How 401k leveraging can supercharge your early retirement

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How 401k leveraging can supercharge your early retirement

401k leveraging is a technique that can boost your speed toward early retirement by using your 401k contribution toward investments, like real estate.

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How 401k leveraging can supercharge your early retirement

Go to college, get the corporate job, start saving immediately in your 401k, and in 40 years you’ll be a millionaire. That’s the conventional wisdom. It isn’t wrong. But for many of us, it also isn’t right.

Joe Wells

I can’t bear the thought of spending 40 years commuting to the office, sitting at a desk for 8 to 10 hours every day, commuting home and only looking forward to the weekend.

Two days out of seven equals 28% of your life. One out of every four days where you can do what you want.

That’s not enough for me, and judging by the fact that you’re on this site, it’s not enough for you either.

One day you will wake up and there won’t be any more time to do the things you’ve always wanted. Do it now.

Paulo Coelho

When you outline your path to early financial independence, a 401k probably isn’t one of the tools you think of. After all, you can’t touch the money without penalty until you’re almost 60 – far too late for most of us.

I’m here to tell you that isn’t true.

Your 401k can and should be one of the biggest tools in your belt to get you to early FI. This strategy is the only way to leverage large amounts of tax-free money into outside investments, and it can help you hit your early retirement goals.

Before we get too far into the story:

What does it mean to leverage your 401k? The technical definition of leverage is using borrowed funds to purchase an asset.

In this specific case, it means using money from your 401k (in the form of a loan) as a down payment on an investment property. It’s a good way to convert pre-tax savings into an income producing asset that can help fund your early financial independence.

This strategy is a 10-year process designed for people with a full time job. It is a wonderful complement to these early retirement strategies. The first five years consist of aggressive saving, followed by a loan, investment, and five years of repayment.

Here is how the strategy works in a perfect world, side by side with a description of how I applied it. Keep in mind, I didn’t realize I was using the strategy until about half way into it, or my story would probably look a lot different.

Step 1: Max your 401k contributions

Ideal Strategy

Picture yourself fresh out of college at your first job. Or maybe you are five or ten years into your career – even better. The first step of this strategy requires a commitment – an uncompromising dedication to aggressive contributions into your 401k account.

Let’s quickly discuss how 401k loans work. Depending on your plan administrator, you can take a loan from your 401k for up to $50,000 or 50% of your total balance, whichever is less.

  • Perks:
  • The loan is paid from your account without penalty or tax implications.
  • The funds can be used for any purpose.
  • You get to select the repayment term, up to a maximum of five years.
  • You pay interest on the loan, but the interest is paid into your account, not to a third party.
  • The borrowed funds never hit your credit report, and if you can’t pay them back, it doesn’t’ affect your credit score.
  • Downsides:
  • The repayments are made with after tax money as regular payroll deductions.
  • THIS IS VERY IMPORTANT: If you leave your job, the loan must be repaid in full within three months. If not, it gets treated as a withdrawal, and you must pay a 10% penalty, plus taxes. This can turn into a very costly situation.

Assuming you want to take the maximum loan, and can be super aggressive with your savings, it will probably take you about five years to get there.

How do I figure?

The current 401k max per year is $19,000, if you are under 50. If you can hit the max for five years, have no employer match, and tiny returns, you can hit $100k in five years, allowing you to take the maximum loan of $50,000.

That sounds like a stretch for most people. I’ll admit I wasn’t able to do it. Here’s an alternative:

  1. Say you’re making an $80k salary – granted that’s a good salary – but you won’t be able to execute this strategy on a very small income.
  2. If you save 15% annually into your 401k that’s $12,000 per year. Financial advisors recommend saving at least 15% to be ready for traditional retirement, so this is by no means excessive when discussing FIRE.
  3. Assume you get a 4% employer match, which is standard. That’s another $3,200 per year for a total of $15,200 in contributions per year.
  4. At a 6% annual rate of return, this works out to about $88,000 after five years. If you receive any raises or bonuses and commit to putting them towards your 401k, you will easily be able to hit $100k in five years.

My Execution

September 2013

I was 21 years old and holding in my hand the offer letter from the first company I would work for. The job was in New York City, and I’m from upstate New York.

When I say upstate New York, I don’t mean Westchester - the upstate that city people talk about – but UPSTATE, buried in snow six months per year, Syracuse Orange fan, never been to a city, upstate New York.

