Real Estate vs. Stocks: Which is the better investment for my 401(k)?

The 401(k) retirement savings plan is one of the most popular vehicles for individuals to plan for their golden years. Millions of workers depend on the 401(k) and many employers see it as a major benefit of the job. When deciding how to invest within your 401(k) we highly recommend being diversified across multiple asset classes if possible. Instead of real estate versus stocks it should be real estate and stocks.

The basics of the 401(k): Created in 1978, the 401(k) is designed to be a retirement savings account that employees can invest a portion of their salary up to a limit and the employer may match some or all of that contribution. The investments are eligible for special tax treatment and there are penalties for early withdrawal.

The 401(k) is a qualified plan – in this case defined contribution (not defined benefit) – that the IRS allows to grow tax free until withdrawal. Employees must make contributions and employers may make contributions as well. Once the employee retires the account balance is controlled entirely by the employee.

Typically, employers will match contributions up to 3% of salary, or 50 cents for each dollar of employee contribution up to a limit. Employer plans vary by company and plan sponsor so be sure to read the fine print on your 401(k). You should contribute at least up to the employer match limit since this will turbo charge your retirement growth.

Contribution limits: In 2020 the maximum employee contribution limit is $19,500.00 or if the employee is aged 50 or more $26,000 (this is so that older workers can try and catch up and still build a significant nest egg for retirement). The maximum joint – employee and employer - contribution is $57,000 (or $63,500 for those aged 50 plus).

Tax treatment: The employee contribution is from before tax dollars. This means that a portion of your pay-check will go directly to your 401(k) and reduce your taxable income. In addition, your investment earnings within your 401(k) will grow tax-free until you make a withdrawal.

With a Roth 401(k) your contributions are made from after tax dollars so you don’t get a deduction in the year you make your contribution, but all withdrawals are completely tax free (earnings and principal).

Withdrawals: When you are ready to start making withdrawals they are treated like normal income and taxed accordingly with some exceptions. If you make an early withdrawal (before age 59 ½ years) you will not only have to pay the taxes but also a 10% penalty. Possibly also state taxes, so be sure not to withdraw early from your 401(k) plan.

As 401(k)s are employer-initiated plans there are a number of triggering events that can allow for a withdrawal.

• Employee retirement.
• Employee leaves job.
• Employee dies or becomes disabled.
• Employee reaches age 59 ½.
• Employee experiences a specific hardship as defined under the plan.
• The plan is terminated.

New for 2020, the CARES Act allows for those unduly affected by the COVID-19 pandemic to make a withdrawal up to $100,000.00 without the 10% penalty even if younger than 59 ½ years. You will still need to pay the tax on the amount withdrawn but you have 3 years to pay it instead of the usual one. Keep in mind that it is your employer that determines your hardship status.

As noted above the Roth 401(k) is tax-free upon withdrawal. You must also start taking the ‘required minimum distributions’ (withdrawals) once you reach age 72 unless you are still employed by your employer.

If you need to leave your job or the plan is terminated you can roll it over in a direct transfer to an IRA (Individual Retirement Account) so that you do not incur taxes or penalties. If you cash out that is the same as making a withdrawal and you do not want to do this unless you have no choice.

Investment Options: Most employer 401(k) plans are very limited in your investment options. Usually you can only choose from your plan sponsors mutual funds or if you are lucky, they have some low-cost index funds or ETFs to choose from.

Cost is a very important consideration. The lower the MER (Management Expense Ratio) the better for you. Management expenses pay for the administration of the plan and the costs of buying and selling stocks and are paid for directly from your investment earnings. The lower they are the more you retain in your retirement accounts. In fact, the very best indicator of fund performance is the cost. Namely the lower the cost the better that fund will perform (so long as you are comparing similar funds. Ie two different S&P500 funds or two different US large-cap funds).

Real Estate Options: Since your options are limited by what your employer’s plan sponsor offers you, the easiest way to invest in real estate is through a real estate fund. Very often these are mutual funds or an index fund that purchases REITs.

The only way to purchase actual real estate or a private placement is by rolling over your 401(k) into an IRA. Specifically, a self-directed IRA that allows for the purchase of real estate.

Returns: Real estate does not follow the usual market swings and so this can provide a measure of diversification for your overall retirement accounts. Traditionally real estate has out-performed the stock market in the long run. It can be a little tricky to compare the two because with real estate investing you need to factor into the equation your income from rental properties and not just the purchase and selling prices of the property.

One way to compare returns of real estate vs the stock market is to look at the performance of REITs (Real Estate Investment Trusts). These are companies that invest in real estate and their stock is freely available on the stock market as well.

If we compare the Vanguard Real Estate ETF total return versus the S&P500 total return real estate comes out the winner, especially over the long term.

Keep in mind that this comparison is not exactly the same a holding real estate in your IRA vs stocks, but it does indicate that real estate can be an excellent yielding asset to hold.

Conclusion: You can only use your 401(k) to invest in real estate by rolling it over into a self-directed IRA. We have shown that real estate can give you an excellent return on your investment when compared to stocks, especially over the long term. With real estate you have the added benefit of the security and safety of owning tangible real assets which will provide peace of mind during a crisis. If you own rental income within your IRA that will protect you against inflation since your revenue will rise with inflation. Having real estate within your retirement accounts will provide diversity to help you weather the storms that always seem to be on the horizon.