401k versus real estate…

On June 3, 2013 by Phil Champagne

By Phil Champagne, Managing partner at Wren Investment Group, LLC

One argument frequently stated as an advantage of 401K in the USA (or RRSP in Canada or the equivalent in other countries) is that it allows the investor to fund their account without having to pay taxes and while it is growing, it is not taxed. But real estate has other advantages that greatly compensate and even make it a better investment and here’s why.

New Commercial Real Estate

Investment in 401Ks are hugely made in mutual funds or other funds with the general mindset of diversification as a key strategy.

It usually means an investment in a basket of relatively established company securities (stocks). More often than enough a large majority of those funds under perform the return by the Dow or other major indexes. So, let’s go through each to see the difference between the 2

401K advantages: (+)

  • Ability to invest income before taxation
  • Capital gain tax deferred to time of withdrawal
  • Most often, employer offers a matching contribution up to a certain amount.

401K disadvantages: (-)

  • Depending on the employer’s plan, somewhat limited choice on investment. Some employer only allows a selection of mutual funds.
  • Typically no leverage on investment.
  • At time of withdrawal during retirement, the withdrawal is taxed at full rate.

Although the advantages seems great, the disadvantages might be more impacting for the majority of folks. The choice available to the investors are relatively limited. So now, let’s see about real estate:

Real Estate advantages:  (+)

  • Leverage. Use of debt to purchase higher value properties, hence magnified gain.
  • Differing taxes through the use of depreciation. The owner needs to deduct the physical value of the property hence providing a tax break on the income from cash flow. Sometimes an owner might not pay any income tax during the first few years of ownership.
  • 1031 exchange allows to sell a property to purchase a new one (usually larger) without paying taxes on capital gain on the property being sold.

Real Estate disadvantages: (-)

  • Leverage could lead to total loss if mismanaged or a downturn in economy.
  • Not liquid, complicated and slow process to buy and sell.

The main benefit of real estate is that at least the disadvantages can be controlled by the investor. He can make the decision about buying at the right price at the right location and having the right management team. For an investor that benefits from a strong team, this investor can then focus on the benefits of the advantages. When done right, the leverage is one of the greatest benefit and trumps the advantage of employer’s contribution the pre-tax contribution benefits for 401K. The 1031 exchange combined with depreciation provides just as much protection against taxes as 401k investments do.

In conclusion, one should consider investing in real estate before investing in 401K. If on the other hand your plan allows for self-directed investment, consider working with a company that can help you with this so you somewhat combined the advantages of both.

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