Learn Me - Normal Investment Account vs Roth IRA vs Real Estate for Semi-Passive Income

After our discussion on the pros and cons of real estate as passive (or not) means of generating additional income, it got me thinking - why don't more people use normal investment accounts for passive income generation? 

We did cover one aspect: leverage. You can leverage real estate far easier than investments? Is this true though? ETFs allow leverage, and in some cases you can set stops or automatic sells in the event of a market crash. Options that wouldn't be available for a rental property. 

I would also assume taxes impact the profits from normal investment accounts as well, but isn't that the same of rental properties? 

Am I correct in the order of priorities for saving/investment is:

1) Emergency Fund

2) 401k

3) HSA

4) Roth IRA

5) Non-tax advantaged investments like real estate or investment accounts. 

?

My wife and I have a lot of money just chilling in high interest savings accounts, and it's soon time to move it elsewhere. We both have a desire that when our daughter is in school that we'd like to do some extended trips overseas. Like, living in another country for a summer. Having some passive income would be nice for those types of situations, for no other reason than it may require job/career changes.

My question is: if I had $100k sitting around (I don't, yet), and I wanted to live off that the income that it could generate, would I be better off to invest in real estate that requires some amount of work on my part, or an investment account pointed towards index funds?

In the market, your $100k is going to generate about $3,000 to $4,000 a year that you can live on. If you want to be really ballsy and not care about inflation, you can go up to $7,000 to $9,000. Can you really live off of that?

It is possible that real estate would be the better buy here for your goals... depending on the market. But it would really have to be a low purchase price and a high rental rate, I'd be looking for a 2% rule instead of 1%. But your statements and desires are contradictory: You say "we'd like to do some extended trips overseas... living in another country for a summer", then you go on to say "invest in real estate that requires some amount of work on my part". Those don't really seem to pair well together. 

I'd say you need to put pen to paper: What house could you buy, what would your return be from rent, and what will your other costs be? What do you end up with at the end of the year?

FWIW, at one point I had my savings list similar to yours. Now I rank it as follows: 

1: Emergency fund

2: 401k up to the employer match

3: HSA

4: 401k up to the limit, assuming good investment options. Switch with #5 if the fund options suck

5: IRA up to the limit (I used to always say Roth, but now I'm not so sold on it)

6: Taxable brokerage account (mostly VTSAX)

pheller said:

Am I correct in the order of priorities for saving/investment is:

1) Emergency Fund

2) 401k

3) HSA

4) Roth IRA

5) Non-tax advantaged investments like real estate or investment accounts. 

?

I'd switch numbers two and three and prioritize the HSA over the 401k. The HSA is the only account available where the money is never taxed (assuming it's spent on medical costs), and after age 65, funds can be withdrawn for anything without penalty (you still pay income tax on them). That beats saving retirement funds in a tax advantaged account, but then having to pay taxes on those funds for medical care later in life.

As for the rest, the answer really depends on how much passive income you're trying to create, when you'll need it, how much risk you're willing to accept with the money invested, and how comfortable you are with a specific asset class. Real estate might be the better option for a person that's knowledgable when it comes to houses and your local real estate market, but leery of stocks. If you need flexibility with the money, then tying it up in real estate might not be the best option as it can be difficult to liquidate. Also consider how much passive income you're trying to create. A rental property that meets the 1% rule (tough to find right now) might net you $100-200 profit/month per door after all expenses, vacancy and future maintenance are accounted for. So if you're trying to cash flow your life, or fund months long sabbaticals in other countries, on that kind of return you'll need a bunch of doors.

I've long told my wife my 10 year plan is to get a house with a rental unit attached. Whether it be short term or long term, having someone else cover most of my mortgage would be nice. Problem is, in my current area, that would require a pretty hefty mortgage (high priced housing.)

In the meantime, the money can be something productive. 

Hi pheller,

As they say, it’s not what you make but what you keep.

Here’s an article from the Motley Fool that I think sticks the landing right between being overly complex and being overly simplistic.

