Is Investing In a 401(k) a Bad Idea?

We are told that investing in retirement plans is a good idea, but can that strategy actually push out your retirement? Although I am a big believer in saving in tax advantageous accounts and believe most investors should have this as part of their overall plan, here are four reasons you may consider avoiding traditional 401ks.

Access to the Money:

With most retirement accounts, including your 401k, you are forced to wait to start taking distributions until you reach the age of 59 ½. You are then forced to start taking distributions when you turn 72.   These restrictions can create a planning nightmare, especially if you want to retire early! Let’s say you are a real estate investor and have figured out that real estate is a great way to invest for retirement.  You learn more about the business by reading the Pine Financial Blog and watching the Pine Financial videos. You start buying rental properties and quickly realize that owning rentals will accelerate your retirement. In fact, you realize that you can become financially free, and you begin to focus on creating more passive income than you have expenses.  With some great money management and some solid investments, you may be able to retire early, but you will not have access to your 401k funds to help with that goal. All the money you are earning in your retirement account and all the money you invested in that account are worthless in accomplishing your early retirement goals.  For this reason, investing in your 401k can actually slow you down.  You might find that you will be shaving many years off your financial freedom timeline by investing that money into other assets, like real estate.

Restrictions on Investments:

With some rare exceptions, you will be restricted on what you can invest in with a company 401k plan.  These restrictions are mostly limited to the more traditional type of investment options, like exchange traded funds (ETFs) and mutual funds.  Because of these restrictions, it is hard to hit the returns that real estate investments are known for.  Obviously, lower returns will slow you down on your financial freedom goal.  This is not the case with IRAs, as you can invest in real estate with your IRA.  That distinction is why we are focusing only on company 401k plans.

Taxed at Ordinary Rates:

If you invest in a piece of real estate, you organically defer taxes on appreciation until you sell the asset.  Because this type of investment has a built-in tax deferral, it limits the value a traditional 401k brings.  This is an often-overlooked reality, and a powerful argument to stick to real estate over mutual funds in a 401k plan.  When you do retire and want access to the cash, you will be taxed at a capital gain rate on the real estate when you sell it.  Those rates are typically much lower than you would pay on your ordinary income.  When you sell assets and take withdraws from your 401k, you will be taxed at ordinary income rates, even if you have owned the asset for many years.  This eliminates the advantage of the reduced capital gains tax.

Leverage:

It is unlikely that you would be able to, or want to, use any loans to purchase assets inside a company 401k plan.  Leverage is one of the primary reasons real estate is a superior investment to many other asset classes, in my opinion.  You will be able to control huge amounts of assets for down payments of 20% of their value.  There are some risks with this, but it does magnify returns.

It is a rather complicated process to determine how an investment would perform inside a 401k or outside a 401k to give a clear picture of my points.  Every investor will invest in different assets, each has their own tax and income levels, and each could have different advantages and disadvantages, like a company match plan or access to great real estate deals.  I tried to take an average person and account for all these variables when deciding which option would have been better over the last 20 years, January 1999 through December 2019.  For my example I used a $50,000 lump sum investment made in January 1999.  In my scenario, each investor makes $75,000 per year from other sources at the time of their investment and at their retirement. I used data on average real estate values on a national level and prices of an S&P 500 ETF over the same period.  Real estate values have increased about 5.1% per year and this particular ETF increased 7.6% per year.  I also made the extraordinary assumption that the rental property purchased would produce no monthly cash flow but would cover the monthly expenses, including the mortgage.  Since I did not account for any cash flow over a 20-year period, which is a highly unlikely outcome, I used a 20-year loan instead of a 30-year loan.

Investor A decided to go the 401k route.  Because he can invest that money before it is taxed, he was able to invest the entire $50,000.  That $50,000 purchased 391.7 shares of the ETF.  20 years later he sold them for $321.23 per share, giving him $125,825.80.  When he takes that money out of the plan, he is taxed at 24%, leaving him $95,627.61.

Investor B decided to forgo the 401k plan and invested her money into a rental property.  She was not able to invest with pretax dollars, so her actual investment was reduced to $38,000, which is enough for the down payment on the averaged priced home in 1999.  She purchased the home for $189,100 and 20 years later sold it for $384,600.  She paid a 20% capital gain tax on only the gain, leaving her with $345,500.

I am in no way saying to not invest in your 401k plan or other retirement accounts, and I am not giving investment advice.  I participate in tax deferred retirement accounts myself.  Every investor’s situation is different and there are other pros and cons of both examples that are not taken into consideration in my example.  For example, I did not account for the effort to manage the property, company match contributions, ease of investment, recapturing deprecation, high costs of tenant turnovers, annual contribution limits, and several others.  I give this example only to illustrate that these four points should be considered when investing for an early retirement.

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