900,000 a year in after tax retirement income. And that’s the way it’ll remain ’til he croaks.

Related: A 100% Employer Match On 401Ks โ€“ The Best Thing Since Sliced Bread?

NOTE:ย Notice how laughably ridiculous it must be for him to even come close to my way? He had to have an annual yield of 12% for 30 consecutive years in the stock market. He then had to have that happen from the day he retired ’til the day he took his last breath. Except in retirement, it wouldn’t be just growth ‘n dividends. It would hafta be ALL dividends or bond income. Of 12%. No, really, stop snickering. That’s beyond ridiculous, but it surely makes my point, doesn’t it? Not only that, but when he turns 70.5 years old, Uncle Sam will begin to demand he take much larger distributions each year, which will not happen with a Roth IRA. The point? There’s no level on which his approach isn’t woefully inferior.

Back to My Approach

In reality, and with the real life knowledge that most notes actually do pay off early, the tax free income will indeed hit around the $1 million mark annually. Here’s the kicker. That will be the lowest income he’ll ever have ’til he dies. This is due to the fact that the notes don’t know or care that he’s retired. They just keep paying off early at random times. The profits remain tax free, and WhipperSnapper keeps buying more notes, generating ever larger monthly payments. If he lives ’til he’s 90, another 30 years, only the Lord knows how much tax free income he’ll be receiving by then.

These numbers are boringly easy to analyze. The process is equally tedious and monotonous. The results, however, are anything but boring, wouldn’t you agree?

I wonder what WhipperSnapper would do in order to spend over $80,000 a month in retirement? ๐Ÿ™‚

About Author

Jeff Brown

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

49 Comments

  1. Adrian Tilley

    Jeff,
    I like the article, and I get the point you’re trying to make in these example articles you put out. A couple of points, for fairness’ sake:

    1. You state that under his plan, he’s investing $26k more than in yours. Not really – he’s only investing $10k more, and the employer’s ponying the rest. Given the match (and depending on the vesting schedule), he would be better to take the match, then move the money once vested. Also, he could probably do both approaches given his income.

    2. You doubt that stocks will continue their historical 7% average growth. Why?

    3. You assume that under your plan all the money will grow at 12%. That can’t happen, because you probably won’t be able to buy a note for *exactly* the available cash in your account. It might only be 70%, in which case you’re only getting that growth on that portion of your account. Your way still might be better, but not as much so.

    4. There’s the possibility under your plan that the first note purchased defaults in 3 months and the house isn’t worth what it was thought to be, and you lose a substantial amount of money. That won’t happen with the market (at least in the long term).

    5. He won’t pay as much in taxes as you expect. If he has any brain, he will establish residence in a state with no income tax (I know he’s still paying federal taxes).

    One question I have for you: where do you get these notes that always pay off, never default, and return at least 12% COC? This is not a snarky question, I really want to look into investing this way with my 401k. What do you do when they default? How hard is it for a novice to do the required due diligence? If a newbie needs to hire someone to do some of this, how much does that affect returns? I would love to see the answers here, or maybe these can be the topics of future articles.

    Also, what is your motivation for pushing notes? I notice that is your primary focus here, and I think it’s fair that we as readers understand why you like this investment method – is it because you sell them on commission?

    Thanks,
    Adrian

    • Good post, Jeff.

      Excellent comment, Adrian.

      Obviously, 12 is greater than 7. And, no tax is better than tax (that’s what the story boils down to). So, the real question is whether or not we can get a 12% rate of return for each year and for the entire investment during each of the 30 years considered in the example, as Adrian asks. Typically, higher return implies higher risk. That is, the _actual_ rate of return after the 30 years maybe less than 7%, due to the risks Adrian mentions.

      It is possible that you may still be ahead given the tax benefits, but since you would start with a lower principal, one needs to calculate it to be certain (sorry, I don’t have a calculator handy right now)

      So, to make the post interesting, sources, availability, historical performance, and risk of these notes is what’s missing. Otherwise, it is no different than discussing about a mythical hedge fund that returns double digits, without any risk.

      Hopefully, Jeff you can point us in that direction. ..

    • Jeff Brown

      Hey Adrian โ€” You ask great questions and make some seriously salient points. Let me go down the list in the same order, and answer them one by one.

      1. I’ll take the last part first. Yeah, he could indeed do both approaches due to his income. But why on earth would he, given the woefully inferior relative results?

      I get your point about just 10k more, no argument there. My only point in mentioning the huge total investment difference was that the match was proven to be a complete waste of time, when results were compared side by side. The match proved completely irrelevant. Unless the comparison ISN’T ultimate after tax retirement income, why would any opt for just 20-35% of what they coulda had?

      2. I do not doubt the stock market would produce a long term, buy and hold yield of 7%. In fact, I accepted his belief as ‘the Lord’s truth’. What I don’t believe is that same stock market yielding 7% dividends for the 30 years of his retirement. Even his tribe tells ad nauseum we’ll only do around 4% in retirement, due to risk aversion. Make sense?

      3. Not only will it make the 12%, it’ll likely do much better, Adrian. Eventually all money is spent on the notes, even though some gets left behind every now and then. That said, in my note fund, even the preferred return of 8% without ever buying one note beats his 7% every time it’s tried. ๐Ÿ™‚ Remember, that’s merely the cash on cash yield. It didn’t account for the built-in profit provided at purchase via the discount. Most of these notes will easily surpass an overall yield of 12%. I bought my first discounted note back in 1976. In my 38 years of note experience, the next one not producing an overall yield in double digits will be the first. That includes every possible market in the last few generations.

