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

Having fun conversations all day is what consistently turns my work into play. Even on the frantic 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. 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. 🙂 Our discussion ended up in a very interesting debate 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 — wait for it — 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.

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

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. 🙂

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. 🙂 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” 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. 🙂 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 — 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. 🙂 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.

NOTE: 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? 🙂

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