A Change in Company Policy Just Granted My Family Seven Figures in Future Wealth

Whoa. This is awesome. My employer announced recently that they’ll be adding a Roth 401(k) as an option for employees to save for retirement starting next year. The current options are pre-tax (what we do now) and after-tax contributions, so this will be a third option.

Of the three, I automatically write off the after-tax option, with the Roth now on the table. It really only seems like a good option if the 401(k) is already getting maxed out. But even then at that point I’d much rather contribute to an IRA because of the immediate control of the account and much wider investment choices.

Like I said, the standard pre-tax 401(k) account is what we do now. It’s a nice way to decrease our immediate tax-burden and shelter some of that money for a couple of decades. It has always irked me a little though, ever since I found out Roth 401(k)s existed (last year, I think) that there were other people out there that would not have to pay taxes when they reached 60 years old on the growth of their investments but I would, simply for checking a box at their HR department and taking a little bit of a tax hit now. Retirement planning completely changes when you account, or forget to account for, the impact of taxes on your investments.

As much as contributing to the Roth sounded like a no-brainer for Mrs. Mase and I, it seemed wise to run the numbers beforehand to see how much of an impact on our finances it could actually make. The basic opportunity cost question is, would we rather pay taxes every year until we’re in our sixties, or shelter that income now and take the tax hit as we withdraw from those accounts decades from now.

Using the future value of an annuity formula to calculate the compound growth, I found that, given our current tax bracket and assuming a static wage each year, we are on track to save over $80,000 in taxes over the course of our working lifetime. Not bad. However, looking at the taxes on the back end, things aren’t as pretty.

I assume that at age 65, we start to draw down on the 401(k) balance at 4% per year (the famous safe withdrawal rate) over a 30-year period. I also assumed a higher tax bracket, because since in this future scenario we were so diligent and saved for decades, the government must punish us by taking a bigger bite out of our paycheck than if we had simply decided to save less and withdraw less. I assumed an 8% return, which I think is reasonable over such a long period of time, and I assumed that the 401(k) gets maxed out to the full $17,500 each year (not accounting for if the IRS raises the limit).

The results? We’d end up paying over a million dollars in taxes on the back-end. Of course, this assumes that the government’s income tax policies aren’t too different than what they are today. We can’t plan properly trying to account for variables out of our control though, so this assumption will have to do. Backing out the initial tax savings from when we were working, we see that the initial tax savings, while nice, don’t nearly offset the amount paid on investment gains and contributions later down the line. We’re talking about seven figures in taxes here.

What about the scenario where we contribute to the Roth instead? Here, the numbers just flip. Instead of saving $80,000 throughout our working lifetime, we end up paying those taxes up front. Less immediate gratification, but hey the end result is just so sweet. Those millions in taxes paid now turn into millions of taxes saved. With that additional money added into our retirement nest egg, Mrs. Mase and I will now have additional tens of thousands of dollars per year flowing in from investment gains (withdrawing 4% of a few million is certainly less than withdrawing 4% from an additional million).

This is really exciting. I’ve definitely become a nerd with this personal finance stuff because I started dancing around the house when I heard the news. I mean, it’s amazing that something so simple such as putting your money in the right account can drastically improve your results. It makes me think about the co-workers I have that are retiring right now or about to in the next few years. I know some of them have several hundred of thousands in their accounts, and I speculate a few of them have got to be 401(k) millionaires (aka the Millionaire Next Door types). This is in addition to pension benefits that they are going to receive. Can you imagine the type of wealth they would have been able to build if they had Roth 401k(s) as an option back in the 1970’s or 80’s?

This is incredible. If you have a Roth 401(k) at work, I suggest you run the numbers for yourself and see how much it benefits your particular situation. If you’re about to retire and plan on living on less income than you are now anyway, the Roth might not make as much sense because you’ll be in a lower tax bracket. If you’re 30 or younger than it should be a no brainer. Even if you retire super early like Mr. Money Mustache and stop contributing to the plan in your 30s or 40s, you will still save a ton of money on income taxes because the money you’ve saved up to that point still has 20 or 30 years to sit and compound. You can take the gains without having to worry about whether you can comfortably write the check for the Toyota for your grandson or write a check for the Tesla.

BHIP Update

As I detailed in a post several months ago, I have created a small account using the Loyal3 investing platform. I am using it to demonstrate how small, incremental savings put aside in an intelligent way can gradually grow to something meaningful.

I’ve been putting in $10 every two weeks or so into Berkshire Hathaway stock. Because Loyal3 is fee free, I can dollar cost average into the position without getting a ton of capital wrested from me in commission fees. In my opinion this is a great step toward making investing more accessible to the general public. The list of companies to choose from is still pretty small, but it seems to be growing every few months.

The BHIP is now over $148 in value, which correlates to slightly over 1 full share in ownership! Now, this might not seem like a big deal to many of you, but this is my first full share of Berkshire Hathaway – I’m quite proud of it. I’m very much looking forward to add to the position gradually over time.

Regardless of the stock price, I plan to keep adding small amounts of money each month (Exceptions exist, of course. If the P/E ratio suddenly jumped to 30 or something, I’d probably sell and find a better use for the funds).