      4. This one’s one of my favorite’s, Adrian. Though WhipperSnapper will clearly have the smarts and know-how to avoid panic selling in a down market, he’s rare as hens’ teeth, right? But let’s address the failed note after just 3 months. We’ll assume your scenario of bottomed out home prices, rendering foreclosure less than gratifying. My fund has note warranties with every note. PPR, the fund manager is known for promptly honoring warranties, without exception, ever. The investor is kept whole, which can’t be said in a stock market downturn. The investor must go through periods of time when they’re simply on a treadmill to nowhere while their portfolio catches up to where they were before the last crash occurred. Still, your point is valid, big time. I’ve bought every single note I’ve ever known off the street. I’ve had to foreclose many times over nearly 40 years, though a very, very low percentage of the time. I’ve yet to lose money, though there were a couple times I sweated things out, barely breaking even. With warranties that’s simply not a concern.

      5. That’s an objectively solid assumption, Adrian. However, I’ll use myself as an example. If I moved from the People’s Republic of CA to Texas or Nevada, I’d save a boatload of money. However, since literally all of my family is within 5 minutes to 3 hours driving, that won’t happen, regardless. Also, why on earth would I move, if I can’t spend the money I have, given the weather paradise that is SoCal? Now, moving away from NY? Who wouldn’t do that, right? ๐Ÿ™‚ Even if he did, and somehow also dodged every dollar of fed tax, he’d still be making only about 30-35% of the guy using my approach.

      6. There is NO place on this planet of which I’m aware that you can buy notes that never ever foreclose. ๐Ÿ™‚ As I counsel clients, anyone tellin’ you you’ll not experience foreclosures is either massively ignorant themselves, or think you are. ๐Ÿ™‚ The answer to your question is the BawldGuy Note Fund, Adrian. It specializes in 1st position notes at a discount, performing, which were acquired as non-performing from lenders around the country. They all carry warranties as mentioned early. I’d love to talk with ya about ’em. Get a hold of me, ok?

      I love your last question, which is your best: “Also, what is your motivation for pushing notes? I notice that is your primary focus here, and I think it’s fair that we as readers understand why you like this investment method – is it because you sell them on commission?”

      I don’t ‘push’ notes. In fact, for every buck I earn brokering notes, I make 3-5 bucks ‘pushing’ real estate. But since I’m note a one act pony, so to speak, I guide folks to what makes sense for them, not me. For example, the advice I’d give my 25-40 year old clients is markedly different than those who’re in the 50s or older. Do I make money with the notes? Yep, comin’ ‘n goin’. But again, if I was concerned with commission figures, I’d never ever guide investors to notes, as the pay cut is huge, compared to real estate for me. My only motivation โ€” as always โ€” is to maximize clients’ ultimate after tax retirement income. Period. Over ‘n out. Make sense?

      Seriously, Adrian, email or call me. We’ll have some fun.

  2. paul salmela

    We can look back 30 years and see how the S&P has performed to determine the average increase and we can try to predict the future from there (although it’s far from an exact science). Can you point us to a note fund that has returned 12% per year over the past 30 years? Are these public funds?

    • William Bonati

      Paul,

      There are many sources for performing notes. Dave Van Horn is popular bc he offers a warranty, Scott Carson, Marc Gold just to name a few and you can find them on Loan MLS, local note investor meet ups, just make sure you do your due diligence or work with someone who is in the business. Many note investors including myself will JV with you do all the work, you get a great ROI.

    • Jeff Brown

      Hey Paul โ€” I don’t think these type of funds have even existed the last 30 years, though I wouldn’t be surprised if they have. They are not public funds, but private offerings, governed by the SEC. Here’s how they work, at least how mine does.

      20-40 investors pool about $5 million in order to buy hundreds of non-performing notes from lenders all over the country. For example, my fund is now in 27 states, adding new ones all the time. So, it does start out as a kind of ‘group fund’, but only at the beginning. As notes are brought back to performing status, they’re offered to the investor members to buy for themselves or their entities, i.e., IRAs and 401k plans. Each note comes with title insurance already paid for, naming you or your entity as lender. There’s also a servicing firm that takes care of your note payments and bookkeeping, though you’re never obligated to use them or anyone else. (I strongly urge note buyers to make use of servicing companies.)

      As far as returns go, long term, I can speak for myself with confidence, having many years experience. Even counting the rare foreclosure, my portfolio, even in so-called ‘down’ economic years has yielded over 10%, and almost always significantly higher. If a note has a cash on cash yield of 10-15%/yr, that DOES NOT count the cap gain realized when it pays of early, which the vast majority do. I recently did a quick analysis of a client’s recently purchased note, assuming a 9 year payoff. It came in at a modes 15.2% for the holding period.

      Here’s another point to ponder, Paul. Note yields, like real estate values and rents, generally tend to ‘track’ inflation. The consensus predicts interest rates to climb in the future, not fall. This will increase the yield of discounted notes. On the other hand, it will also increase the value of future notes for sale, as the discount will be less to create the same yield as a note with a lower face interest rate. Make sense?

      • paul salmela

        If we can’t track a fund long term into the past it’s hard for me to understand how we can say that we should expect at 12% return for the next 30 years. I just looked at how the S&P fund has done from 1984 to 2014 (the last 30 years) and it has averaged around an 11% gain assuming the dividends were reinvested. Will this continue for the next 30 years? Will we be able to get 12% from notes consistently over the next 30 years? The only answer is… I’ll let you know in 30 years!

        • Jeff Brown

          I understand it might be hard for you, Paul, as there hasn’t been a note fund to track that long, I get it. However, I and thousands of savvy note investors have been getting double digit returns since Ford was in office, far more than 30 years. Does that past performance predict future performance? Not hardly. But, considering that even with interest rates for real estate being the lowest in my adult life, we’re getting 12-15% on merely the cash on cash part of the yield, NOT counting the built-in profit via the price discount, I’m fairly happy with my bet. Furthermore, I’ve yet to see ANY 10 period where discounted notes haven’t literally eaten the stock market’s lunch, regardless of the relative strength/weakness of the overall national economy.

