Why Your 401k Is A Retirement Income Loser!

A savvy commenter and a couple buddies made known to me that last week’s post at a sentence or two they didn’t quite grasp.

I read it myself, and calling that sentence the perfect example of tortured syntax would be straining the concept of kindness. 🙂 Here’s the offending prose.

“If all you ever did was buy discounted first position notes secured by real estate, you’d surpass the after tax income from that significantly lower amount by double, at least in most cases.”

I wrote that in the context of what I call ‘gutting’ an employer sponsored 401k.

The consequences of executing this option are immediately felt in terms of hurtful income taxes and, to add insult to injury, a 10% penalty as salt in the wound. Don’t let anyone soft peddle this strategy to ya. There’s simply no way to sugarcoat the potential of having the impressive fruits of years of discipline cut in half — due to a decision YOU made.

In an event I recently hosted and at which I spoke, the tax expert in attendance who also spoke on the subject, backed up what I said about the brutal nature of the taxes and penalty. Please allow me to give an example of why I often say to pay the dang taxes and penalty.

It’s all about results, right?

Here’s an Example for Ya.

The investor/taxpayer couple both have a relatively large work related 401k balance. The choice is whether or not to take the hit of taxes/penalty and invest in different vehicles for retirement than are available at work — OR — stay the course at work, grow it to an even bigger balance, and be happy with the 4% +/- that now huge amount would generate.

They have a combined $700k 401k balance now, which in a horrible scenario will be cut in half by taxes/penalty if they ‘gutted’ ’em. We’ll assume they then put the now ‘measly’ $350k into a Roth IRA for the expressed purpose of investing in first position notes, secured by real estate. We’ll further assume their cash on cash return is 12%, which is at the bottom of the current range, 12-15%. That would then produce a tax free annual income to your new Roth of $42k. The cash on cash return doesn’t take into account the other, rather significant return built in to the various note purchases, the discount.

Let’s Assume they’re Say, 48, and will Retire at 65.

At the end of the first year their payments alone will buy another note. Using the same minimum return, that’s an additional annual income to the Roth of around $5k. Total Roth income is now $47k a year. Their payments keep buying notes — for 17 consecutive years. Each year the payments are a bit more than last year’s. For 17 consecutive years, year after year. 😉

Let’s circle back to the first big purchase of notes with the $350k. Just as likely as not, they acquired $500k in notes. ($350k = their combined balance at time of purchase) Who knows when those notes will pay off? I sure don’t, as it’s a completely random event. The latest data says 6-10 years. But that data and $10 will get us both some coffee and a cookie. 😉 Let’s be silly conservative and say that those original notes didn’t pay off ’til 15 years have passed. They’d still have a couple years before retirement, right? Let’s pause a second here, and begin adding up all the income your Roth would be collecting at that point, ok?

We’ve established the $42k/yr from the first big purchase, using the $350k. For the next 15 years they bought more notes with just the payments. The first year’s income from that approach yielded around $5k/yr additional income. Every year after that produced a bit more. Let’s arbitrarily say that the average for the 15 years was around $7k or so, a conservative amount. That comes out to $105k, which we’ll round down to $100k, just cuz we can. Again, let’s pause to appreciate what they’ve accomplished here.

Their initial purchase of notes produced about $42k in annual income to their Roth. Over the next 15 years they used that income to buy more and more notes, each year a bit more than the last. Those small purchases have now amassed an annual income — NOT COUNTING the $42k/yr — of $100k.

But Wait, There’s More! 🙂

The original notes have all now paid off at the end of the 15th year, a couple years before their retirement party. That’s roughly a $480k payoff, give or take. That capital is now put into more notes, again at the low end of the yield range, which results in approximately $57k/yr, which is a $15k/yr raise. Before continuing, their annual payments to the Roth have now reached $157k/yr. That figure is insultingly low, as in my 38 years of note investing experience, the vast majority of your notes woulda paid off sooner than this scenario assumes. But I digress.

The last couple years before they retire, and frankly many before that, but I wanna derail the naysayers before they start huffin’ and puffin’, each year will see them increase their annual Roth income by around $18.5k the first year, and about $21k/yr the second, and last year before retirement.

That means they’d begin retirement with a TAX FREE annual income of around $196k. 😉

Let’s pause again to reflect on what their choice was 17 years earlier. Let’s say they opted to stay the course with their employer sponsored 401k plans. Let’s further assume they grew the $700k balance to $2 million. Don’t laugh, I’m not. 🙂 It’s laughable, but let’s assume they were able to generate a 10% annual return ’til they died, never ever missing a year. That’s $200k/yr pre-tax annual income. However, their federal income tax liability will be about $43k/yr. Let’s say their state tax is from California and takes away another $14k. That leaves them an after tax annual income of give or take $142k/yr.

Remember now, that figure assumed they’d never ever miss generating a 10% yield on your capital.

Meanwhile, back at the ranch, the other ‘them’, the ones who paid the horribly high taxes and penalty 17 years earlier, are enjoying their first year of retirement with roughly $5k a month more after tax income than the 401k ‘them’. But wait, it gets worse, far worse. But before I outline those factors, let me tell about the real killer surprise the feds have in store for you guys.

About 5.5 years after you retire, 70.5, they’ll knock on your door and begin FORCING you to take more out each year than you wish. You won’t have a choice. I have a way around that that’s wickedly simple, but it also requires the taxpayer to pay, you know, taxes. However, cuz they opted for their approach instead of mine, those taxes will be horrifically more in terms of dollars, than if they’d bitten the tax/penalty bullet when they were much younger. In other words, pay ’em now or pay ’em way more blood money, later, when they need it the most.

1. The almost $200k/yr TAX FREE income the brave ‘they’ generated the first year as a retiree, is mostly likely to be, in real life, more like $250-350k/yr.

2. Furthermore, whatever the figure is will in fact be the lowest retirement income you’ll ever receive, as long as you live.

3. Why? Cuz notes don’t know you guys retired so they keep on randomly paying off, TAX FREE, so that you can then rinse ‘n repeat, creating ever more TAX FREE income in retirement. You keep getting raises while on your latest cruise. Who knew? 🙂

What I was trying to say, though not very well at all, was that when I suggest folks might consider gutting their employer sponsored 401k, I’m offering an alternative approach. That approach is to move the before tax capital into a Roth ‘envelope’ and begin buying first position notes secured by real estate.

I know, I know. Boy do I ever know how emotional this decision can be. Why on earth would anyone purposefully cut their retirement (401k) nest egg in half?!! I just told you guys why, and was conservative to a fault in how it was done. Here are the facts to remember.

You’re definitely not gonna grow today’s $700,000 (or whatever) into $2 million in the next 17 years. The unspoken assumptions there are that you’ll never have a losing year; and that you’ll average roughly 35% greater return than Americans have over the last two decades.
Does anyone think they’re gonna keep investing in the same vehicles available in their 401k and make 10% a year once they retire? Really? That return is nearly triple what Americans have been able to generate in their 401k plans the last 20 years.
If you overcome the very real emotions attached to ‘gutting’ your 401k, you’ll live to laugh out loud at your initial anxiety, which was indeed just as real.

Always go with the empirical evidence!

Be sure to leave your comments below!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.