Long-Term Capital Gains for 2020

Link is giving me trouble so here’s this…

https://www.fool.com/investing/2019/12/07/long-term-capital-gains-tax-rates-in-2020.aspx

Given what you’ve shared, I’d consider a basket of large-cap dividend stocks (Merck, Bristol-Myers Squibb, Schlumberger, Philip Morris, Mcdonald’s, etc.) as you could get an average return of around 4.0% at a reduced tax rate and be positioned for likely value appreciation over time.    

So, a Roth IRA will allow you to withdraw contributions without tax or penalty, and those funds could be used for something like this.

The downsides are that the withdrawals must be contributions, not gains.

So if you want to fund say $10-15k per year for extended time off/travel, you'd need to have a bunch of 5 year old contributions in the IRA to begin with. Current contribution limits are $6k/yr/person so you and your wife could theoretically pull $12k annually combined without losing too much other than opportunity cost. It's essentially a Roth conversion ladder (worth researching if you aren't familiar), but instead of funding regular living expenses every year in early retirement, you'd be funding travel or whatever, and continuing to work.

So, if that's an option worth considering, I'd dump as much as you can into a Roth IRA for you as well as your wife and then hammer down on the 401k as those funds can also be rolled into the Roth IRA (taxes will be required if it's a traditional 401k). If you have any old 401ks floating around or anything that can be rolled over into the account, do that as it will greatly increase your "contributions" in short order compared to just doing the yearly max.

Obviously, there's opportunity cost involved and the funds you withdraw won't be earning you interest, and will in turn be extending your working life. Your call on how much value you put on that.

In reply to STM317 :

I believe that the Roth IRA withdrawl requirement is moot if the account is over 5 years old and you have had assets in there for that period of time. .

In reply to jimbbski :

I think that only applies if you're over age 59.5:

• If you want to withdraw contributions: After-tax contributions — commonly called “basis” — can be withdrawn at any time, for any reason, with no taxes or withdrawal penalties.
• If you want to withdraw earnings: You must satisfy two requirements for a qualified distribution to avoid taxes and a 10% early withdrawal penalty. First, you must have held a Roth IRA account for at least five years, a clock that starts ticking at the beginning of the year of your first contribution. Second, you must be at least 59½, disabled, dead (the distribution is taken by heirs) or using up to $10,000 toward a first-home purchase.

I've reworded my post above slightly to hopefully be more clear and accurate

So, just so I'm clear: 

I put $100,000 in a Roth IRA.

In 5 years, it's made $20,000. 

I can pull the $100,000 when I'm 40 for no reason, as long as the $20,000 stays put?

In reply to pheller :

Sort of. The 100k can be pulled anytime. Use it to pay for the kid's college, or travel, or whatever.

The gains are only tax free if you've had the Roth for 5 years and are over the age of 59.5, otherwise they'd be subject to tax and 10% penalty

CAN you put 100k in a Roth IRA?

I thought Roth had pretty low input limits each year. Like $5k.

Robbie said:

CAN you put 100k in a Roth IRA?

I thought Roth had pretty low input limits each year. Like $5k.

Contribution limit is 6k per person in 2020 for both ROth and traditional IRAs, but I believe you can rollover something like a 401k of any amount (so long as you pay applicable taxes).

Robbie said:

CAN you put 100k in a Roth IRA?

I thought Roth had pretty low input limits each year. Like $5k.

Not quite true here.  IRA limits are $6k, assuming you're under age 50. Over age 50, you have an extra $1k that you can contribute. This limit is the same pre-tax (Traditional) as it is for post-tax (Roth). 

At a certain income level you're discluded from them (either of them) too - I think it is $120k MAGI for a single filer and $190k MAGI married filing jointly. Could be off by a couple grand. 

However, the point that you're really getting at is... how do you get that money in there if you can only contribute a small amount each year? Well, through a 401k rollover. You can contribute $19.5k to the 401k in 2020 - again, either traditional or Roth if it is offered. When you leave the company with your 401k, you can roll the 401k over into an IRA. Even if you roll it into a Traditoinal IRA, you can convert a portion or all of it to Roth if you desire at any time. Go look up a conversion ladder. Good method for those who are planning on retiring prior to 59.5, and it also lets you control your income and hence lower your tax liability.

