Investing in Roth/Traditional vs Paying off debt

[malucol]

Hello Bogleheads,

I am a single 37yr old and had no debt. Sufficient emergency funds. Save and invest with Bogleheads principles.
I currently contribute the max. pre-tax 401k amount allowed (18K), my company matches 5% and I also contribute around 20K to after-tax Roth 401k.
I have 35000 of Roth IRA contributions (Grew to 40000 now)
I am in the 25% Federal and 0% State (FL) bracket.

I acquired a commercial property with considerable debt $500,000. The rental income from the commercial property is $6000/month which goes towards the debt servicing. The debt of $500,000 is serviced at 12% interest.

Q1.) Should I take out my 35000 in Roth IRA (>5 years) contributions to pay off some of the debts.
Q2.) Divert my after-tax Roth 401k of 20K anually towards the servicing of debts.

Is paying off 12% debt more valuable than Roth space for a 37yr old.

Q3.) Should I use my pre-tax contributions of 18K (or the amount after my company matches) to pay off the debts as well? If I use this I will be paying extra 25% taxes on 18K that I avoid now. In retirement I expect to be paying less than 25% taxes according to some threads I've been reading.

I left out my other assets and my job situation. Mathematically what would be the best choice in the above scenario.

Thank you.

[Duckie]

malucol, welcome to the forum.

The rental income from the commercial property is $6000/month which goes towards the debt servicing. The debt of $500,000 is serviced at 12% interest.

You make $72K on the rent before taxes and your interest alone is $60K. This doesn't sound to me like it was a good investment.

Should I take out my 35000 in Roth IRA (>5 years) contributions to pay off some of the debts.

No.

Divert my after-tax Roth 401k of 20K anually towards the servicing of debts.

Yes.

Is paying off 12% debt more valuable than Roth space for a 37yr old.

Not to me.

Should I use my pre-tax contributions of 18K (or the amount after my company matches) to pay off the debts as well?

Maybe.

[Dude2]

Should I use my pre-tax contributions of 18K (or the amount after my company matches) to pay off the debts as well?

Maybe.

How-Much-Does-My-401-k-Plan-Save-Me-In-Taxes-

When you do the math, you discover that the two most important tax benefits for retirement savings are the non-taxation of trust earnings and (where this is relevant) any shifting of income from a high tax rate year (the year of contribution) to a lower tax rate year (the year of distribution). To figure out how much taxes you are saving, you then have to compare what you're getting from the plan with what you would have gotten if you saved outside the plan. That's your tax benefit.

The retirement tax benefit has significant value. The key factors in driving that value are: (1) how long you leave your money in the plan; (2) how much you earn while your money is in the plan; and (3) whether your tax rate on distribution is lower than your rate was when you made your contribution.

[TheAncientOne]

Why are you paying 12%? Can't you refinance this loan? If I were stuck with a 12% loan (and you must not be since you're saying you have the option of paying it down), I wouldn't be putting any additional money into retirement accounts other than the 18K for your 401K.

[Nate79]

Good Lord. 12%? As no investment could even come close to a guaranteed return of 12% pay it off asap. Or dump the stinker.

[JBTX]

Best option:

Try to get out of this commercial property. It is a loser


Next best option:


See if there is anyway you can refinance the 12% to something much lower.


Third best option:

Prioritize paying off 12% debt, after meeting your 401k match. You aren't likely to get 12% (or even 8-9% after tax impact) in the market over the next decade.

[FiveK]

Is paying off 12% debt more valuable than Roth space for a 37yr old.

Yes.

See both Prioritizing investments - Bogleheads and Investment Order.

Paying off a debt with interest that high is likely more effective than anything except getting an employer match on retirement account contributions.

See also Prioritizing investments- HSA goes where? and subsequent posts for some math behind those ordered lists. One could substitute 401k, IRA, etc., for HSA and reach the same conclusion.

[JBTX]

What is unfortunate is paying off a half million in debt is going to set back his retirement contributions for a while.

[randomguy]

Good Lord. 12%? As no investment could even come close to a guaranteed return of 12% pay it off asap. Or dump the stinker.

Well this property is paying off 14%:)

The question is what has changed to make you want to pay the debt off now but not before? I assume the plan was to be break even for a decade and as rents creep up to watch the profits flow in. Why change the course?

I would also worry about losing the opportunity cost (say 10 years of 401(k)+roth savings) and protection (i.e. what if you have to declare bankruptcy because your investment building crashes) for the potential of making a few more bucks.

[4th and Inches]

12% Interest? Wow! That's like the highest non-credit card interest rate I have ever heard someone say they had on bogleheads unless they were talking about mortgages from many years ago.

[malucol]

Thank you all for your responses.

Maybe acquired is not the right word. The property is a gift to me from my family, the debt is supposed to be paid off in 6 years using the rent. Beyond that, I get the rent monthly. I was hoping to see if it makes sense to pay off the loan earlier because of the 12% interest rate.

