Trad or Roth Retirement Accounts…the Tradeoffs
Except, this isn't going to be your usual take...
We Could Do the Usual Trad vs Roth Analysis…
I could slow walk you through the usual benefits and drawbacks between traditional 401k retirement accounts and Roth 401k retirement accounts, but you can get that analysis here and here and here, and…well you get the idea. And since I’m a sucker for cool online calculators, I’ll add this Trad vs Roth 401k calculator to the mix as well.
But Let’s Do Something Better
If I’m going to turn you into a true contrarian investor and lead you to financial independence sooner than later, I want to show you how to think differently. Break out of the mold that financial planners and banks and employers try to cast you into - keeping you a debt-serf, and their loyal servant - until the day you “retire” from the job you had to have. My idea for you is never wanting to retire because as a financially independent person you now have a job meaningful to you. A job you love because it reflects your passions.
So, with that in mind, how should we look at this question of traditional versus Roth 401k? What is the one thing that matters most when you’ve committed yourself to breaking the mold and becoming financially independent before the taskmasters of the world want you to be? In a word, access to the most funds now. Why do I say that? Because you cannot know when and where your opportunities to acquire productive assets will materialize. You will be on a hunt, waiting patiently for the right moment but what if at that moment, you don't have enough cash or access to enough traditional loans that make sense outside of retirement accounts to seize the opportunity?
You are (or will be) told time and again that taking money out of your retirement account is a bad idea. A REALLY BAD IDEA. They say you will fall behind on your retirement goals, that the money taken out won’t grow in value…BUT what if you take that money and instead of frittering it away on a vacation, or car, or other depreciating, non-productive asset you can invest it in a productive asset with annual cash on cash returns of over 18% or better? Most mainstream financial gurus act as if there is no better investment in the world than those precious retirement accounts, but after you’ve claimed the match that assumption becomes false.
The funds you will find in a 401k will never consistently deliver even 15% on an annual basis, but you may encounter many productive asset investment opportunities in your life that will do that well or much much better. 401k funds are supposed to be safe plays, the market index funds, or the ones that perform a little above or below that threshold. Sure, when the market is really on a tear you might have a year or two of 30% gains, or even one year of 75% gains, but nothing in a 401k will ever deliver reliably high annual returns like the investments I’m talking about to complete your journey to financial independence.
You might say, okay, so why invest in my 401k at all? It’s about the match. For a person on the FI-before-retirement journey that’s the main benefit. Down the road, another reason is if you’ve developed the problem of high earnings (full disclosure: It’s my goal for you to have this problem) and you’ve achieved financial independence. Then, using a traditional 401k and traditional IRA to shelter some of that money from taxes can be a good choice. But until FI is achieved, aim for the most flexible/cash-accessible arrangement possible with your retirement accounts. You may never need to borrow from them, but I can tell you that in my case I’ve borrowed from my retirement accounts many times, and in each instance invested it in productive assets accelerating my financial independence and not harming my future retirement prospects in the least.
This is not an investing principle, per se, but consider this: achieving financial independence transforms every dollar in retirement savings into fun money. You don't need it. The productive assets you’ve acquired (plus an emergency fund) provide all the income you need in perpetuity. In another post, I’ll delve into how to structure your FI portfolio to resist inflation and recessions, but that’s what FI is all about. When you can access the retirement funds you don’t need without penalty, do something fun with it. Give it away to causes that mean the most to you. Gift it to your children while you’re still here. Or, since you can’t ever be 100% certain of what comes next, keep it as a backup plan or sleep insurance, whatever gives you the most peace. If you do this right, your retirement funds will be like an afterthought.
However, first, we have to get you to FI. Saving in these retirement funds when a match is offered is the good, low-hanging fruit you should avail yourself of. So, let’s go back now and break down the benefit of a Trad versus Roth account based on the singular criteria of having maximum available cash. The following table assumes the following: Annual Salary of $50,000. Single person. Tax savings are coming off the top of earned income, so a single person saves paying the higher rate taxes of 22% on funds contributed to a Traditional 401k:
Now, my daring to even do this analysis will drive mainstream financial talking heads INSANE, but I have a different set of goals for you than they do (FI before you retire instead of relying on this rigged system to retire), so here goes:
What I’ve done above is figure out, after 7 years of the funds being held in these accounts, how much available cash you would have IF you managed to see a 6% return on the funds in the retirement account AND got the same return on the additional funds in your pocket ($660/year) as a result of tax savings when funding a traditional 401k account.