  3. Sandeep S.

    Jeff,
    Great article and it does drive the point home that Notes should be taken seriously as investments. And that if done correctly, they will beat stock market. However, I do have some specific questions/concerns with the comparisons you make. Adrian already asked a lot of pertinent (hard) questions.

    1. All of your articles have the same content – sometimes I wonder why don’t people get it that you have to put out same content every couple of weeks.
    2. The 7% stock market return is “zero effort” return. i.e. invest 100% in s&p index fund and forget it. I have to assume that Note investing, esp. to get 12% for all 30 years, takes some effort (including handling repossession of homes with defaulted notes). Or inversely, if someone is very smart (like this whippersnapper who clearly is super bright) and puts effort – one can get higher returns than the average market of 7%.
    3. The gist of this (and every other) article is based on 2 principles:
    a) The Notes have 12%+ returns so they are better than stocks.
    b) If you convert to Roth – you will come out ahead when you retire (as your income tax rate will be high due to high income)
    I think readers would appreciate if you separate these two as these two principals are orthogonal to each other. For example, if Notes return > 12% consistently – then why use them only in retirement accounts? Or why only in Roth? They should be a better choice for every place where one invests in stock market. Similarly if conversion to Roth is a superior move for retirement, it is a superior move regardless of Notes.
    I understand that you combine them to showcase the maximum impact but I think it turns the content into black magic (and may be that’s why the readers don’t get it and you have to repeat every 2 weeks).
    4. For all the readers (including me) who are already convinced that Notes are superior – it will be great if you can write a post that outlines steps on “how to buy discounted 1st position Notes for > 12% return”

    Full Disclosure: I am fully invested in Real Estate and firmly believe that for people with average or slightly above average smartness – Real Estate related investments will produce much higher returns than stocks.

    • Jeff Brown

      You truly made me smile, Sandeep. I seem to get it from all sides. If I write about strategy or combining multiple strategies, I’ve upset some cuz it didn’t go into as much detail as they prefer. If I go into detail, providing numbers galore, it’s the same content over and over. I do get your point, however.

      1. The majority of BP’s content on this blog is the same stuff, from different viewpoints. What I say often causes folks to recoil, as it goes against what they’ve believed for quite some time. The reason we all invest is so we can retire both well, and when we choose. I present one man’s modus operandi. Folks challenge it week after week, yet I keep producing the results written about year after year. ๐Ÿ™‚

      2. Is ‘no effort’ vs a little effort really the pivot point? I doubt it seriously. Besides, real estate has property managers, and watch your note portfolio is far simpler. The first week of each month just go online to your bank account to see if all your payments arrive. Management finished. ๐Ÿ™‚ Foreclosures are handled by experts, not the investors, just like bad tenants are handled by management firms and lawyers if required. None of this is E=MC2, right? The bottom line to your question is, as the post inarguably points out, do ya wanna retire with $215k/yr after tax, or triple that much. Your call. No rush. Take your time.

      As far as doing better than the 7% due to being so smart? Go ahead, let him take his chances. My way will still win in the end. It’s been winning these long term battles since before I was born. ๐Ÿ™‚

      3. A & B โ€” Yeah, your question and my answer are pretty much Captain Obvious no-brainers, right? I get it. Are notes always better than the stock market? Is a prime ribeye steak cooked perfectly better than an overdone hamburger? The next stock I buy will be the first, Paul. And yes, 12% always beats 7%, which is the main reason I’ll remain forever puzzled by those who attempt to defend that position. Different strokes etc., but math is math.

      For the record, in my professional opinion notes are better than stocks not merely due to relative long term return. Somebody, anybody tell me the last time they bought stock with some sort of security instrument behind it, like a trust deed or mortgage. After explaining that one, please tell me about the wonderful warranty the stockbroker gave you with the stock certificate. See what I mean, Verne? Most folks don’t wanna get into the weeds when it comes to real estate, notes, and the stock market.

      Frankly, the stock market crowd as it relates to 401k plans, has one of the most shameful 30 year records ever when it comes to retirement results. The reasons don’t matter. The results speak for themselves. The average American celebrates their 65th birthday with $100k or less in their company sponsored 401k. Yeah, I wanna blow out those candles. ๐Ÿ™‚ THE common denominator with those millions of Americans is . . . they ALL had the magical match.

      Your point that Roth is best even without notes as the driving force is excellently made, Paul. I use notes to show how one can remain secure, generate impressive yields, without risking financial life ‘n limb. I also love you ‘black magic’ comment, big time. First, it’s hilarious, and much appreciated. Second, it only appears to be somewhat magical when directly compared to the all powerful but relatively impotent stock market approach. :).

      4. Your request to write a post telling folks how to find and buy these type notes will never happen from my keyboard, period. The reason is that the DIY crowd would get themselves annihilated faster than the grass on your front lawn on Saturday mornings. ๐Ÿ™‚ Amateurs don’t fare real well when buying discounted notes off ‘the street’. This is true everywhere I’ve looked. That’s the main reason I established the note fund, which presents notes with the professionally conducted due diligence already completed. When it comes to buying discounted notes secured by real estate, don’t try this at home. ๐Ÿ™‚ I’d dead serious about that.

      I’d love to chat with ya about this one on one, Paul. I bet I could clear things up for you in no time.

        • Jeff Brown

          Hey Sandeep โ€” I’m reminded of the old saying, “Call me anything you’d like, just not late for dinner.” ๐Ÿ™‚

          Any time you’d like to arrange some quality time on the phone, please do it. I’d love the opportunity to chat with you.

      • Jaden Boudle

        Hey Jeff-

        First off, thanks for the article. It was a really great read and has definitely piqued my interested.