Robbie said:

CAN you put 100k in a Roth IRA?

I thought Roth had pretty low input limits each year. Like $5k.

If you're thinking about the total value of the Roth, besides whatever you put in each year and any rollovers you make, don't forget that it will accumulate value on its own (assuming the investments are sound).

Something that may have been inferred above...depending on your situation and your plans for the future, it may be advantageous to put money in both a Roth and a conventional IRA.

stuart in mn said:

Robbie said:

CAN you put 100k in a Roth IRA?

I thought Roth had pretty low input limits each year. Like $5k.

If you're thinking about the total value of the Roth, besides whatever you put in each year and any rollovers you make, don't forget that it will accumulate value on its own (assuming the investments are sound).

But in Phellers situation, he won't be able to pull out the accumlated value - he can pull out only the contributions. Nothing more. 

This is where the conversion ladder makes sense. Lets say you put in $1,000 into a Roth IRA. It earns 7.1% interest for 10 years. You now have $2,000! But, something happened and you need some cash, fast. So you can pull out your $1,000 contribution. The $1,000 earnings cannot be touched. 

Alternatively, you can put that $1,000 in a Traditional IRA. Same return, same timeline. You have $2,000. Now, you need cash again. Since you can't touch anything in a TIRA, you do a Roth Conversion. You owe $440 in taxes, since the $2,000 conversion counts as income. However, now you can pull the full $2,000 out leaving you with a net $1,560. 

So this leads us back to traditional investment accounts. 

Why not just use those? 

pheller said:

So this leads us back to traditional investment accounts. 

Why not just use those? 

The tax advantages. 

If you go with the Roth, you are not going to be taxed on the earnings. You were already taxed on the contributions. 

If you go with the Traditional IRA, you're not taxed on the earnings and you are deferring your tax on the contributions. 

If you go with a traditional brokerage account, i.e. one that is not in a retirement tax-sheltered account, you're taxed on the contributions (income tax - this will be the same for the Roth) and then you're taxed on the earnings, either as if it was regular income if held for less than a year (so probably either 12% or 22%), or capital gains tax if you hold it longer than a year (0% or 15%, based on income). 

More than likely you're saving 7% on the taxes, if you're not saving 7% you're saving 12% on it. And if you're higher than that, then you would be at an income level where you wouldn't be having this conversation. 

The tax advantages. 

If you go with a traditional brokerage account, i.e. one that is not in a retirement tax-sheltered account, you're taxed on the contributions (income tax - this will be the same for the Roth) and then you're taxed on the earnings, either as if it was regular income if held for less than a year (so probably either 12% or 22%), or capital gains tax if you hold it longer than a year (0% or 15%, based on income). 

More than likely you're saving 7% on the taxes, if you're not saving 7% you're saving 12% on it. And if you're higher than that, then you would be at an income level where you wouldn't be having this conversation. 

But the Roth IRA won't be earning me anything for years to come. It would take 10 years of $12,000 contributes before my wife and I are making anywhere near reasonable amounts to live off of. 

I still don't understand the rollover angle or how that works. 

Even at a 12% tax rate, a traditional investment account is still earning money. 8% of $100,0000 is $8,000 year, 12% of that is 960 bucks, so you're still seeing 7% profit. What am I missing?

pheller said:

The tax advantages. 

If you go with a traditional brokerage account, i.e. one that is not in a retirement tax-sheltered account, you're taxed on the contributions (income tax - this will be the same for the Roth) and then you're taxed on the earnings, either as if it was regular income if held for less than a year (so probably either 12% or 22%), or capital gains tax if you hold it longer than a year (0% or 15%, based on income). 

More than likely you're saving 7% on the taxes, if you're not saving 7% you're saving 12% on it. And if you're higher than that, then you would be at an income level where you wouldn't be having this conversation. 

But the Roth IRA won't be earning me anything for years to come. It would take 10 years of $12,000 contributes before my wife and I are making anywhere near reasonable amounts to live off of. 

I still don't understand the rollover angle or how that works. 