As a quick point of comparison, if you were to take your $3,000 per year ($21,000 total), not put it in a retirement account at all, and invested it at a 6% return for seven years, your cash in hand after 7 years would be $25,993, so going the retirement fund route with matching puts you ahead overall by more than $10,000. Fund the 401k when there’s matching!
Doing The Unthinkable!
So now you find an opportunity to invest in a productive asset, let’s say a home or other similar real estate opportunity. You’ve done your due diligence (picked up a turnkey property or factored in all repair costs to get it ready to rent), and you’ve factored in margins of safety (10% less rent, 1 month per year vacancy, 10% annual maintenance expenses on the home), and you can determine under these conservative assumptions that your cash on cash returns will be 15% or better. But what you do not have is a downpayment to anchor the loan you will take to purchase the property.
This might be the moment to do the UNTHINKABLE.
Take a loan from yourself to acquire a productive asset that will be more productive than the funds available to you in your 401k - AND - will provide an inflation hedge that very few 401k’s, if any, offer such a hedge for - AND - will create a new income stream independent from your primary job.
Hmm, when I say it like that, the unthinkable sounds very thinkable!
The rules usually allow you to borrow up to 50% of your 401k savings (regardless of Trad or Roth) up to a maximum of $50,000. So if you have saved $50,000 in the account, you can borrow up to $25,000. With $100,000 or more in the account, you can borrow $50,000. The cool thing about this option is no penalties. No taxes, just taking the money out, paying yourself the interest at the prevailing rate when the loan is taken, and paying the funds back into your account on up to a 5-year timeline. There are some caveats to consider for this scenario:
Before you hatch this plan, make sure your employer offers this option. Most do, but not all.
Know the vesting rules for your plan. Vesting means that the funds your employer has contributed are considered yours to keep regardless of employment status. Most 401k funds vest within 5 years or less but understand plan administrators will not normally allow you to borrow against unvested funds in the account.
If you leave your employer or are fired/laid off, you will likely have to pay the balance of funds still owed within a short timeframe.
If you can’t repay the unpaid amount, you are taxed and assessed penalties in accordance with the type of account you have. If you’ve done your due diligence right you’ll still be okay with the overall outcome because the benefits will outweigh the taxes and penalties.
The repayment schedule will increase your monthly expenses for up to 5 years until it is paid in full, so add this to your overall costs when examining a productive asset investment opportunity. If you are trying to get a traditional loan at the same time for the asset you intend to buy, they will factor your monthly payment obligation on the 401k loan into whether you can manage their loan. Be sure to know what the bank will agree to before taking the 401k loan.
Do not take loans like this for speculative investing purposes. Even though you are borrowing from yourself, it increases your baseline costs for several years and must be repaid, so in my book, it is still a loan.
I have gone the loan-to-myself-from-the-401k route a number of times over the years and haven’t regretted a single one of those loans based on what I invested in at the time.
Closing Remarks
While I’ve shown you how it can indeed be thinkable and even a good idea to borrow funds from your 401k account, and that going Traditional is a faster path to accumulating more accessible cash, I must emphasize that this is not the course I recommend you take unless it is the only available solution at the time for a REALLY GOOD productive asset investment opportunity that will:
Increase your total monthly income as soon as the deal is done, and
Will increase your income not derived from your primary job once acquired.
A better course is to save just enough in the 401k to maximize the employer match and then ALSO SAVE outside the 401k, another 10-15% or more if you can manage it, so your first option for investing monies in a productive asset opportunity will always be the unrestricted funds in your possession.
I would go so far as to say the unrestricted funds you are able to save should establish the limitations on how big an investment opportunity you should normally consider. But if this is your only path to acquiring productive assets because you cannot save meaningful additional amounts outside of your 401k, this is indeed thinkable and for the right opportunities, even a good idea.
Until next time, may peace and prosperity be with you.
The Natural Economist
Next up: The Enemies of Profitable Investing…Fear and Fear of Missing Out (FOMO)