Today’s question comes from Alex and he says, Hey Marco, great show. I have been listening for a long time and look forward to each and every one of your episodes.
Well, thank you Alex. I really appreciate that. I want to chop up your email here into chunks so I can actually answer parts of it as I go through it.
So Alex goes on to say, here I am 31. And in the process of saving money for a down payment to buy my first rental, I am very interested in real estate and have a goal of building enough passive income through rental properties within the next 10, 15 years to have the financial freedom to quit my W2 job.
Alex, congratulations on your goal setting! I like the specificity. That is fantastic! It sounds like you’re very clear on what you want to achieve. And I’m also glad that you know what you want. And especially with your age being 31 in your early thirties, that’s a great accomplishment right then and there because a lot of people don’t even set goals and many people don’t even get their financial life in order until they’re in their late forties and fifties. So congratulations with all that.
So Alex goes on to say, my employer offers a 401k and matches up to 5%. I currently contribute 5% so I can take advantage of the full match. I put an additional 8% in savings for a down payment on a rental property. After buying my first rental, I plan to continue saving at the same or higher rate and adding the additional rental income into the fund for buying new rentals.
Great plan and congratulations again, for being very clear on what it is you’re trying to do, Alex, that is well thought out and I applaud you for that. So when we’re talking about 401ks and a match, if you’re getting a 5% match for every dollar you’re putting in, that’s actually very good. And you know, it’s nothing to sneeze out because if you don’t have too many other options and really it’s just your W2 income and no other income, and you can save for retirement using a 401k and get a hundred percent return on whatever your contribution is. That is a very, very good rate of return. Plus, in addition to that, for those of you who are contributing to 401k, which I am not necessarily a big fan of, you have to remember that if you’re getting a match up to whatever your employer matches, let’s call it 5% and you get a hundred percent return on your contribution. That’s great because it compounds.
So the key to making this work though is you have to have a fairly large 401k with a very good average annual rate of return that compounds over a long period of time for it to be something significant because you’re going to need one, two or $3 million or more. When you get to retirement age, to be able to get a livable income off of that from a reasonable rate of interest that you’re going to get, or find 10 years, 20 years, 30, 40 years down the road from that 401k. In this particular case, you are also saving 8%, which is great. Most people don’t save at all. An interesting fact is 47 to 49% of Americans can’t even raise $400 in cash if they came up with an emergency of some kind. And so that is clearly a problem in America.
Now, the things remember with a 401k is you have something called a contribution limit that has been relaxed in 2020 with all that has going on. So for employees this year, the contribution limits to all 401k accounts that are held by the same employee. And regardless of current employment status is $57,000 or 100% of your compensation. Whichever is less. We have to assume that you’re making more than $57,000 here, but that is your limit. And that is actually a pretty high limit for a W2 contribution. Like I said before, I’m not a big fan of a 401k. There are other options and better options. In fact, I gave up my 401k a long, long time ago. I just did the math and I figured that it was worth paying the fees and taxes in pulling the cash out and reinvesting that elsewhere because what I gave up short term, I made up longterm.
So your email goes on to say here, the question I have been contemplating for some time is whether I should continue to put money in the 401k provided by my employer or go all-in on real estate. I have projected out different scenarios, such as all in, on real estate versus a balance of real estate and 401k based on my calculations, I will achieve higher net worth by focusing on real estate. This will also allow me to reach financial freedom at a younger age. My hesitation is that I feel I am putting all my eggs in one basket. If I go all-in on real estate, I also feel like I am leaving money on the table. If I do not take advantage of my employers match in the 401k,
Interesting Alex, this is a great analysis and you probably are doing what I would do with a spreadsheet and a pad of paper and a pen. This is a great analysis and it’s actually the right way to go about it because you’re thinking about it. Logically methodically, mathematically, you’re doing analysis and that’s great. And it’s great that you’re focusing on financial freedom at your young age, especially considering you have a 401k available through your employer. Now, as a side note, some employers will allow you to, self-direct a 401k and they may not even know it. So you have to talk to your HR department or whoever’s in charge and ask them about it. They may look at you funny and scratch their head because they’ve probably never been asked before, but there are various companies. I’m not sure what they’re called. They’re not custodians they’re institutions that will allow you to self direct your 401k while you’re still employed at that particular employer, they probably don’t like it. And they don’t talk about it because they don’t know about it.
It’s really something that they would prefer you don’t do, but it is an option. I know people who’ve done this. So let’s just go on here with your email, you say the counter argument to the first hesitation can be pulled from episode 257 – Money “Secrets” Of The Wealthy, where you and Andrew discussed the disadvantage of diversification points of which I agree in terms of my concern with leaving money on the table. It could also be argued that by not going all in, on real estate, I am leaving more money on the table as shown in the different scenarios. I have calculated, which by the way, you’ve not provided to me. So I’m just going along with your email here, as you can probably see I’m leaning towards going in on real estate, but I wanted to hear your thoughts on this topic.
Okay? So Alex, again, you know, thanks for the email. I had a lot of comments there, but here’s kind of the way I look at this. Let’s take an example, a hypothetical example. Let’s say you have $70,000 in your retirement account, your 401k, and it’s invested in probably the most common thing, which are typically mutual funds, some sort of ETF or mutual fund and what you probably know, but if you don’t, you may want to read the book 401(k)aos, you can learn about all the various fees that are buried within these funds, particularly mutual funds that are used in 401ks. But most of the assets, if you will, the vehicles you invest in through a self-directed account or a 401k or an IRA are riddled with fees. And so those are not helping you in terms of your overall returns. And that’s why returns are pretty anemic often with these types of investments.