Another thing to note is, I don’t invest via auto withdrawals from my checking account. Every purchase is deliberate. Although the convenience factor is obvious, I am choosing to make purchases manually because I feel it a lot more when I do so. It helps me solidify mentally and emotionally that I am investing my hard earned cash in a profitable enterprise. I don’t know, maybe that sounds silly, but for me I get a little bit of satisfaction every time I get to hit the “buy now” button.

I feel like because I have been reading and studying so much about personal finance and investing in the two years, I feel a strong need to take action and start buying shares of great companies. Because my wife and I are totally focused on paying off our mortgage as quickly as possible, our cashflow is pretty much spoken for, down to the last dollar. Slowly building up the BHIP helps me get out my strong urge to invest without disrupting my family’s overall financial plan.

Some people get their kicks from buying motorcycles or going on spending sprees at the mall. For some reason I realize over the last year or so I am not really one of those people. Although I enjoy spending to a certain degree (I love travelling as well as other hobbies), I get a high degree of joy from saving and investing surplus cash.

Anyway, here are the current numbers for the BHIP. I’ve added a line to display my current ownership of shares, for the sake of remembering that even if the portfolio value drops in half tomorrow, there is a visual indicator of my level of ownership in the actual business, which is important to remember.

 

The stock price has been increasing a bit since I started buying.

The stock price has been increasing a bit since I started buying.

Contemplating Condo Investment Options

In May of 2013, my wife and I moved from our first apartment to a one bedroom, foreclosed condo unit down the street. Our lease was up and we felt like we were comfortable enough with the city at that point to purchase a reasonable place for us to live. The idea was to spend less on our housing expenses while building equity in something that we would eventually own. We would attack the debt and eventually pay everything off.

Originally, we had been thinking of a single family home, and we searched many different neighborhoods in the city looking for the perfect property. The more we searched though, the more we realized we weren’t ready to leave the downtown area. It’s super-walk able – close to our favorite restaurants and bars, as well as Mrs. Mase’s job. Getting a single-family home would mean leaving all of that convenience behind.

We found a great condo unit and decided to go for it. Over a year later, we were recently discussing the pros and cons of living in a condo and what potential impact it could have on our finances in the future. As you know, we’re now 40% done paying off the mortgage so we can see the light at the end of the tunnel and envision ourselves sitting on paid for real estate.

Once we pay the mortgage off, we plan to keep living here and continue to save money like crazy. The money that was used to pay off the mortgage super-fast will then go to saving up cash to buy the next home. Once we decide to move in a few years, we have a couple of options:

  1. Sell the condo and combine the money with savings to purchase a nice single family home in cash.
  2. Sell the condo and purchase an investment, whether a rental home, stocks, etc.
  3. Keep the condo and rent it out to tenants.
  4. Keep the condo and rent it out as a vacation rental (a la Air BnB).

When we initially bought the place, we had the intention that we would go with option three and turn the property into our first rental. This option still very much appeals to us because we know the rental market is strong here in the heart of the city, and we know we have a great location. A traditional leasing arrangement would probably work out well, because a lot of transplants coming into the city as well as students who want to live downtown would make good tenants.

Option one is unlikely, simply because we would both feel imprudent upgrading houses so much so early. If there’s one thing I’ve learned from Robert Kiyosaki’s books…upgrade assets before upgrading lifestyle!

Option two is where things get interesting. Depending on the current real estate levels and market rents at the time we could potentially move into a new home, we’d have to run some numbers in order to figure out different opportunity costs. Given the comparable rents in the area and the appraised value, would we be able to get a higher risk-adjusted, after-tax rate of return than we could with other investment opportunities if we sold?

One big thing to consider here is the nature of condominium buildings. One thing that kind of bothers me in the back of my mind is the fact that there are certain expenses not under our control. Namely, the condo association fee is bound to continue rising. I got the proposed budget for next year in the mail and was going over it with my wife – it’s looks like all of the owner’s cut of the fees is increasing by just over 10%!

The question is, will this be compensated for by higher property values and rent rates in the near future? The building we live in is old, and as such the insurance premiums are much higher than on newer buildings in the city. The board of directors is doing a prudent thing by stacking a lot of money in reserves and paying a good insurance provider in order to prevent a large assessment in the event of catastrophe.

However, one has to wonder when the rising expenses become too much to justify option three? Even with no debt on the property, if the net cash flows are not there compared to the value of the unit than we might actually be better off selling and buying REITS or a single family home with a higher cap rate. Time will tell. The good thing is that the future only comes one day at a time. When the decision has to be made we will be armed with updated data in order to make an informed decision.

A way to potentially take greater advantage of the property’s intrinsic value is to rent the unit out as a vacation rental – option four. After reading Paula @ Afford Anything’s analysis of her vacation rental experience, I think it’s a feasible idea. You do a little extra work but ultimately have higher rates of return. Mrs. Mase and I agree that our property has a lot potential for this, being so close to a convention center, the Arch, museums and various other places that would appeal to visitors to the city.

Regardless of the choice we make, we’ll be moving one step closer to financial independence, and that’s the important thing to keep in mind. What do you think? Are there more options that would be wise to consider?