Introduction
If it is asked to any common person whether it makes more sense to invest in real estate than in 401K, the answer probably will be negative in most of the cases. In fact, after the real estate crash of 2008, an increased number of people have started investing more in 401K and less in real estate (Robbins, 2014). However, if the same question is asked to a person who is knowledgeable in finance and has the ability to calculate the future value of money based on present investment capabilities, then the answer will be completely opposite. For most of the people with little bit of knowledge of market dynamics and returns, investment in real-estate will be both a long term as well as short term choice. This essay will compare investment in 401K with that of investment in real estate. This will also discuss the pros and cons of each investment options.
Investment in 401K vs Real Estate If Starting Late in Life
It is not uncommon for people to start saving late in life. The majority of the people do not even think of saving till the time they reach the age of 40 years. However, the earlier one begins to save, the better one’s retirement income will pan out. For the sake of discussion, it is better to assume that Mr. X is a 51 years old man who wants to retire by the time he turns 60. Therefore, he has 9 years left for saving. To compare what will be the total income at the end of the period for the 401K option (Option 1) and real-estate option (Option 2), some assumptions will be made. Mr. X earns $50,500 per year, which is the median income for American households as per bankrate.com data. It will be assumed that he saves $420 per month or 10% of his monthly income. If Mr. X invests $420 in 401K, then he gets a matching contribution of $300 from his employer. As per the bankrate.com data available between 2000 and 2014, the average market return was 9.4% and it can be assumed that it will be same for the next 9 years as well (Robbins, 2014). The average inflation rate for the last 15 years had been close to 3% and it will remain same for the next 10 years (Robbins, 2014). The calculations are done in a separate excel file that shows the cash flows in detail. This discussion only uses the final numbers.
It can be assumed now that instead of investing in 401K, Mr. X decides to invest in income generating assets like real-estate. It is assumed that Mr. X buys rental properties at $12,000 for onetime down payment. This will help him get $400 monthly cash flow after principal, interest, insurance and taxes and $100 as monthly maintenance and vacancy reserve. However, as Mr. X is not investing in 401K, he will not get the monthly $300 contribution he was getting from the employer. When he starts saving $420 per month, initially he will not be able to buy anything as a minimum amount is required for the investment in real-estate (Ro and Gallimore, 2013). At 29 months, when the total amount exceeds $12,000, he will buy his first real-estate rental property. As soon as Mr. X buys his first property, he will start saving $820 per month ($420 from income and $400 from cash flow). He will take only 15 more months to save the next $12,000 and buy the next property. From 44 months (29+15) onwards, he will save $1,220 per month and so on. If he can continue this for 9 years, then he will end up with a monthly cash flow (rent income) of $7600 from 20 properties that he will be able to buy. This is equivalent to an income of $91,200 per year. The equity capture, which also happens with investment in real-estate, has not been considered here (Ro and Gallimore, 2013).
Therefore, in the short term, by investing in 401K, Mr. X will end up getting only $125,160 one time. This is the only cash Mr. X will have for the rest of his retired life. If Mr. X lives 15 years after retirement, then it translates to only $10,400 yearly income. On the other hand, real-estate investment makes much more sense. It will give Mr. X a steady monthly flow of cash equivalent to $7,600 plus it may also give Mr. X equity capture worth more than a few hundred thousand dollars.
There is no comparison between 401K and real-estate investment in terms of returns. In the short term, 401K will never be able to build enough fund for his retirement. However, real estate investment has a few problems. For example, if the real-estate asset in which one has invested is somehow destroyed or is non-performing, then one’s whole investment of $12,000 will go down the drain. One may not be able to get any salvage value in most of the cases (Ro and Gallimore, 2013). A famous case surfaced in 2012 when a person lost all 12 of his retirement properties located in Hawaii when a volcano erupted. However, investing in many properties in diverse geographies reduces market related risk. One other problem is to find suitable real-estate resources in which investment can be done. Investment in stock market or retirement funds (mutual funds) using the 401K may not require a huge knowledge but investment in good real-estate requires a little bit more effort (Ro and Gallimore, 2013).
