The Money Mustache Community
Learning, Sharing, and Teaching => Real Estate and Landlording => Topic started by: Genevieve on March 03, 2015, 04:28:30 PM
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Hello fellow Mustachians,
I wanted to get your thoughts on investing in a 401(k) vs. investing in real estate.
Assuming you are OK with using leverage for your real estate investments, but leveraging stocks sounds scary, at what point will you make more money with real estate than you will with the 401(k) tax deferral?
Let's compare investing $10 in a 401(k) and assume a 8% return over 30 years. That $10 would be worth $100.63.
Let's say you're in the 28% tax bracket with that $10. Assuming you live in a place with no state taxes, that $10 would then be $7.20 after taxes. If you're able to earn a 10% return rate on your money over 30 years, you'd end up with $125.64.
This scenario doesn't account for any appreciation in the real estate either. And you'll have access to the cash flow, while you'd be penalized for withdrawing from the 401(k).
So there's a point where it might make sense to invest in real estate, even when you haven't maxed out your 401(k).
Thoughts?
Did I do my math right?
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There are about a billion threads on this. If you are a high income person you can easily do both, unless you have a terrible spending problem.
-Walt
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Walt -- send over the thread so I can learn if there are a billion threads!
Just you can do both doesn't mean there isn't an order of operations -- which comes first in your mind? And why?
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Do a search.
-W
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Come on, seriously?! I did a search in the forum before posting.
I saw people give blanket recommendations about maxing out a 401(k) without any real analysis on the $$$ benefit.
I also saw an impassioned discussion about the merits of stock investing vs. real estate investing.
From my initial analysis, it seems like it would definitely depend on your tax bracket. It seems like maxing out a 401(k) is a lower risk, less effort, but probably lower return. REI would involve more work, but if you did it right you'd probably earn more. The fact that your opportunity cost involves not getting that tax deduction means that you have a higher opportunity cost for the investment.
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If your google-fu is that bad, stay as far away from real estate as you possibly can.
http://forum.mrmoneymustache.com/investor-alley/real-estate-vs-stock-market/
http://forum.mrmoneymustache.com/investor-alley/real-estate-v-stocks/
http://forum.mrmoneymustache.com/real-estate-and-landlording/real-estate-vs-stocks/
http://forum.mrmoneymustache.com/real-estate-and-landlording/rental-property-vs-investments/
http://forum.mrmoneymustache.com/investor-alley/article-why-real-estate-returns-are-higher-than-stocks-bonds-and-mutual-funds/
-W
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None of those posts discuss how the opportunity cost of a 401(k) tax deferral impacts the value of REI.
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The forum's most active moderator, Arebelspy, has done precisely this and plans to retire soon with income comprised almost entirely (or so I infer) from real estate.
The choice is a lot more complicated than comparing tax deferral benefits vs. leverage. There have been some excellent discussions here on what constitutes a good rental purchase, what continuing costs are likely to be, etc.
I believe Waltworks, in addition to occasionally posting grumpy exhortations to search, is also a landlord in addition to his bike building business. :-)
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If you really want to do the calculation, you'll need to know a LOT of things about the specific tax/income situation, tolerance for risk/leverage, opportunities available in tax-advantaged accounts (ie company match/not, low or high fee funds, etc), total savings available to fund investments, assumptions about future market returns and rental cash flow returns and/or appreciation, willingness to rehab/manage/sweat-equity rentals or not, etc, etc, etc.
Lots of people like real estate. I'm one of them. I like stocks too. I like to have both, but directly comparing them is almost impossible in any generic way. If you put a gun to my head, I'd say that all things being equal (ie effort/reward and leverage/risk included in the calculation) they are about the same but for most people stocks/bonds are a better bet and if there are tax advantaged accounts available funding those first should basically always be priority number one. It is just going to be hard to have other investments beat something that starts with what might be a 30+% advantage due to the tax savings. Can you find amazing rental properties that will? Sure. Especially from 2008-2011 or so! Should you defer maxing your tax-advantaged accounts to wait for an amazing RE deal? I wouldn't.