I never expected to stay in NYC after my 3 month internship, but here I was holding that letter. I signed on and started my career, excited, ambitious, and naïve.

With the advice from my Dad, I opened a 401k as soon as I was eligible and began contributing 7 or 8%.

November 2014

Just over one year after starting my first job, at 22 years old, I was holding another offer letter. This one was from a bigger company, offering to pay me 30% more than I was making. It felt like a no-brainer, so I jumped.

Upon starting the new job, I opened another 401k and transferred my old one in. The transfer amounted to about $8,000 that I had saved in 14 months.

With my new higher salary, I decided I could comfortably save 12% in my 401k.

Step 2: Look for an opportunity

Ideal Strategy

The Roman philosopher Seneca once said, “Luck is what happens when preparation meets opportunity.” Based on Seneca’s formula, we can make our own luck.

Preparation is what we discussed in Step 1. As you enter your second or third year of 401k saving, you need to start looking for your opportunity to invest the money at year five. Hence, part two in creating your own luck.

From my personal experience, I found this strategy lends itself well to real estate investment. If you want to take the same path, start learning about real estate. Here’s what I recommend:

  1. Start listening to The Bigger Pockets Podcast. Start from the beginning and listen to every episode. That’s what I did, and I can promise you it is time well spent.
  2. As you work through the podcasts, you’ll have a better idea what type of real estate you’re interested in – multi family, single family, turnkey, flipping, note investing, maybe even crowd funding.
  3. Once you decide your area of interest, read some books on that specific topic. The BP podcast will provide you with plenty of recommendations, but I liked these:
  4. The Millionaire Real Estate Investor by Gary Keller
  5. Tax Strategies for the Savvy Real Estate Investor by Amanda Han and Matthew MacFarland
  6. The Book on Investing in Real Estate with No and Low Money Down by Brandon Turner

After you learn about how to invest in real estate, you need to decide where you will invest. I invest in the area where I attended college. This is the same area where my business partner grew up.

This gives us two distinct advantages:

  • I know the area very well from spending my college time delivering pizzas.
  • My partner has a ton of connections. Anything we need done, he has a guy.

Start with the areas in which you have a competitive advantage.

Browse Trulia or Zillow. Talk to an agent. Explain you’re not ready to buy yet, but you want to learn the area. The agent who takes the time to help you even when they know you’re not buying yet is the agent you should stick with. That person will be a valuable resource.

My Execution

August 2015

Around this time, I developed an interest in real estate. I knew nothing about FIRE, I just wanted to make more money. Real estate seemed like the way to do it.

I had some money saved on the side, so I decided to start looking with a partner. We met with a realtor and saw a couple houses, but we felt we were in over our heads. Real estate would get moved to the back burner for a while so we could learn more and save more money.

December 2015

By the end of 2015, I socked away nearly $11,000 more into my 401k. At this point I was 23, and I started reading a bit about personal finance, but I still had no idea about FIRE.

Motivated by Ramit Sethi’s book and listening to money advice from Tony Robbins, I cranked my contribution rate to nearly 20%.  

December 2016

I remained disciplined with my contributions all year and closed out 2016 as my best year yet - $17,332 added to my 401k!

I was in full-fledged retirement savings mode. I knew about FIRE at this point but still thought it was unrealistic and unattainable. That said, the novelty of corporate America was wearing off. I was 24 years old and ready to retire.

I started 2017 on pace to hit the 401k contribution limit, but plans are made to be broken…

Step 3: Pull the trigger on the loan

Ideal Strategy

This point should be about five years into your execution of this strategy. Ideally your 401k balance will be about $100k, allowing you to take the maximum loan of $50k.

Don’t forget: you only want to take the loan if the market is in a good place. It doesn’t make sense to pull out in a down market.

At this point you might be feeling some reluctance. That generic financial advice is flashing in the back of your mind: “Taking a loan from your 401k is never a good idea.”

Keep in mind, you have a strategy, and that advice is generic bullshit. Many people taking a 401k loan are doing it for an impulsive, zero yield reason:

  • They don’t have enough money in their savings account to cover a surprise expense.
  • They want to treat themselves to a depreciating asset – motorcycle, sports car, snowmobile, vacation, whatever.
  • They are using it to wipe out credit card debt which was amassed over years of bad decisions.