        I’m a newbie investor and have a little bit of money in my 403B- not a lot yet (I’m 31 and have two kids so the amount I’ve been able to sock away on my relatively meager day to day income hasn’t been that impressive), but enough to make me wonder if I’d be able to start in this note investing business. You’ve got me convinced that it’s a lot more lucrative than what I’ve been doing so far. So where would I start? How much do you need to get going in this? Can you point me to some good resources for learning more about note investing?

        Thanks in advance for your help, and a big congrats on your lucrative investment strategy!

  4. jim m.

    Guaranteeing a note will perform has to be the same as a broker guaranteeing returns in the stock market. If you really wanted to give him responsible advice you could tell him to diversify with some notes and some real estate instead of liquidating his retirement account and throwing all his eggs in one big basket. I’d run very far and fast if I had a conversation like this.

    • Jeff Brown

      Keep runnin’, Jim. ๐Ÿ™‚ Please quote this post where it says anyone guarantees anything, especially a note’s return. You’re putting words in my mouth. I’ll use mine, you use yours, ok?

      You’re apparently far more savvy than 9 figure hedge funds who flock to these warrantied notes like cats to tuna. Good luck.

  5. Sam McPeek

    I think that the smartest thing for any investor to do, whether they are as smart as “whipper snapper” or not is to diversify their financial/retirement portfollio. I think that it is wise to invest in the market. My employer matches the first 6% of my investment plus an additional 3% yearly. That means that my 6% Roth 401K contribution has a 150% return right form the start. I’m not of a mind to leave that “free” money out there.

    I also think that anyone who counts solely on one investment vehicle for their retirement or their future is doing themselves a disservice. I don’t think it should be REI or 401K, but rather how to be successful at both. Just think how much he’ll have if “Whipper Snapper” does both, which he should be able to do if he is printing money…

    • Jeff Brown

      Hey Sam โ€” I agree with spreading the vehicles out, if it’s possible. Many folks coming to me are less than a decade from retirement. A recent caller was just a year away. Even if they had a million bucks with a year to go, what would you tell ’em to do? As much as I love real estate, I’d steer away from it.

      As far as the traditional concept of diversification goes, I’ve always gladly yielded to Warren Buffett’s take on the subject. He said, “Diversification is for those who don’t know what they’re doing.” Harsh? Yeah, but some pretty straight talk, coming from a pretty straight talkin’ guy.

      About that magical match. A person giving $16k per year, with a match of an additional $16k from their employer, will, if they never invested it, end up in 30 years with less than a million bucks, around $960k or so. Yet, the argument you proffer is that he’s making 100% on his money every single yea. Even he did make 7% on all that, he’d still end up with just $3 million. Even at a yield of 10% in retirement, truly the work of a genius if accomplished, that’s just $300k before taxes. Given what I know of notes the last 4 decades, my way generates double that in AFTER tax income, while using far LESS capital.

      When possible, I have clients benefit from 3 separate/independent income sources at retirement. A fourth if we count notes in their own names. I agree with ya on that one, IF it’s possible, which it isn’t always.

  6. Derek Martin

    I have the money in the Roth. I have 30 years in front of me. And I have enough “wicked smarts” to believe in your way. Now what?

    I’ve seen you suggest PPR Note Co. They list for sale about 1 performing note per week. Dave Van Horn himself will tell you that he doesn’t have enough to sell. In my experience, there just isn’t the inventory available.

    Of course, I could build the network myself, but comparing that to readily-available, passive stock market investing is not a fair comparison, is it?

    • Jeff Brown

      This is exactly why, at least in part, I established the note fund, with PPR as fund manager, Derek. Heck, just a few days ago one of my clients bought two performing notes in less than a half hour. There are currently over 200 notes in the pipeline, which will ultimately grow to somewhere in the range of 3-500. Since the fund is just this month a year old, it takes awhile to get all those notes through the pipeline, and ready to sell to investors.

      And you’re dead-on right about the availability of stocks. We can all take our chances at that roulette table any time we choose. ๐Ÿ™‚ Sorry, couldn’t help myself.

  7. Jason Gilliam

    You really don’t need to do a detailed analysis to determine which is better between 7% pre-tax earnings and 12% after tax earnings, both over 30 years. Am I missing something? A more interesting assessment would be to investigate whether or not a full time employee should borrow from your 401k to buy a buy-and-hold rental,(to see if that approach would beat the traditional retirement plan) assuming conservative values for inflation.

    • Jeff Brown

      I’ve been doin’ that analysis since Reagan was in office, Jason. The stock market simply doesn’t come out well when the long view is taken. It only worsens when the period is for 30 years.

      Since I never include any value increase in any real estate investment analysis, yet still slaughter the stock market, inflation becomes merely an unexpected gift from above if it happens. ๐Ÿ™‚

      The practical problem for most folks in your scenario, Jason, is that most out there simply wouldn’t have the horsepower to pay back that loan in 5 years with interest.

  8. Hey Bawld Guy,

    I bet you almost had to work up a sweat today answering a lot of very good questions about investing in Discounted Notes. It would be interesting to compare equal yield from Notes and equities but using the Roth for the notes, i know you already gave the Whipper Snapper the advantage at every corner, but the very first premise is to compare the after tax net income from putting in after tax dollars into a Roth with limited contribution limits versus into a tax deductible 401 contribution of at least double the annual contribution amount–if not triple the amount. To that end it would only seem fair to me to put the balance of the after tax residual from the Whipper Snapper’s annual 16k 401k contribution into a separate note portfolio.

    So if we took 60% of 16,000 for after tax income instead of taking the 401k deduction he would have $9,600 less the $5,500 for his roth leaving and additional $4,100 he could put in another note portfolio that would be subject to income taxes at retirement or at his age probably the better alternative would be to invest in an EIUL policy that would have significant after tax benefits at retirement. I’ll let you calculate the value of that left over residual in either option, but it won’t be insignificant for sure.