As I said, though, unless you are self employed and can pull the cool solo 401k $52k/year contribution, we are talking a small amount of money ($23.5k) in the tax deferred accounts. If you are in a high tax bracket at all it should be child's play to come up with enough to fund some RE activities as well.
-W
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I agree with walt...This involves a lot of variables, assumptions and math. I will point out that if your emploer offers a match, that's a 100 percent tax free return on your investment the first year. So a lot of people would take advantage of that even if they are real estate focused.
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Do both, but if you must choose an order of preference, then first max out your 401k then invest in real estate. This is going to be true for about 99.9999% of the population, with the super-rare, genius real estate investing wiz as the only possible exception.
It's not all about the return rate. Besides the work involved in real estate, there's the matter of certainty vs. speculation. Getting a guaranteed tax benefit has advantages over uncertain real estate returns (and an employer match makes it a complete slam dunk). If you offered me a guaranteed 28% return on investment, I'd jump on that over anything speculative.
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The answer to this question depends on what returns you can realistically expect to get from real estate. If you can get a cash-on-cash return that exceeds the stock markets historical 9-11% return, then the numbers would favor real estate, ignoring all tax implications. Of course, this also ignores the effort and difference in risk involved, but speaking from a strictly numerical perspective, you want to choose the investment that returns higher.
The tax benefits muddy up the discussion, but I haven't seen anybody point out that real estate is incredibly tax advantaged as well. You may not owe any tax or very little for many years due to depreciation and unrealized capital gains. You can also write off business costs like travel expenses and a home office. If you decide to sell a property, you can 1031 exchange it to a bigger property without incurring any taxes (similar in practice to a tax-advantaged retirement account).
In many ways, I feel like real estate is more tax-advantaged than a 401k because with a 401k what would have been capital gains rate in a taxable account (15% tax) are taxed at your income tax bracket when you withdraw (25% rate for many Americans, maybe 15% or less for Mustachians). Also, your 401k withdrawals may push your income high enough to cause your SSI to be taxed in retirement, whereas it might be easier to shelter income with real estate preventing that from happening.
Recently, I was trying to figure out what the best decision was regarding 401k vs investing in real estate for myself. I'm finding properties that return cash-on-cash of 20% so that is the better investment without any tax implications figured in. Since my company matches 50% on a 401k, I decided to only contribute up to the amount to get the full match (6% of salary for me) and keep the rest of my money accessible to continue investing in real estate. I also have funds in two Roth IRA's (mine and my wife's) that I may tap for additional RE investing.
I guess my point is that at a certain level of return, real estate wins the discussion no matter what the tax benefits of 401ks/IRA's are.
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It's not all about the return rate. Besides the work involved in real estate, there's the matter of certainty vs. speculation. Getting a guaranteed tax benefit has advantages over uncertain real estate returns (and an employer match makes it a complete slam dunk). If you offered me a guaranteed 28% return on investment, I'd jump on that over anything speculative.
This isn't really right.
You are comparing a 28% one year return, followed by speculative returns largely outside your control, against other speculative returns which are a lot more within your control.
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So in a Bigger Pockets article the author suggested you needed to beat 6% a year for stocks to make it worth it.
(http://www.biggerpockets.com/renewsblog/2013/07/17/real-estate-vs-stocks/& http://forum.mrmoneymustache.com/real-estate-and-landlording/real-estate-vs-stocks/)
With the opportunity cost of a 401k, the numbers would look something closer to this.
Tax Rate Original Investment Rate of return $ after 30 years
28% 10 8.00% $100.63
7.2 9.25% $102.32
33% 10 8.00% $100.63
6.7 9.50% $101.98
35% 10 8.00% $100.63
6.5 9.60% $101.68
39.6% 10 8.00% $100.63
6.04 9.90% $102.56
I feel like a mental framework for decision making could be:
1) Do I have an employer match? If so, do that. 100% return the first year would require 12% to just break even in the 28% federal tax bracket.
2) Do you actually want to do the work of REI? Do I have the skills?
3) Am I comfortable with my diversification if I invest in real estate?
4) Am I comfortable with the amount of leverage needed?