Those people will likely either end up not repaying the loan and taking a major tax hit, OR they will eliminate their future contributions to make the loan payments. Those people SHOULD NOT take a 401k loan.

Remember – THIS IS NOT WHAT YOU ARE DOING!! You are executing a strategy, one that has been in the works for years at this point. Stay the course. Defy conventional wisdom. Drive your own bus.

Once you have your target acquired, pull the trigger. Take the loan and invest it in your well researched real estate investment.

I want to pause quickly to answer a few questions you may have:

  • Q: Why should I do this through my 401k? Why not just save money on the side and use it?

A: Using your 401k allows you to save A LOT more money because it is pre-tax money. It also grows tax free, unlike any other account you could use on the side. This strategy is essentially a loophole to invest more money in less time.

You re-pay the loan with after-tax money, but you’ve already invested the lump sum. Additionally, after five years you will probably have a higher salary, so repaying the loan with after tax money won’t hurt as bad.

  • Q: I’m making good returns in my 401k. Are you sure this won’t set me back?

A: This is a fair point. A 401k usually provides consistent and acceptable returns (6%-12%). This is precisely why you need to do your homework. Your target real estate investment needs to produce a high enough return to be worth your time and worth the risk.

I projected that my real estate investments would give me between a 25% and 30% cash on cash return. I missed the mark a bit – it’s more like 20% - but I was confident in my research enough to know that even if I missed the mark, the returns would still be worth the risk.

Keep in mind, I advocate for high to medium risk, medium to low consequence, investments. This strategy isn’t risk-free. Evaluate your risk tolerance and make your own decision.

Another way to hedge your risk is to spread your cash across several properties. This may require you to bring on a partner, but it helps lessen the risk of losing your shirt when you have a tenant who stops paying rent/destroys a unit/runs up an enormous water bill and leaves.

  • Q: I live in an expensive market where $50k isn’t enough for a real estate investment. Should I still use this strategy?

A: There are several work-arounds here. I live in one of the most expensive markets in the country – Westchester County, NY. I don’t invest there. One of the advantages of living in an expensive market is you probably make a higher salary. You just need to get a little creative.

Maybe you execute this strategy with a partner (like I did) or with a spouse. Adding a person allows you to jump to $100k to invest.

Maybe you invest outside the area in which you live (also like I did). Regardless of where you live in the country, you are probably no more than a two hour drive from an affordable market.

Maybe you save money in addition to your 401k (once again, like I did). Hopefully, you do! Use some of that money to supplement your down payment.

My point is that you can find an excuse, or you can find a solution. You decide what type of person you want to be.

My Execution

March 2017

Nearly a year and a half after looking at our first property, my partner and I were ready to pull the trigger. We spent that year and a half saving money and learning everything we could about multi-family investing.

We coordinated with an agent, drove 4 hours to our target market, and spent an entire Saturday looking at properties. We looked at eight properties over the course of the day, and what we saw covered the entire spectrum.

We saw a shower beneath a staircase that was too small to stand up in. We met refugees from several different countries. We saw people who slept on bare mattresses on the floor and had lawn furniture in front of their flat screen TV and game console.

Most of what we saw was dirty, depressing, and frightening. We ended the day thankful for everything we had.

We also found a diamond in the rough. Well, maybe not a diamond, but it was good enough for us. We made an offer, put down a deposit, and took our first step into real estate investing.

June 2017

Things began to move quickly. We owned one duplex, and at this point had our offers accepted on three more properties, which would bring our total to ten units.

I didn’t have enough cash on hand to cover my half of the up-front costs, so I used a bit of strategy and took a loan from my 401k. The loan was about $15,000 and allowed me to cover my half.

August 2017

We closed on one of the three houses in the first week of August. The other two closings were slated for some time in September.

One of Joe's investment properties

Then, in the third week of August, I LOST MY JOB. As you can imagine, this presented several problems:

  1. While I wanted to retire, I was not even remotely close to a financial position that would allow me to retire. My savings would allow me a few months, at best.
  2. I had two more properties to close on. Several days before a closing, the bank verifies your employment. That was going to be hard for them to do if I didn’t have a job.
  3. The balance on my 401k loan was still almost $15,000, and I had 3 months to repay it unless I wanted to give about 30% to Uncle Sam at tax time.

I considered the risk of losing my job when I took the loan, but I didn’t assign much weight to it because it seemed unlikely. But then the unlikely became reality and I was up shit's creek.