[Olemiss540]

Thank you all for your responses.

Maybe acquired is not the right word. The property is a gift to me from my family, the debt is supposed to be paid off in 6 years using the rent. Beyond that, I get the rent monthly. I was hoping to see if it makes sense to pay off the loan earlier because of the 12% interest rate.

Look at it this way, if you had the opportunity for a post tax investment that guaranteed 12% annual returns, would you cut retirement account funding to do it?

My answer is a RESOUNDING yes. Outside of the company 401k match, there is NO better use for your money than paying this loan down and guaranteeing a 12% return.

This assumes you can not get out from under the loan or refinance to a much lower rate. All available money needs to be directed to paying off this loan as if it was an emergency.

Can you tap your home equity? HELOC? 401k loan? Downsize your vehicles? Sell a kidney?

[randomguy]

Thank you all for your responses.

Maybe acquired is not the right word. The property is a gift to me from my family, the debt is supposed to be paid off in 6 years using the rent. Beyond that, I get the rent monthly. I was hoping to see if it makes sense to pay off the loan earlier because of the 12% interest rate.

Look at it this way, if you had the opportunity for a post tax investment that guaranteed 12% annual returns, would you cut retirement account funding to do it?

My answer is a RESOUNDING yes. Outside of the company 401k match, there is NO better use for your money than paying this loan down and guaranteeing a 12% return.

This assumes you can not get out from under the loan or refinance to a much lower rate. All available money needs to be directed to paying off this loan as if it was an emergency.

Can you tap your home equity? HELOC? 401k loan? Downsize your vehicles? Sell a kidney?

This isn't remotely an emergency. This is debt that is backed by an income stream that pays it off. That isn't remotely the same as credit card debt for example. You could just ignore the whole property and in some years the debt will be gone.

Are you better off paying off a 12% tax deductible loan (i.e. I expect the OP will be in the 28% bracket when depreciation goes away an 72k of income is added in) or making 8%+ (we are talking 30 years here.That is a long time to get returns that are 20% below historical norms) tax free? I doubt you see a drastic difference when you see what happens over the next 20+ years. Not sure I would give up diversification for a decade to save a few bucks.

Seems like the first step should be to see if you can refinance to a 4-7% commercial rate. You would have to look at your situation to see how close you are to the underwriting standards before doing irrevocable things.

[Olemiss540]

Thank you all for your responses.

Maybe acquired is not the right word. The property is a gift to me from my family, the debt is supposed to be paid off in 6 years using the rent. Beyond that, I get the rent monthly. I was hoping to see if it makes sense to pay off the loan earlier because of the 12% interest rate.

Look at it this way, if you had the opportunity for a post tax investment that guaranteed 12% annual returns, would you cut retirement account funding to do it?

My answer is a RESOUNDING yes. Outside of the company 401k match, there is NO better use for your money than paying this loan down and guaranteeing a 12% return.

This assumes you can not get out from under the loan or refinance to a much lower rate. All available money needs to be directed to paying off this loan as if it was an emergency.

Can you tap your home equity? HELOC? 401k loan? Downsize your vehicles? Sell a kidney?

This isn't remotely an emergency. This is debt that is backed by an income stream that pays it off. That isn't remotely the same as credit card debt for example. You could just ignore the whole property and in some years the debt will be gone.

Are you better off paying off a 12% tax deductible loan (i.e. I expect the OP will be in the 28% bracket when depreciation goes away an 72k of income is added in) or making 8%+ (we are talking 30 years here.That is a long time to get returns that are 20% below historical norms) tax free? I doubt you see a drastic difference when you see what happens over the next 20+ years. Not sure I would give up diversification for a decade to save a few bucks.

Seems like the first step should be to see if you can refinance to a 4-7% commercial rate. You would have to look at your situation to see how close you are to the underwriting standards before doing irrevocable things.

You are ignoring the fact that the 8% return is guaranteed. If you were able to find a CD or treasuries that paid 8%, would you put a single dollar into the stock market?

12% debt has a return on investment of 12% regardless of deductibility. Any dollar you pay down that increases your net worth at a rate of 12% versus not paying the loan down regardless of the deduction since you have to pay it with after tax money regardless.

[KlangFool]

OP,

The answer to all your questions is no for a very simple and important reason: diversification. This commercial property should stand on its own. If it is a good deal, you should keep it and it will be paid off in 6 years. If it is not, do not keep it.

If you put the rest of your money into this commercial property, you are putting all your eggs into this one basket. What if it does not work out? What if the tenant goes bankrupt. then what? You do not have the reserve to survive any shortfall if you put all your money into this commercial property.

Is the commercial loan a recourse or non-recourse loan? Can the bank go after the rest of your asset if it failed?

When we go into this kind of consideration, we need to think about our risk exposure. What if things turn out bad, what is our reserve?

