When it comes to investing for retirement, many people consider putting money into their 401k retirement accounts versus investing in real estate. Both options have their own pros and cons in terms of returns, taxes, risks and more. This article analyzes the key factors to weigh when deciding between these two popular retirement investing vehicles.
401k has historically higher returns than real estate
Based on historical market performance data, investing in a diversified 401k retirement account has generated higher average annual returns compared to returns from residential real estate appreciation. For example, over the past 30 years, the S&P 500 index has returned over 11% annualized, while national home price appreciation has been around 5% per year on average. So purely looking at investment returns, 401ks seem to clearly outperform. However, real estate also provides recurring rental income and significant tax deductions that can greatly impact overall profits.
Real estate allows tax deductions to reduce taxable income
A key benefit of investing in investment real estate is the ability to reduce taxable income through depreciation deductions and other paper losses from expenses. For example, with rental properties, expenses like mortgage interest, property taxes, maintenance costs and depreciation can all be deducted from rental income each year to lower tax bills. Since 401k contributions reduce taxable W-2 income instead, there is less opportunity for layered tax minimization. So real estate investing creates more tax efficiency compared to 401k investing in taxable accounts.
Leverage magnifies profits but also risks for real estate
Real estate investors are able to utilize leverage through mortgages to magnify their investment returns. For example, if a property appreciates by 10% but an investor only contributed a 20% downpayment, then their return on invested capital would equal 50%. 401k accounts do not allow leverage, so investors can generally only realize market returns. However, leverage also exacerbates losses, so real estate carries greater downside risk for investors as well. Managing those risks is key.
In summary, 401k retirement accounts earn higher historical returns but real estate investing can create tax savings and benefits from leverage. As part of an overall diversified portfolio, both offer solid options for retirement goals.