This was a bit of a stressful situation, but I like to solve problems, and I’m a proponent of taking calculated risks. When I take these risks, I am fully aware of the potential consequences.

I went into problem-solving mode. How could I fulfill my obligations to my partner, get a new job, and not give a huge chunk of money to the government (effectively negating any benefit of leveraging this strategy)?

  • Step 1: I had an honest conversation with my business partner. I told him what happened and told him exactly what my financial picture looked like. I had enough money to fulfill my obligations for both closings, but it would leave my personal reserves dangerously low.

Honesty, as always, was the best policy. He understood, and we brainstormed together how we could solve the problem.

  • Step 2: We decided it was not in our best interests to close on both houses. Luckily, one of the properties had some issues about which we were skeptical. We explained my hardship to the bank and the realtor, and we were able to get out of the deal without even losing our deposit.

Luckily, we still qualified to close on the other property without my income – dodged a bullet on that one. We closed at the end of September.

  • Step 3: I needed a new job, ASAP! Lucky for me, a company was hiring for a contract gig that fit my exact skill set. It was short term, but it paid significantly more than I was making before. I started the first week of September.
Another investment property

November 2017

After two months of 70 hour weeks, I left the contract job for another full time position. I was quickly approaching the 3 month repayment deadline for my 401k loan.

I was watching my bank account every day, waiting for the last direct deposit from the contract job. I needed the money to repay the loan.

Finally, the day before the loan was due, the money hit my account.

I clearly remember leaving my new job at lunch time, walking to the bank to get a $15k cashier’s check, then stopping at FedEx on my way back. It cost me nearly $60 to overnight that check, but I avoided the 10% penalty and all the taxes.

December 2017

401k loan paid off, check.

New 401k plan with new employer, check.

Old 401k rolled into the new one, check.

And you probably wouldn’t guess this one – new 401k loan…CHECK.

We didn’t waste any time. As soon as I had income again, we found another property to buy. Most people would’ve been too scared to go down the same road, but not me. I saw the worst case, and I knew it wasn’t that bad.

I also saw the awesome potential of the 401k loan.  

Step 4: Repay, repeat, retire

Ideal Strategy

This step is more of a “choose your own ending” type of story. If you started the strategy later in your career, maybe you can retire. If you started straight out of college, good for you! Maybe you can retire too, or maybe you will need to run the play again. But let’s not get ahead of ourselves…

First you need to repay the loan. When you take it out, you will be automatically set up with payroll deductions for repayment.

Assuming your plan charges 6% interest like mine (remember, you’re paying this interest to yourself), you select a five year repayment term, and your loan amount was $50k, your monthly payment will be about $1,000 or around $500 per paycheck.

You’ve got a couple options here:

  1. Stop contributing to your 401k. This probably won’t totally offset your payment, but it might get you close. If you’re really young and want to retire early, this might be the best option. You can’t touch your 401k balance until you’re 60 anyway, so a balance over $100k doesn’t add much value to your strategy.
  2. Use your income from the real estate investment to offset the loan repayments. Again, this might not be dollar for dollar, but it might get you close.
  3. Feel the squeeze. This option is a bit painful, but it’s what I’m doing. Simply reduce your lifestyle by the amount of the monthly payments. Maybe this means selling your motorcycle (like I did), or taking fewer vacations, or spending less money on happy hour.

As the saying goes, the juice is worth the squeeze. If you don’t feel a little bit of pressure, you’re probably not trying hard enough.

If you make it to this part of the strategy, you owe yourself a reward. Celebrating meaningful milestones is a great way to promote improvement.

My Execution

Since I’m still in the process of this step, I don’t have much for ya here. I’m watching the movie at the same time as you, wondering what the ending will look like.

My hope is to have my loan paid off within the next two years. The one thing I don’t like about having an outstanding 401k loan is feeling like I am tied to my current employer.

After my repayment is complete, I don’t plan to use this strategy again. Hopefully I will have enough money coming in from real estate and other resources that it won’t be necessary.

If I could go back to 2013 and do it all over again, I would follow the same general path. Of course, it would look a lot more like the “ideal execution” version. But ideal execution doesn’t always make for the best stories…

...or lessons.

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Steve Adcock
Steves a 38-year-old early retiree who writes about the intersection of happiness and financial independence.

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