KlangFool

[randomguy]

You are ignoring the fact that the 8% return is guaranteed. If you were able to find a CD or treasuries that paid 8%, would you put a single dollar into the stock market?

12% debt has a return on investment of 12% regardless of deductibility. Any dollar you pay down that increases your net worth at a rate of 12% versus not paying the loan down regardless of the deduction since you have to pay it with after tax money regardless.

Of course I would invest in the market. Paying 45% taxes every year is brutal. Basic math

100k @8%, paying 45% taxes every year on gains = 364k in 30 years
100k @8% paying 20% on gains at the end of 30 years = 700k

I am willing to take on volatility for 2x as much money. You have to be pretty risk adverse not to.

Paying off the loan has a return of 12%. Investing at 8% and getting 4% tax savings (remember paying off the loan costs you both the deductibility of the loan AND the loss of 401(k) deduction benefits) also has a 12% return. It is real easy to focus on one side of the equation while ignoring the other. Opportunity cost is something that most people never think about.

[Olemiss540]

OP,

The answer to all your questions is no for a very simple and important reason: diversification. This commercial property should stand on its own. If it is a good deal, you should keep it and it will be paid off in 6 years. If it is not, do not keep it.

If you put the rest of your money into this commercial property, you are putting all your eggs into this one basket. What if it does not work out? What if the tenant goes bankrupt. then what? You do not have the reserve to survive any shortfall if you put all your money into this commercial property.

Is the commercial loan a recourse or non-recourse loan? Can the bank go after the rest of your asset if it failed?

When we go into this kind of consideration, we need to think about our risk exposure. What if things turn out bad, what is our reserve?

KlangFool

Personally, I think risk exposure and diversification should have been considered PRIOR to purchase. The egg has hatched so to speak, and the OP is buried in high interest debt because of that. I would sell or refinance to a much lower interest rate, but if neither of those is feasible, pay down the debt as quickly as possible by whatever means is possible. 12% is mindnumbingly high and diversifying into lower return unguarenteed investments seems silly until it is gone.

[Olemiss540]

100k @8%, paying 45% taxes every year on gains = 364k in 30 years
100k @8% paying 20% on gains at the end of 30 years = 700k

I am willing to take on volatility for 2x as much money. You have to be pretty risk adverse not to.

How does this math equation have anything to do with the OP's situation? How much does a 500k mortgage at 12% cost over 30 years?

There is no opportunity cost when the other opportunity has a lower EXPECTED return and the initial opportunity has a higher guaranteed return.

I will quit posting on this topic, as I eigther have a misunderstanding on investing in commercial real estate (entirely possible) or am not intelligent enough to properly convey the mathmatic logic behind my reasoning.

[KlangFool]

OP,

The answer to all your questions is no for a very simple and important reason: diversification. This commercial property should stand on its own. If it is a good deal, you should keep it and it will be paid off in 6 years. If it is not, do not keep it.

If you put the rest of your money into this commercial property, you are putting all your eggs into this one basket. What if it does not work out? What if the tenant goes bankrupt. then what? You do not have the reserve to survive any shortfall if you put all your money into this commercial property.

Is the commercial loan a recourse or non-recourse loan? Can the bank go after the rest of your asset if it failed?

When we go into this kind of consideration, we need to think about our risk exposure. What if things turn out bad, what is our reserve?

KlangFool

Personally, I think risk exposure and diversification should have been considered PRIOR to purchase. The egg has hatched so to speak, and the OP is buried in high interest debt because of that. I would sell or refinance to a much lower interest rate, but if neither of those is feasible, pay down the debt as quickly as possible by whatever means is possible. 12% is mindnumbingly high and diversifying into lower return unguarenteed investments seems silly until it is gone.

Olemiss540,

A) It will not be quick. It will take at least 3 years. And, if OP burns out all his reserve by paying this loan, he would not survive any shortfall over this period. It will be disastrous. There is no backup plan.

B) If OP does not pre-pay the loan, he has the reserve to survive even if some problem shows up.

The answer is obvious to me. The risk is too great and the reward is minimal. Perhaps 6% per year more return over 3 years for about 60K per year. Please note that OP will be paying a lot of tax for pre-paying the loan.

KlangFool

[FiveK]

Thank you all for your responses.

Maybe acquired is not the right word. The property is a gift to me from my family, the debt is supposed to be paid off in 6 years using the rent. Beyond that, I get the rent monthly. I was hoping to see if it makes sense to pay off the loan earlier because of the 12% interest rate.

There are a lot of numbers being thrown around, some of which seem suspect. E.g., to pay off a $500K loan at 12% in six years takes $9775/mo, not $6000/mo.

Also, if you are receiving $72K/yr from this rental in perpetuity, it is unclear how you could expect to be paying less than a 25% federal tax rate in retirement.

Not sure where the 45% number from a few posts ago came from either.