    For me the real area of interest would be to know a little more about the warranty program and what kind of stress it could function under? As I take it your fund has gone around the country and bought up non-performing first deed of trust mortgages in over 20+ states from lender portfolios and Dave and his gang with their experience do a lot of due diligence on the portfolio of notes they buy. They obviously buy these at a steep discount since they are non-performing with the idea that by working with the borrowers they can get them performing again and then sell them to your note buyers at a “marked up price” which rewards Dave and the gang for their efforts. It would be helpful to know what any historical default rates might have been over the years for first deed of trust notes whether it is 10% or 40% etc. after they move from non-performing to performing.

    I would assume that Dave and the gang are typically way more efficient than large lenders who you are buying these note portfolios from in regards to evaluating the underlying value of the asset and determining how to either get them performing again or foreclosing on them at a profit–i.e. there is a potential profit from buying these notes from the lenders that provides enough margin to cover costs and potential losses and still resale individual notes to investors to yield 12%.

    The warranty is really icing on the cake to the note investor. It would be helpful to understand the math behind the warranty strength in a manner similar to something like some other type of insurance–i.e. how deep are Dave’s/your pockets and what type of a storm could you weather? We all have seen the weak link in financial hedges fail when someone in the middle of the chain burns through their equity and cant pay off the claim, them screwing up everyone downstream from that hedge. Mind you the warranty is a great feature, we just know it ain’t free and some insight as to how you perceive it and can afford it would be helpful to more accurately value the benefit.

    As i recall the warranty replaces the defaulted individual note with one of equal value, right? Does the note investor forego some cash flow between the time the note defaults and the “replacement note” starts providing cash flow?

    I ask about this because I think it is important to explain how the warranty works and how you and Dave can afford to offer it on top of the 12%. It is a great feature for a passive note investor no doubt, let the Pros From Dover handle that non-performing note in any of the 20+ states it was originated in .

    And last but not least, while some folks feel that a more aggressive investor might make more than 7% long term in the stock market, I might also suggest that valuable employee might also be able to convince his employer to forgo the $16,000 match to the 401k and give employee say half of that at least in an additional annual before tax salary yielding an additional $4,800 year to invest in that EIUL giving $9,600 per year for premiums (with the residual $4,800 from above)—wonder what that looks like at 65!!

    I didn’t quite follow the impact on notes with inflation, but what I am hearing you say is that for as long and longer than you have been buying them the market for folks who either know what they are doing or find someone to do it for them typically yields at least a 12% return even when we have a currently have a universe of notes that probably were originally in the 5.5-7.5% range when issued?

    Mind expanding as always Jeff, going to talk to my 32 yo Whipper Snapper son about getting that Roth 401k setup for his property management business/remodeling business so he can begin to start building that 2nd leg of his retirement portfolio with discounted notes. His 4 duplexes are now yielding 8.5+% cap rates and $139,000/year gross income with .8% vacancy. We are going to look at the return on equity as it may be time to sell the one that was his former primary residence and put the $300k in equity in there into a couple more properties before he loses the personal residence exemption on capital gains.

    He has done okay in the last 6 years since he bought the first one!!! Time to add the Discounted Notes and likely start the EIUL so he has the trifecta working for him. It has been amazing to see how his success so far at such a young age has wetted his appetite to double down, work harder and get more capital at work, and really focus on the after tax return for his retirement by using all available alternatives to just sitting in equities.

    the one challenge is his GS 15 govy job that probably does not provide a lot of alternatives for his annual 401k investment with match. I will see him next week over the holiday and begin to discuss what the rules are there, perhaps borrowing it might be an alternative to liquidating it, just needs to exceed the after tax yield I would think.

    this ran on a bit, waiting for some fiberglass resin to dry on a 1946 Chris Craft we are renovating this fall ๐Ÿ™‚

    gotta run time for one more coat of resin.

    jeffrey

    • Jeff Brown

      Hey Jeff โ€” As usual, you don’t ask sissy questions, which is much appreciated, by the way. This thread has been amazing in the high level of give ‘n take.

      The warranty simply accounts for the investor’s original principal, Jeff. Pay $50k for a note. Receive $15k in payments. Borrower defaults. If you don’t wish to foreclose, and it can’t be rehabbed, the fund will then โ€” AT YOUR OPTION โ€” give you either fund credits or wire cash to you in an amount equal to the difference of what you paid for the note, and the payments you received. In the example above that would be $35k. It DOESN’T involve substituting another note. You give the defaulted note back to the fund, the fund makes you whole.

      I’ve given Dave Van Horn a heads up on this question, Jeff, so that he can answer the best question in your thread, how strong is the warranty in difficult times. I’ll tell you might thought.

      The fund is now roughly 65% capitalized, around $3.25 million in cash. The assets have already risen to around $14 million. I’d say the warranty is fairly safe. ๐Ÿ™‚

      Company sponsored 401s are pretty restrictive as to what the money can buy, leaving relatively little real control for the employee. Your son can buy whatever his guys allow on the menu. Trust me, notes will never be on the list, unless at some point Wall St. figures out how to get paid for it. ๐Ÿ™‚

      In any case, the available capital to fund warranties doesn’t seem to be an issue. Are they impregnable? Not freakin’ likely. Also, as to your query about the percentage of notes that might default, it appears it would roughly 15% or so. Out of that number, it’s my experience that much of the time the best option would be to go through the foreclosure process. In my many years there have been many times I’ve netted far more in foreclosure than was actually owed me. The warranty isn’t meant to be the initial ‘go to’ when troubles arise. It’s there if the investor decides, for THEIR own reasons, that foreclosure isn’t the preferred avenue to take.

      • jeffrey gordon on

        Hey, one thing i learned in baseball–“you throw some weak stuff over the plate and you will be looking for the ball on the other side of the fence for a long time”. Thanks for acknowledgement though.

        I suspect looking over the offering documents would provide a lot of the details we are all trying to draw out of you bit by bit.