Even at a 12% tax rate, a traditional investment account is still earning money. 8% of $100,0000 is $8,000 year, 12% of that is 960 bucks, so you're still seeing 7% profit. What am I missing?

Assuming both and your wife have a 401k, between the 2 of you you can contribute $51,000 annually to your 401k's and IRAs. So it would take about 2 years to get there with the contributions. 

I don't have time to do the calculations now, but ultimately it is saving you money on your taxes if you compare it to a taxable brokerage account.  

In reply to mtn :

Yeah, you're right. I deleted that post to avoid confusion/incorrect info

mtn said:

Assuming both and your wife have a 401k, between the 2 of you you can contribute $51,000 annually to your 401k's and IRAs. So it would take about 2 years to get there with the contributions. 

I don't have time to do the calculations now, but ultimately it is saving you money on your taxes if you compare it to a taxable brokerage account.  

But I can't withdrawl from 401k prior to retirement age, right? 

Or are you saying I'd be better to withdrawl from a 401k or IRA even with penaltys over a brokerage account? 

Again, this isn't about "what's the best long term investment mechanism" it's about "where can I put my money today to start pulling from the gains ASAP." 

STM317 said:

In reply to mtn :

Yeah, you're right. I deleted that post to avoid confusion/incorrect info

Deleted my response to avoid further confusion

pheller said:

mtn said:

Assuming both and your wife have a 401k, between the 2 of you you can contribute $51,000 annually to your 401k's and IRAs. So it would take about 2 years to get there with the contributions. 

I don't have time to do the calculations now, but ultimately it is saving you money on your taxes if you compare it to a taxable brokerage account.  

But I can't withdrawl from 401k prior to retirement age, right? 

Or are you saying I'd be better to withdrawl from a 401k or IRA even with penaltys over a brokerage account? 

Again, this isn't about "what's the best long term investment mechanism" it's about "where can I put my money today to start pulling from the gains ASAP." 

https://www.madfientist.com/how-to-access-retirement-funds-early/   Note that you do need to plan ahead at least 5 years for this, but you can be doing it with your TIRA before you ever roll over your 401k

Anyone actively trade in their accounts?     I prefer ETF's for oil futures (up or down) since I find them interesting.

I rolled traditional IRA money over into an eTrade account and I've beaten my old advisor 3 years in a row, so I'm just going all-in on managing it myself.    

As for accessing gains within my accounts, I took a home equity loan a while back and dumped some of the cash into a traditional non-tax sheltered eTrade account that can be accessed with a checkbook or debit card (all through my same eTrade dashboard).   

My only regret is that I didn't do it a long time ago.  

I've watched friends struggle with bad tenants/evictions and bad remodels/contractors so I'm not into that type of investing.

fornetti14 said:

Anyone actively trade in their accounts?     I prefer ETF's for oil futures (up or down) since I find them interesting.

I rolled traditional IRA money over into an eTrade account and I've beaten my old advisor 3 years in a row, so I'm just going all-in on managing it myself.    

 

As for accessing gains within my accounts, I took a home equity loan a while back and dumped some of the cash into a traditional non-tax sheltered eTrade account that can be accessed with a checkbook or debit card (all through my same eTrade dashboard).   

My only regret is that I didn't do it a long time ago.  

I've watched friends struggle with bad tenants/evictions and bad remodels/contractors so I'm not into that type of investing.

I do with a small portion of my IRA. https://grassrootsmotorsports.com/forum/off-topic-discussion/speaking-of-day-trading-what-platform-ira-content/135796/page1/

I was using an algorithm blindly, it did very well for me then started to crash (the code and/or platform). There was nothing wrong with the code, so I use it for buying ideas but don't follow it closely anymore.

Now I'm mostly in and out of a few specific stocks and VTSAX. I look for opportunities, but if I don't see one I'm comfortable with I don't buy. And I don't even actively look. I'm currently in ABBV - when they popped up in headlines for purchasing Allergan, their stock dropped 17% and I could NOT figure out why. So I loaded up, and kept buying more until it was in the 80's. I'll probably sell in the next month to get back to VTSAX.