Other pros and cons:
+1 RE: Ability to understand the market and negotiate for a price below market value
+1 RE: 3% historic appreciation
+1 RE: Access to cash flow if you need it
+1 RE: Additional tax benefits
+1 RE: Ability to control your investment
+1 index fund in 401k: So easy to sell, even if there's a penalty to get it out of the tax-deferred account early.
+1 index fund in 401k: Way less work
+1 index fund in 401k: So simple to reinvest profits
Depending on your personal preferences, you can weigh these factors accordingly.
Obviously you'd want a way better cash on cash return than these numbers to justify the extra work. I still think it's interesting to know the numbers.
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This may or may not be helpful, but as a general rule, I like to order my investments in ascending order of risk. That is, do the "safest" investments first, and then, introduce riskier, but with higher upside options investments next.
So, save for an emergency fund. Once you have that, work to max out your 401K. Then Roth. Then taxable investment account. Then, if you still have money left over, do real estate.
For me, the reason I'd choose 401K first over RE is because I'd have a lot of my assets tied up in a single property. An earthquake isn't going to level my 401K. A 401K offers greater diversification of assets.
You could even do both. Invest in REITs via your 401K if the option is there. You get your RE investment without the hassle and risk and if you want to shift investments at some point, you can do that in the 401K vehicle.
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With leverage, you can probably get a higher return on real estate. However, this will require more work than 401K so it will be somewhat of a part-time job and/or business.
Call me crazy, but I enjoy being a landlord. I enjoy providing high-quality housing to hard working people at an affordable price. My tenants are often very thankful and it's a great experience. I cannot replicate that with a 401K.
At a theoretical level, if you hate your job and want to FIRE asap, real estate might be a better fit. If you enjoy your job and don't see yourself retiring for a long time, then 401K is probably a better fit.
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Call me crazy, but I enjoy being a landlord. I enjoy providing high-quality housing to hard working people at an affordable price. My tenants are often very thankful and it's a great experience. I cannot replicate that with a 401K.
+1
And I really dislike the stock market. Sure I've got index funds, but to me it's all gambling. Real estate in my area with my properties is very low risk.
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Call me crazy, but I enjoy being a landlord. I enjoy providing high-quality housing to hard working people at an affordable price. My tenants are often very thankful and it's a great experience. I cannot replicate that with a 401K.
+1
And I really dislike the stock market. Sure I've got index funds, but to me it's all gambling. Real estate in my area with my properties is very low risk.
With leverage, you can probably get a higher return on real estate. However, this will require more work than 401K so it will be somewhat of a part-time job and/or business.
Call me crazy, but I enjoy being a landlord. I enjoy providing high-quality housing to hard working people at an affordable price. My tenants are often very thankful and it's a great experience. I cannot replicate that with a 401K.
At a theoretical level, if you hate your job and want to FIRE asap, real estate might be a better fit. If you enjoy your job and don't see yourself retiring for a long time, then 401K is probably a better fit.
+1
I am enjoying real estate way more than my 401k. RE has fast tracked me to FI by 10 years. It's not for everyone however.
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So in a Bigger Pockets article the author suggested you needed to beat 6% a year for stocks to make it worth it.
http://www.biggerpockets.com/renewsblog/2013/07/17/real-estate-vs-stocks/
And that makes an intuitive kind of sense.. stocks earn about 9% nominal, if you get 6% return on your RE plus about 3% appreciation (matching inflation), that's about 9%. It's a rough estimate, ignoring taxes and such, but that makes sense.
Now add in the fact that you lose out on the 401k tax benefits though, and you'll need another percent or two.
I would say unless you're earning double digit returns on your RE, you should be maxing your 401k (and even then, if you're saving > 40-50k/yr, max it first). Double digit returns are hard. They've been easy the last 5 years, but typically it's not a given.
So by far the vast majority should max the 401k first, then go for RE (and to get that 10% return, you'd better either have a rent to price ratio of at least 1.5% and use leverage at a low interest rate, or be getting closer to 2% rent to price without leverage).
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RE has fast tracked me to FI by 10 years. It's not for everyone however.
Ditto, and agreed.