        Thanks for helping me clarify the note warranty details. Can we work on that point a little more?

        This is my understanding on the note warranty–the warranty basically says that i as a note investor would get back all my original principal less the total payments I have received from the note since i bought it from you? If it is a couple of years down the road and there were no payments then I would be recapturing my original investment with whatever the “built in” coupon is based on the monthly payment i did receive divided by the amount capital I have invested, If i wait too long after my payments might stop then i would be risking my getting back my original capital without as high of a return as what projected based on the original note price I paid vs the monthly payment made by the original borrower.

        I seem to remember you mentioning 8% somewhere as either a forecasted yield, I need to go look at that again.

        Last but not least, the servicer on these notes, who is that and what relationship do they have to you and/or Dave. I would assume we are dependent upon them of staying right on top of program and especially making sure that the property is always fully insured to minimize any risk that was either accidential or intentional?

        I would also assume the servicer is paid a set monthly fee and would come out of my net check from the note payment?

        This has been a great post Jeff, I really appreciate hearing from such a wide range of folks out there and there perspective. Not sure they truly understand that you are not just a one trick pony, but have actually created, what i think, is one of the very best boring, slow and steady retirement investment strategies , and trust me as a former CPA type, with strong background in financial planning and years and years in the real estate field, you stand out center field all by yourself! While none of this is an easy DIY process, the combination of buying undervalued assets and combining them with excellent management and taking full advantage of current tax laws truly has the potential to at least double if not triple the after tax income for a low six figure professional/business owner. While at the same time ensuring your family has mostly “hard” assets securing the financial instruments and with an EIUL enough money to easily handle the worst outcome of one’s early demise!

        I call it the Bawld Guy Trifecta retirment bonanza and when someone shows me something better balance, more diversified and less boring and not dependent upon my sell orders being sent through a straw while the big boys are using a fire hose, let me know I will be happy to consider all challengers!

        thanks Jeff, still waiting to see that that additional $9,600 a year in EIUL premium would deliver to the Whipper Snapper!!

        jeffrey

        1. I have the option of exercising the warranty and returning the note to you, or I can decide to hang on to the note and likely foreclose on it?
        a. If I decide to foreclose, do I do that myself and have to put together the entire
        operation or can I get some help from you guys, especially since the property
        is likely out of my area?
        b. If I read your last comment you are telling me the note portfolio was bought
        for about 24% on the dollar or are you saying the relative value of my note
        investment cost to either the current note balance or Broker Price Opinion
        (BPO) is approximately 24% obviously the relationship to the BPO would be
        the more important fact?

        In any event it sure would seem there is a lot of potential equity to cover the cash invested, even in a foreclosure, but not many passive type investors are going to want to learn the foreclosure business to protect their $50,000 investment–I know I would want someone to do it for me that will be effective and not bleed me to death with costs/fees.

        It would be handy to have a little background on the foreclosure process, how long it takes, what types of costs are involved and what additional risks are potentially involved.

        Attorneys are not cheap so again being able to find someone who can handle the deal and get it done quickly and cost effectively would be huge to me as a passive investor.

        I am assuming that not every note in a bulk portfolio you buy is going to be suitable to your note fund, and that is what Dave and his gang are doing in the last year–doing their due diligence of the various notes and working with borrowers to get as many as possible back performing so hopefully the home owner can keep the property and eventually sale the house and or refi it and pay off my note early so can capture that differential between my discounted invested note price and the remaining balance on the mortgage at the time I invest in the note–nothing better as a landlord or tenant than a happy tenant in a property taking care of it and paying back our returns every month.

        2. I have

    • Dave Van Horn

      Hi Jeffrey,
      Jeff brought some of your questions to my attention, so I hope you donโ€™t mind if I jump in and try to answer a few of these for you.
      Our performance warranty for re-performing notes, in simple terms, protects an investorโ€™s initial investment principal minus any payments they received during their time of ownership (this warranty is nontransferable). After purchase, if the loan were to default again we would work to get the note re-performing. If we are unable to do so between 4-6 months (depending on the FC Laws of the state), we would buy the note back for the initial investment amount minus payments received.
      Weโ€™ve been honoring this warranty for several years now. Although we get a slight premium for offering a warranty we are able to do so because our re-default rate is less than 15%. Also keep in mind our asset managers who are salary plus commission get a charge back if we repurchase the loan.
      I hope this is helpful! Please let me know if you have any other questions about our Performance warranty.
      Best,
      Dave

      • Hi Dave, thanks for weighing in, always nice to have another member of the Pros From Dover squad educating and taking the time to answer questions from us simple farmer types.

        I am brand new to the mechanics/details of buying Discounted Notes so please bear with me as I build a framework to understand them and evaluate them–a sickness to systemize my knowledge so I can find it when my memory fails one of these days, hopefully I might have a question or two that someone else is coming up with.

        todays questions:

        First off I am very impressed with your offering any kind of warranty on these things, that has to help most folks feel more comfortable the first time around the rodeo ring.

        I am going to run some numbers next and am using some data i have discussed with Jeff, but please feel free to correct me on anything I have incorrect.

        Here is my saturday morning give and take:

        1. Note Defaults after 6 months of payments, I have the option to let you guys work it out to get it re-performing for 4-6 months?

        a. Since I am buying the note is being bought at a discount to original face value (approx. +/- 60% of face value price) what is the typical net yield from the coupon rate payment going to return the investor on an annualized basis? i.e. assume 4% original note rate on a 100k note = $4,000 year interest payments + principal reduction divided by $60,000 cost would be approx. 6.6% return on investor capital. If the coupon rate is higher or lower so will could the yield to the investor–

        b. what type of portfolio coupon rate average is in the Bawld Guy fund?

        c. do i understand if I ask you to get the note re-performing and it doesn’t get done within 4-6 months I will still be able to sell you the note, but if the note defaulted after six months and I gave it another 6 months before I sold it to you then my return above has now dropped to approx. 3.3% annualized since I didn’t get any more payments while i waited for you to work it out?

        d. Am I on the hook for any associated costs of the workout?

        e. If it does not workout, can I hire you guys to foreclose on it and if so can you postulate about how that might go, time costs, net yield to me etc.

        e. if I can not hire you to work it out is there any chance I could find someone else to do it or do it myself?