And this is why self-direction is so good, but after you factor out all those fees, you could be netting somewhere between four and 8% per year, hopefully on average, but let’s just call it 6% per year on average. So after 10 years, if you assume a net 6% annualized return, you’ll have approximately $120,000 in your account. So you started with 70,000, 6% net per year annualized. It gives you $125,000. Keep in mind that this may be a little bit more with your employer’s match. But the thing is, I don’t know what those numbers are and you have to take a close look at those, because if you are putting in, let’s say $500 a year, which is not much, and you’re getting a hundred percent match on that. That’s not going to add up to a lot, even with some compounding, you need to be making pretty significant contributions each year for this to really grow quickly after 10 years. That’s the first example.
Now, if you place that same $70,000 into a self-directed IRA or a solo 401k, where you actually have direct control over those funds and you can invest them in real estate. Now you can apply, leverage, and use those funds to purchase up to $280,000 in real estate. So that’s assuming that you’re using that 70,000 as a 25% down payment, and you do that across four properties. You can have a $280,000 portfolio of real estate. Now let’s assume those properties now average the same 6% net annualized return in terms of cash flow. And they also appreciate at an average of only 3% per year. After 10 years, you will have approximately $500,000 of real estate from the same $70,000 that you started with. So that’s about four times the return overall return you would see from your 401k or IRA, even if you took that $70,000 and purchased one property, all cash, no financing. Your return after 10 years would be approximately $219,000. So about double the financing, the leverage allows you to get twice as much as that scenario. Even if you were buying one property, all cash, you can see that your overall return would be about two times what you would have with the IRA or 401k.
With real estate, you’re the owner. It’s a tangible asset. You have the ability to collect monthly and annual income from the rents. You let someone like a property manager manage it, and you have now a portfolio of assets that you can leave to your family or friends or whoever it may be your air after you pass away. And these benefits are also compounded in a tax-advantaged vehicle. So there’s a lot of power in building a real estate portfolio, and it is really something that makes real estate investing one of the most ideal vehicles for creating wealth.
Again, remember with real estate, you have income equity buildup. You have the appreciation, you have depreciation, you have the ability to leverage and you have tax benefits is the perfect tax-favored vehicle with your 401k plan. Yes, it’s tax-advantaged, but you’re deferring those taxes to a future date. And hopefully, your lifestyle is going to be bigger and better, not worse when you retire to use that 401k unless your lifestyle is the same or less, you may end up having to pay more taxes. So even though it’s tax advantage, now the reality is is that by the time you retire, you might be ended up paying the same or more taxes. If you’re in a higher tax bracket. One advantage I do see with 401k plans is that match. But again, you have to look at it, not in terms of percentages by itself, look at the match in terms of dollar amounts. So yes, it’s a hundred percent match. You’re essentially getting a hundred percent on your contribution, but if you’re only contributing a dollar and you’re getting an extra dollar on top of that. So for a total of $2, that’s really not gonna move the needle. Is it? So again, I’m oversimplifying, I realize that, but it’s something to pencil out and keep in mind.
I want to wrap it up, leave you with this thought, you know, one of the most successful and probably smartest investors in the world is Warren Buffett. And he said, not one but two interesting things about diversification. The first thing he said about diversification is that diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing. So there’s a lot of truth in that. So if you understand real estate investing and you study it and you become better at it, as you’re actually taking action and building your real estate portfolio, you will become better and better. And ignorance will never be a problem you will do incredibly well which segues to the second thing that Warren Buffett says, and he says, diversification may preserve wealth, but concentration builds wealth. And so to your dilemma of whether you should go all-in on one or the other, or have a balance of both where you have a foot in each, this is where Warren buffet is basically answering your question. Diversification may preserve wealth, but concentration builds wealth.
And that segues to my comment about diversification. And that is this diversification makes sense once you’ve accumulated a large net worth and expanding your overall asset mix within your investment portfolio makes sense. So as an example, what you would do is you would focus on and concentrate on building whatever you’re really good at whether it’s businesses or real estate or whatever it may be. Once you get to a point where you have a large net worth, and I’m not going to define that in terms of numbers because that large is different to different people, but you get to the point where you’re more than comfortable. You’ve achieved certain goals. Now you can start to expand into other assets and diversify your investment portfolio into other things, whether it’s gold and silver and or other businesses and or cryptocurrency and or, or whatever, oil and gas or cannabis or different types of real estate, whatever it may be. But until then, until you have the ability to expand without affecting or diluting, what you’re focused on, stick to one thing, build it big and strong, deep roots, tall buildings, whatever it may be, and then diversify. So that’s when it makes sense to diversify in my books.
All right, Alex, I hope that helps. I appreciate the question. Thank you very much!
For everybody else listening to this, any question about real estate investing or finance, send it over to me through passiverealestateinvesting.com or just go to Ask Marco.com, that’s a little bit easier to remember. Share this show with other likeminded people. Don’t be afraid to refer. I love it when you do so.
Thanks for listening. I’ll see you on the next episode.
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