MoneyPhile

I am not a fan of taking on debt. My next investment venture – a duplex home – will take some time to save up for, if I want to purchase it for cash. I estimate that I will need at least 150K to buy a home that I can repair to a point where it can be rented out for passive income. In the meantime, I have some issues as to where I should be investing this money while I’m saving for a duplex. This article walks through my thought process on what would be the better choice in keeping my money (tax sheltered or not), over the next five years.


Assuming I can save $2500 (after tax) per month in cash, getting paid monthly, where is the best place that I should stash my money?

I have a few options for this Withdrawal Penalty comparison:
1. Leave the money in my bank savings account (earning at this rate, 1.10%)
2. Increase 401K contribution – use pre-tax money to purchase DRIP stock, and withdraw after 5 years when needed for the Duplex; pay early 10% penalty. Assume 10% dividend per year, and tax rate of 30%.
3. Invest in one or more DRIP stocks, non-tax sheltered. Assume 10% dividend per year, and tax rate of 30%.

DRIP stands for Dividend Re-Investment Plan – This is a stock purchase plan that is set up directly with the Investment Relations department of a company to allow for purchase of shares of stock, at set intervals. For example, I can set aside 100 each month to purchase shares of company X at the share price at the end of the month.
Pros: It allows investors to own fractional shares, and not have to pay the heavy brokerage fees every month (as it is dealing directly with the company and not the broker).
Cons: You will need to keep track of the cost basis at every month for tax purposes, which can be very tedious. Also, you are taxed on both the dividend (even if it is re-invested), as well as any gains from sales, so again, very important to track the cost basis.

Option 1: Leave money in bank account (non-tax sheltered), at 1.1%

We can use a formula: A = P(1 + r/q)nq
P is the principal (the money you start with, your first deposit = 2500)
r is the annual rate of interest as a decimal (10% means r = 0.10)
n is the number of years you leave it on deposit (=5)
q is the number of times it is compounded a year (=12)
A is how much money you’ve accumulated after n years, including interest.

Using a compound interest calculator, with an initial deposit of $0.00, monthly contributions of $2500.00 and an assumed annual interest rate of 1.1% for 5 years, I will earn a total of $154129.08.

Option 2: Let’s see what happens when I use my pre-tax money to invest in a DRIP.
Annual Dividend Return = 10%
Term = 5 Years
A = P(1 + r/q)nq
P = Monthly Contribution = after tax income / tax rate = 2500 / .7 = $3571.43
r = 0.10
n = 5 years
q =12
A is how much money you’ve accumulated after n years, including interest.
Using the same calculator:
With an initial deposit of $0.00, monthly contributions of $3571.43 and an assumed annual interest rate of 10% for 5 years, I will earn a total of $276561.08.
However, there are 2 catches:
1. 10% Early withdrawal tax on the balance
$276561.08 – (0.1 * $276561.08) = 248904.97

2. Now, we apply the regular tax rate of 30%, and we have:
248904.97 – (0.3*248904.97) = $174233.48
Therefore, I will be left with a $174233.48 return.

Option 3: We do not put anything in 401K, but we put it into a DRIP (assume dividend tax law has not been extended, and we pay full 30% earned income tax on it).

A = P(1 + r/q)nq
P = Monthly Contribution = 2500
r = 0.10 * .7 = .07 (factored for tax)
n = 5 years
q =12

With an initial deposit of $0.00, monthly contributions of $2500.00 and an assumed annual interest rate of 7% for 5 years, I will earn a total of $178982.25.

Therefore, given the three options, the best outcome would be to choose a DRIP account, in a non-tax sheltered account.

However, if we do the same calculation above, let’s say for 10 years, comparing Option 2 and Option 3 we get:

Option 2: 401 Sheltered @$3571.43 for 10 Years (Better)
Result: $731589.50.
After 10% Penalty: 658430.55
After 30% Tax: $460901.39

Option 3: Non-Sheltered @$2500 for 10 Years
10 Year – Non-Sheltered: $432712.02

By waiting 5 additional years in a tax sheltered account, I will actually make more money then if it was in a non-sheltered DRIP.

Let’s see what happens when we adjust the rate from 10% to 5%, and keep the number of years to be 5 years.

Option 2:
5 Year @5% – 401 Sheltered: $242878.96
After 10% Penalty: 218591.06
After 30% Tax: 153013

Option 3: (Better)
10 Year – Non-Sheltered: $163665.28

Observations: Where “Best” to Invest:
Short Term (up to 6 years):  Non-Tax Sheltered
Long Term:                                  Tax-Sheltered

Therefore, it is very important when comparing investment options, how long you intend to keep the investment in place. The longer you have to invest (without withdrawal), the better it will be to keep it in a tax sheltered account, such as 401k. However, if you do not intend to keep the investment long term, as in my example, 5 years and less, it does not make sense to put the money in a 401k. Of course, the ideal situation would be to leave it in the 401K account until 59.5 years, and avoid the 10% withdrawal penalty altogether.