Investment in 401K vs Real Estate for long term
In the long run also, from pure financial perspective, real-estate investment is far superior than investing only in 401K. The calculations for the 30 years will not be repeated as it is clear that the results will already be highly in favor of the real-estate investment. However, as discussed previously, investment in real-estate property requires a little more due diligence than stock market through 401K. For the long term, traditional 401K contribution will be compared with that of investment in discounted notes secured by real-estate through Roth envelop.
It is now assumed that Mr. X started saving from the age of 29 years and he has 31 years before he retires. Mr. X’s income and saving is assumed to be the same as the previous example. If he saves $420 per month in traditional 401K with an additional employee contribution of $300, then in 31 years, the total amount in 401K fund will be $1.52 million. Mr. X also needs to pay tax on this amount as and when he decides to take the money out of 401K account. Assuming a 20% tax rate, the total amount available to Mr. X will be $1.22 million.
Now it is important to take a look at the other option. In the case of investment in Roth, Mr. X cannot contribute more than $5,500 for the first 21 years and then maximum $6,500 for the last 10 years. The yield rate for discounted notes secured by real-estate is on an average 15-18% but the rate that will be assumed here is 15% (at the bottom end of the range) for the calculation. The assumption is that Mr. X will invest in Roth account and all amounts will be taken out of Roth to invest in notes backed by real estate. The cash received from the notes will be used to repay the Roth loan till it is fully paid. Doing similar calculation for what has been done for the traditional 401K plan, the total future value of the fund will be $3.1 million. This amount is more than double the previous amount also as this is an amount that is absolutely tax free (Roth). Therefore, this option actually gives almost 3 times the money to Mr. X after retirement than in the traditional 401K option.
Summary of Returns
As can be seen from the above table that if someone is starting to invest late then investing in 401K is not a good option as it will not give good amount after retirement. The only way to ensure substantial amount upon retirement is to invest in real estate units. On the other hand, if a person starts to invest early then apart from investing in real estate, investing in traditional 401K can also give good amount and is very secure tool. Roth is another way to invest securely as well as get good return. In fact, if one invests in discounted notes secured by real-estate properties, then the net return upon retirement will be higher than traditional 401K.
Conclusion
Retirement planning is a very important process in all of our lives. Especially, when people are living longer after retirement, more money is required to sustain a good quality of life after retirement. 401K is the traditional way of saving money for retirement. As per government rules, 401K funds are almost secured and even IRS cannot touch it except for some very special cases. However, saving a good amount for retirement by investing in 401K alone is not easy. It requires many decades of planning and systematic saving. In fact, if someone begins to save from an early period in his career for retirement, then he may opt for Roth. Investing in notes or real estate properties through Roth account is a good choice to grow one’s money at a faster rate. However, like traditional 401K, Roth is also not good for short term growth. Direct investment in real estate units or rental homes often can give substantially more return and a higher stream of monthly cash flow at a higher risk.
References
Elton, E., Gruber, M., & Blake, C. (2012). The Adequacy of Investment Choices Offered By 401K Plans. SSRN Journal. doi:10.2139/ssrn.567122
Dvorak, T. (2014). Do 401k plan advisors take their own advice? Journal of Pension Economics and Finance, 14(01), 55-75. doi:10.1017/s1474747214000043
Ro, S., & Gallimore, P. (2013). Real Estate Mutual Funds: Herding, Momentum Trading and Performance. Real Estate Economics, 42(1), 190-222. doi:10.1111/1540-6229.12024
Śmietana, K. (2014). Diversification Principles of Real Estate Portfolios. Real Estate Management and Valuation, 22(1). doi:10.2478/remav-2014-0007
Robbins, E. (2014). Essentials of retirement planning. New York: Business Expert Press.