        I look forward to hearing back on this Dave, please let me know if you need any clarification etc.

        I got to go work on a couple new boat projects :).

  9. Chris Rosenberg

    Hi jeff. I love your articles and your experienced insight on investments I am not very familiar with. I just have a couple of things to say. I’m not a big fan of 401Ks either but I like the company match. I agree with Adrian in the first comment about how he will establish residence in a different state to avoid state taxes. I’m born and raised in nyc and I won’t be retiring here. I didn’t notice you mention anywhere that since you are contributing to a Roth you will be paying taxes before contributions so even though you will be contributing $5500 you will be paying a lot more money up front due to taxes, especially in nyc. That all adds up. So living in nyc and contributing to a Roth you will pay federal, state, and city taxes up front and withdrawing tax free whether you retire to a tax free state or not. With a 401K you will be contributing before paying any of those taxes to nyc and when you retire to florida you will only be paying federal income taxes. These are very possible scenarios for a lot of people. It would be interesting to see how these two different scenarios would affect retirement income. Also, if this kid is actually a financial whiz then he should be ashamed of himself if he will only earn a 7% CAGR in the stock market. And jeff, you said “This is exactly why, at least in part, I established the note fund, with PPR as fund manager”. So do you expect all of us to start a note fund? Seriously, how the heck do I even get started with note investing? I’d like a “guaranteed” 12%. But for most people it’s a lot easier to fill out a one time form and have your company withdraw money from your paycheck and match it and put it into the S&P 500. You literally will never have to check on it again until you retire and should make at least 7%. But if you are a financial whiz kid you should be averaging at least a 15% CAGR.

    So what it boils down to is cash on cash return and taxes.

    And I have one last question. If the 30 year treasury was paying 15% and you were 30 years old what would you do?

    • Jeff Brown

      Yes and no, Kirk. To be an official member/investor of the fund, you indeed must be accredited. To buy notes you don’t. However, understand two things: 1) Those inside the fund make 8% annual preferred return on their money until invested in notes. 2) The fund members get a free two week look at all new notes for sale. Nobody else on the planet gets to see ’em for those 14 days. From day 15 through 28, the uncredited ‘registered’ note buyers get their look, along with the fund members. Beginning on day 29 the rest of the world gets their shot at anything left.

      • jeffrey gordon on

        okay, that is where the 8% number i remember was from. a minimal yeild till invested in notes, got to love that, even making 8% in my roth would be okay, any limit on how long one can sit without buying a note ๐Ÿ™‚ ?

  10. Lear R.

    I discovered loan notes from Robert Kyosaki’s Rich Dad books last year and has been a fan every since then. The great thing is the concept is pretty simple and I can aggressively pursue my goals financially. With banks paying .0 something percent I will never save enough to buy my kid her first car, or her first rental property for that matter. I set up a loan notes fund in March of last year with 1K, it has a return of 20 plus percent. I am looking forward to an investment vehicle that quickly meets financial goals and then some.

    My question is how much of the proceeds are taxable if buying notes and collecting payments on the loan notes platform such as http://www.lendingclub.com and if all of the income is taxable, how would one shield this income from taxes in the future?

  11. Jeff Brown

    Hey Lear โ€” If you’re receiving interest, not your retirement plan, the interest is taxable as if it’s pay from a second job. If you make a profit, as in discounted notes, you can benefit from the much lower capital gains tax if you held the not longer than a year before realizing the gain.

  12. Tommy Lorden

    Good discussion. Thank you. Note funds appear pretty compelling, at least in terms of the benefits over the LONG run (i.e. as a part of a retirement strategy.) But how would you characterize the opportunity and benefits with note funds in the short term, for current income? Particularly measured against other real estate investments like buy and hold rentals where a cash on cash return might push 10% with a potential appreciation kicker if you are buying right.

  13. Jeffrey Pacailler

    Jeff,

    Excellent article. As you will see, it really got me thinking. While I don’t disagree with your conclusion, I do want to challenge you on one thing. It doesn’t seem to me like the comparison between the 401k and Roth IRA is “apples to apples” and is a bit misleading. You don’t take into account one of the main benefits of a 401k – tax deferral.

    Effectively, the $16,000 contribution by Whipper Snapper is not his real, out-of-pocket investment. A large portion of that – about 40% per your assumptions – will be paid to the government if chooses not to contribute it to a 401k. Therefore, in order to make a $32,000 investment ($16k salary and $16k match) in his 401k, “Whipper Snapper” will sacrifice $9,600 from his pocket. That’s a pretty good return already, even if the market stays flat.

    Using this perspective with your other assumptions, Whipper Snapper has a starting balance of $200,000, will pay an additional $9,600 each year (but receive $32,000 in contributions) and this investment will compound at 7% annually. As you show in your original post, this results in an account balance of a bit over $4.5 million at age 60.

    My math shows that the actual IRR of this method is just under 10%. As I said upfront, I don’t disagree with your position that notes are a superior alternative to the stock market. However, I think that investing through a 401k with a strong company match, like Whipper Snapper is doing, is not as “laughably ridiculous” as you might make it seem. A 10% return sustained over 30 years while adding diversity to your retirement funds is not something to be ignored. Additionally, and to some most importantly, this is a method that e*Trade might have you believe can be managed by a baby from his crib with a smartphone app. I don’t think you would make the same claim for your strategy.

    I’d love to hear your thoughts and, if any of my logic is off, please correct me.

