Should I withhold from contributing to a 401K for now?

[Jonathan Newlin]

Hi all! I am just starting out in REI and am looking at every option of saving and building capital to invest. I am 25 and contributing around $100-$200 a pay period to my 401K. I have only begun contributions last year. My question is should I withhold from contributing in order to put the $100-$200 per pay period toward? I understand the power of compound interest and the value of putting away for retirement young, however would the cash be better put into RE in the long run? I realize this is a case specific question and depends on how savvy of an investor I become in time, but would appreciate any feedback.

Note: My employer does not match

[Scott Trench]

Hi Jonathan - I feel that it is a great thing that you are starting to think about investing and conscientiously socking away capital. Here's how I approached this situation at the age of 24, perhaps similar to your situation: 

At 24, I was making about $48,000 per year. I was very interested and eager to invest, and was reading a large number of books on the subjects of advancing my career, general self-improvement, sales, marketing, business, real estate, stock investing, etc. Because of this pattern and the clear priority I placed on the rapid accumulation of wealth, I supposed that at some point in the following decades, that I would be wealthy relative to my position at the time.

I also surmised that because I was going to get aggressive about accumulating capital, that my income would be in a higher marginal tax bracket at retirement than the one I was in at 24 - while making $48K. For example, if I were able to amass a several million dollar net worth over a 30-year career, my income might be over $100K per year at retirement. Therefore the decision for me was clear: 

If I invest using a retirement account, I would use a ROTH IRA. The money goes in after I am taxed today, but grows and both the contributions and gains can be withdrawn tax-free at retirement age. 

If, on the other hand, I were 50 years old earning $250K per year and expected to retire within 10 years and withdraw $75K per year from my accounts, I would make a different choice and choose to contribute in a tax-deferred 401(k). This would enable me to lower my taxable income while in a high relative tax bracket to where I expected to be at retirement age.

So, in my position at that time, and for the reasons stated, a Roth IRA is preferable. One thing that would have changed the dynamic for me would have been an employer match, but as you discuss that does not apply in your situation - those matches often occur only in a tax-deferred 401(k). (Incidentally, here at BP, we recognize this dilemma and offer to provide employer contributions either a traditional 401(k) or a Roth 401(k) in part due to this "problem" for some team members).

On to the next point however - about whether to contribute AT ALL to the retirement accounts. I think that the answer depends on how aggressive you want to get about accumulating capital. If you are going to save your way to retirement a few hundred bucks a month at a time, I think that accumulating capital in a retirement account, perhaps a Roth, might be a great way to go. However, if you are looking to rapidly accelerate towards financial freedom and invest in real estate, you may find yourself with a hard problem -- you will simply need to accumulate more capital (likely after-tax, but a minority of investors do use retirement accounts to buy property) at a faster rate. 

I think that the initial reserves alone (which you need access to likely in an after-tax checking or savings account) for an investor getting into this business needs to be in the $10-$15K range. This is the minimum needed to cover an unexpected eviction, rehab, roof, etc. Anything less than this in reserves means that you can be hit with an unexpected problem. Based on your savings rate (but dependent on how much you currently have saved), this means you are YEARs away from being able to invest with a strong financial foundation. 

Coming full circle - the answer to your question is likely that retirement accounts may be the way to go for now, until you have a plan for being able to accumulate $10-$20K over the course of a year or two with which to put towards a real estate investment. If you are able to get to that level of capital accumulation, you will be in a much stronger position to invest, and will then face the hard problem (but good one) about how much to allocate to your real estate investments and how much to allocate to your retirement accounts.