401(k) vs. Real Estate

Which builds a better retirement?

by Lance Morgan

Every retirement saver is ultimately seeking retirement security. They want investment vehicles that empower consistent, long-term growth and, ultimately, provide a source of retirement income that outpaces inflation. And if those vehicles can provide them with tax advantages, all the better.

Over the past several decades, many retirement savers have leaned heavily on 401(k) accounts in their pursuit of retirement security. Statistics show that more than 70 million people currently hold 401(k) accounts, with assets in those accounts totaling nearly $9 trillion.

But changes to the economy in recent years have made it more challenging to achieve retirement security with a traditional 401(k). A number of factors have led to heightened volatility in the stock market, threatening the reliability of the investment source that typically fuels 401(k) growth. And higher-than-average inflation threatens to make it more challenging for the traditional target amounts pursued by 401(k)s to fund the retirement lifestyles people have come to expect.

Real estate provides an alternative to 401(k)s that has the capability to address the challenges emerging in today’s financial landscape. In some ways, it even enhances the benefits that people seek with 401(k) investing. The following explores how real estate compares to 401(k)s as a vehicle for building retirement security.

Can Real Estate Provide A Comparable Rate Of Return?

The rate of return on a 401(k) account is closely tied to the type of investments it includes. In the vast majority of cases, however, investors seek a 401(k) strategy that leverages a diversified portfolio to facilitate steady growth while mitigating risk. While returns can fluctuate over time based on a variety of factors, including market performance and investor risk profile, most experts say the long-term average rate of return that 401(k) investors can typically expect is between 5 and 8 percent.

Recent stock market performance supports those numbers. Over the past 25 years, for example, the total annual return on the S&P 500 accounting for all the ups and downs is approximately 7.98 percent.

However, recent studies have found that real estate investing involving both commercial and residential properties outperformed the S&P 500 over the past 25 years. Some reports show the average annualized return on residential and diversified real estate investments to be as high as 10.3 percent. While a variety of factors can influence an investor’s particular rate of return, real estate investing has clearly shown it is capable of meeting and exceeding the rate of return that retirement savers can expect from their 401(k).

Does Real Estate Offer Tax-Deferred Growth?

The tax advantages investors gain from leveraging a 401(k) constitute a significant part of their draw. Except for the Roth variety, 401(k)s give investors a tax-deferred investment vehicle. Their contributions are made pre-tax, which lowers their current tax obligations, and they grow tax deferred, with tax paid only when funds are withdrawn.

Real estate also provides an investment vehicle that allows for tax-deferred growth. Regardless of how much the property increases in value, the tax is deferred until a taxable event occurs. In most cases, the taxable event is the sale of the property. To add to the benefits of real estate investing, the long-term capital gains taxes paid on the sale of a property are typically lower than the average income taxes paid on distributions from a 401(k).

Real estate also provides the opportunity for tax deductions, rather than just tax deferral. With the tax deferral provided by a 401(k), investors are simply kicking the can down the road. While the hope is that taxes on their investment can be reduced by triggering them in a season when they are in a lower tax bracket, a 401(k) doesn’t provide an opportunity to escape them altogether.

Real estate’s tax deductions allow investors to reduce their taxable income rather than just deferring their tax obligation. For example, depreciation deductions can allow investors who rent property to reduce the amount of taxable rental income, which lowers their income tax.

Recent changes to tax law implemented under the One Big Beautiful Bill Act enhance the tax savings potential of real estate by allowing investors to tap into 100 percent bonus depreciation. The new law says investors, after certifying certain qualifications through cost segregation studies, can claim 100 percent of depreciation deductions in the first year they own the property, rather than spreading those deductions over a longer period.

The sizable paper losses that the new law allows can dramatically reduce tax obligations by reducing actual taxable income. For example, those purchasing a $1 million investment property with an $800,000 depreciable basis could reduce their income by as much as $250,000.

Does Real Estate Provide Better Liquidity Than 401(k)s?

Illiquidity is one of the key downsides of 401(k)s. As a trade-off for the tax advantages that 401(k) investors gain, their access to their investment is limited. Withdrawals taken before the legal retirement age, which is currently set at 59 ½, typically trigger penalties and tax obligations.

With real estate investing, no such liquidity limitations are imposed. Real estate investors hold the key to the value they’ve accumulated in their property and can convert their investment to income by selling at any time.

Additionally, real estate enables investors to generate cash flow through rental income, which can provide passive income before and during retirement. Those who engage in real estate investing over the same time period that people typically commit to 401(k) investing can easily generate cash flow from rental payments that can fund the same retirement income as $1 million in a 401(k) account.

In addition, rent can be raised periodically to increase earnings. That means retirees can tap into a source of income that keeps up with inflation, which has become challenging for retirement strategies that rely exclusively on a 401(k) account.

In terms of liquidity, 401(k) investing also comes with the disadvantage of forced liquidity. Tax laws generally require 401(k) account holders to begin taking disbursements at age 73. These required minimum distributions essentially force account holders to start spending their retirement savings to create tax revenue for the government.

The forced liquidity imposed by 401(k) rules can lead to losses for account holders due to sequence-of-returns risk. If the mandatory disbursements are triggered during a down market, account holders may experience losses that threaten the effectiveness of their overall retirement plan.

Forced liquidity also comes into play when a 401(k) holder dies. At that time, all of the value remaining in the account becomes taxable income.

Real estate does not expose investors to forced liquidity. In fact, real estate investments can be passed on to heirs at the time of the investor’s death without the type of forced liquidity that 401(k) investments trigger. And through step-up in basis provisions, the heirs who inherit the property can continue to enjoy tax benefits.

The current economy makes it more difficult for traditional 401(k) accounts to deliver the types of returns needed to fund a secure retirement. Real estate, however, opens the door to alternative strategies that can improve the impact of retirement investing. Investors who tap into those strategies will gain opportunities to reduce tax burdens, increase cash flow, and gain more control over how and when their investments are spent.