  14. Jeff Brown

    Hey Jeffrey โ€” You’re not off an inch. Your logic is impeccable. And yet, I think you’ll agree my approach still slaughtered WhipperSnapper’s when it came to bottom line after tax retirement income. But your math is not debatable. Period. In the end, he could literally double his income at retirement and remain embarrassingly behind my guy. Make sense?

  15. Jeff, thanks for the great post. I have, as many other commenters, read many of your articles relating to note investing and am seriously interested. I do have a question relating to a basic premise of the strategy you laid out here.

    If WhipperSnapper is printing $1,000 bills at his job, I can only assume he is pulling in more than 120k/year (as a single filer). As you likely know this makes him ineligible to contribute to a Roth. What is young Whip to do?

    Thanks!

    • Jeff Brown

      Hey Andy โ€” That’s a problem some clients face for sure. Sometimes, if married, their spouse either has their own business, or work as independent contractors, which allows for the creation of a Solo 401k. If that’s not in the cards, it sometimes possible for the big earner to convert their employer’s 401k to a Roth. That would at least allow any growth to be rolled over into either a Roth IRA/401k upon retirement or when employment there ends.

      Sometimes the options menu leaves us wanting, right?

    • The backdoor roth has been available since 2010. You make a non deductible contribution to a traditional IRA and then convert it shortly after. The conversion will be tax free unless you have a traditional IRA in which case it will be subject to the pro rata rule. The traditional ira could be rolled into 401k to prevent this issue.

  16. Ed Gray

    Jeff,

    Great article and incredible feedback in the comment section. I’ve been in the note business for a very short time setting up an LLC to do so. I have had the opportunity to go through PPR’s online webinars. Dave’s guys are top notch and opened my eyes even further to this great business. I’ve been on the fence about converting my Roth IRA to a self-directed Roth IRA. I use a dividend growth investing strategy within my current Roth that I was banking on taking all of my dividends tax free at the age of 59 1/2. This article has however made me question that strategy. A self directed Roth IRA buying performing warrantied notes from PPR sounds like an incredible opportunity.

    1) Are you an accredited investor with PPR or are you just bidding with the masses? I missed out on taking their training that has now ended as of 2014, I know that would have given me a first chance to buy two weeks before the masses.

    2) With the self directed Roth IRA are you dropping an LLC into it?

    Thank you,

    Ed

  17. chris samson

    Great article Jeff! Just listened to your podcast twice yesterday and have been reading everything I can find about your strategy. I agree with most of what you have said and would love to learn more. However, there are a few things that you talk about that I think need further explanation in regards to 401k match and Roth vs traditional IRA/401k.

    #1. Opting out of your employers match for 401k. I think the biggest question here is: How much do I need to increase my rate of return to justify giving up the โ€œfree moneyโ€? Letโ€™s assume a 50% match, you have $5,000 yearly to invest, 7% return on the stock market and a 30 year timeframe:

    PV = $0
    PMT = $7,500 ($5,000 + $2,500 employer match)
    I = 7%
    T = 30yrs
    Solve for FV = $708,000

    We can then take that same future value, take off the employer match for yearly investment and solve for our breakeven rate of return:

    PV = $0
    PMT = $5,000
    T = 30yrs
    FV = $708,000
    Solve for I = 9.21%

    Spread = 2.21%.

    This shows that in order for me to give up the employer match the rate of return on the alternative investment it must return 2.21% greater than the 7% return on the stock market. Now if we increase the timeframe or increase the expected return for stocks the spread becomes smaller. If we decrease the timeframe or decrease the expected return for stocks the spread becomes larger. i.e. if I have 1 year to invest then the spread becomes 50% or equal to the 50% match. Bottom line, giving up the employer match has to be justified by a pretty significate increase in your expected rate of return AND a longer timeframe. As you have pointed out 12% vs 7% over 30 years obviously justifies this.

    #2 Roth is better than traditional 401k/IRA. The better questions to ask are: What are federal/state tax brackets when you are contributing vs withdrawing? What tax bracket will you be in when contributing vs withdrawing? If you are in a lower tax bracket when contributing vs withdrawing then Roth is better. If you are in a higher tax bracket when contributing vs withdrawing then Traditional 401k/IRA is better. Mathematically speaking, if we assume that you are in the exact same tax bracket when you contribute as you will be when you withdraw the Roth and Traditional 401k/IRA are equally beneficial.

    For example letโ€™s use the same situation as above; $5,000 yearly to invest, 7% rate of return, 30 year timeframe, 35% tax rate.

    Traditional 401k/IRA
    PV = $0
    PMT = $5,000 (pretax)
    T = 30yrs
    Solve for FV = $472,000
    After 35% tax = $307,000

    Roth
    PV = $0
    PMT = $3,250 (post 35% tax)
    T = 30yrs
    Solve for FV = $307,000
    Tax free = $307,000

    Comparing $5,000 in the Roth vs $5,000 in a Traditional 401k/IRA is not comparing apples to apples because the $5,000 contributed to the Roth actually โ€œcostโ€ you more of todayโ€™s dollars. However, most people donโ€™t factor this in. They say, should I put $5,000 in a Roth or $5,000 in a Traditional 401k/IRA? It is for this reason that I prefer the Roth, the Roth essentially โ€œtricksโ€ you into saving more money today. There are also the added benefits of not having to worry about where future tax rates will be and having a better perspective of actual purchasing power of your portfolio.

    I hope that was helpful.

    • Adrian Tilley

      Chris,
      Good analysis. I think your point about the timeframe is a good one. Another option to consider would be to get the match, then withdraw asap, maybe 5 years or so and reinvest in something else with a higher ROI. At that timeframe, the IRA has to win.

      Also, 12% ROI is not unique to REI. P2P like lendingclub is another way to get ~12% with no time put in.

      adrian

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