401K Vs Real Estate Investing for 20 Year Olds

[Eric Selhorn]

Disclaimer: All investment strategies and investments involve risk of loss. Nothing discussed below should be construed as investment advice.

So, you’re in your 20s, have a job and are finally making some money on your own. Maybe you’re renting an apartment with a friend, sleeping on a couch, or living at home with M&D. You get that first paycheck and notice your employer automatically took out a portion of your salary and create you a brand-new 401K account. Now you’re curious if that’s the best place for your savings.

Although there could easily be a book written about this, my goal here is to provide a quick comparison.

Let’s start with the Pros of investing in your 401K.

• 401(k) contributions are “before tax” money - When you finally pay taxes on your 401(k), it may be at a lower rate. In addition, the tax that you would have initially paid the IRS is now invested and growing for the next few decades.
• Employer Contribution Match - Employers are all over the map regarding how much they match these days. For the most part they range from a match of 1%-5% of your salary. Don’t forget match means you need to contribute that same amount (or more). I had an employer once that matched 1/3 of my contribution up to 5% of my salary. This forced employees to contribute 15% of their salary to get the full match.
• Automatic Contributions – A portion of your salary is automatically deducted directly from your paycheck so if you’re not looking at your statements every month, you could perhaps completely forget you’re making them. For newbies and the undisciplined - automatic savings is the way to go: Out of sight, out of mind. There’s also something to say about consistent investing (google “dollar cost averaging”). You’ll be investing in great markets, OK markets, and bad markets but more importantly you won’t be trying to time the market which let’s be real – is a fool’s game.
• Power of compounding. I’ll spare you the Einstein quote about this, but I need to emphasize the importance of compounding. If you invest early and often you can easily achieve that hockey stick graph for your investment balance. While this is certainly the case for investing in your 401K it also exists in any investment where you are reinvesting the returns.

And now for some of the Cons of investing in your 401K

• 401(k) contributions are “before tax” money - Wait didn’t we say this was a positive. The truth is we have no idea what the tax rates will be in 40 years it could be lower; it could be higher. Granted you have some control over when you take withdrawals and therefore when you’re taxed – you certainly have limited options.
• Contributions are locked up for decades – Distributions from a 401K plan prior to the age of 59 1/2 are subject to early withdrawal penalties of 10% in addition to the income tax. The 401K plan is a retirement savings strategy so it makes sense that you wouldn’t have access to it until you are at retirement age. Unfortunately, if you come across a great investment opportunity outside of your 401K, you will not be able to participate with the money you’ve accumulated within your 401K.
• False Sense of Security – Currently the max contribution is $19,500. I could understand why some may assume that if you max out, you’ll be set for retirement. I hate to break it to you but no one at the IRS calculated a magic number that works for everyone. Deciding how much to invest for your retirement is a personal calculation.
• High fees associated with the account. - The only thing I hate more than fees are hidden fees. Most 401K plans come with management and recording keeping fees. Although Plan administrators are required to distribute fee disclosures annually the fees, it takes some effort to find them and fully understand the net impact on your investment balance.

Now let’s look at the Pros and Cons of Real Estate Investing

If you haven’t read Rich Dad Poor Dad yet, I don’t know what you’re doing on BiggerPockets or how you got here. Click the address bar of your preferred web browser, go to Amazon.com and purchase the book. Once you’re done reading come back and continue reading this post.

The real estate investing we're talking about is not in a REIT or a fund or a syndication etc. If you're a true real estate investor you own a real estate business. That's an important distinction because one is very passive and the other not so much. That said, taking on the additional responsibilities of running the business you will reap the reward in higher returns.

Here are some of the Pros of investing in a real estate property.

• Appreciation – Despite the recent skyrocketing housing prices historically real estate has appreciated at annual rate of 2%. (Appreciation is expected to continue to be much higher in the near term). All of that appreciation is yours – not the banks. For example, if you only put 25% down on a property that means you are earning an APR of 8% (100%/25%*2%) all of which increases the equity you own in the property.
• Illogical Tax Benefits – In order to attract investors to continue to invest in Real Estate the government has created a very tax friendly environment for real estate investors. You have an income producing asset that is appreciating but you are allowed to reduce your taxable income by the depreciation.
• Tenants pays down your loan – A portion of your tenant’s rent is used to pay your mortgage payment.
• Cash out refinancing – In the recent past real estate investors have had the benefit of consistent interest rate reductions coinciding with quickly appreciating assets. Investors have been able to take advantage by refinancing their loans to lower interest rates and at the same taking out equity from the property.
• Outsource property management – Once you grow your business to a certain level it may make more sense for you to hire a property manager. Personally, I managed my properties early on because I wanted to reinvest as much of the cashflow back into the business to grow it quicker. I also had the time, energy, and love for real estate that you’ll need to survive managing your own properties.

And now for some of the Cons of investing in real estate

• Not Passive (at first) It’s a lot more work to be a landlord. When people say you earn passive income from real estate, they are lying to you. You’ll need to put some work and time on getting your property leased and maintained.
• More leverage, more risk – there’s no such thing as a free lunch. Even though your tenant is paying your loan payments, you are still fully responsible for the debt. The way you limit your risk is by doing all the right things upfront. Having a great team and doing your due diligence are the most important parts of investing in real estate.
• Illiquid – Granted we are currently experiencing a seller’s market; real estate is still not a very liquid asset. Finding a buyer and closing on a deal takes time. Even completing a cash out refinance take a lot of time.

Personally, I’m an advocate for achieving Financial Independence much earlier than the “normal retirement age”. In order to achieve this, it will take investing early and often. Most advisors in the personal finance industry recommend at least 10% but I think that’s way too low and should be at least 25%. If I could provide my 20 something self-advice, I would recommend investing 10% in my 401K and 15% in a brokerage account. 10% in my 401K would likely be enough to get any/all match my employer provides. I would continue to invest in my brokerage account until I was ready and able to purchase real estate. Then I would hack my living situation in order to live for free and therefore invest more of my cash inflow to continue to grow my wealth (google House Hack). Let me know if you would like to hear more about this strategy.