In this video from the Motley Fool Answers podcast, Alison Southwick and Robert Brokamp welcome Sean Gates to the show as they answer listener questions.
For this question, the cast considers the case of a forward-thinking young tech worker who has his retirement savings locked down and is now looking ahead to his second career -- as a bar owner. Should he put the money he is saving for that dream into the stock market via a normal brokerage account or pay off his hefty (but low-interest) mortgage?
A full transcript follows the video.
This podcast was recorded on Dec. 13, 2016.
Alison Southwick: This question comes to us from Peter. Peter writes: "I'm a 24-year-old tech worker and my dream is to retire when I'm in my mid-40s and start an e-sports bar one day." He wants to know which option he should pursue. He's basically saying (I'm summarizing this a bit) that he contributes to his 401(k) up to the company match and he also maxes out his Roth IRA.
But what he's wondering is if he should put an extra $360,000 per year into non-retirement accounts or if he should put that money against his capital of a 4% mortgage. So he says: "What are the best options if I want to start a bar? Are there any accounts that you can pull money out tax-free if you start a small business?"
Robert Brokamp: This is an interesting question. The one thing I would say [is] when you are starting a business, when you pay off your loan, you lose a certain amount of liquidity. You've taken all this money that you had in a brokerage account, you paid off your loan, but now you don't have that money.
If you're going to be starting a business, it would seem to me like having that liquidity is pretty important. He's young. He's thinking long term in terms of when he's actually going to need that money, so you'd think over the long term he could earn a return that's higher than his current mortgage. So I would lean toward keeping the mortgage and then investing the money. What do you think, Sean?
Sean Gates: Yes, and you're a brother of a different mother, I think, because I have similar goals. I don't have the e-sports thing down, but ...
Southwick: Ooh! What do you want to open up?
Gates: Well, I just want to be a bum and travel the world.
Southwick: Just do nothing?
Gates: But, yeah, Bro's point is spot-on in terms of loss of liquidity. I would say it's very clear that in this case you would want to save that money in a taxable brokerage account on the side, and invest that money for this future goal. If you pay down your mortgage, that's locked up. Who's to say that another financial crisis happens and the value of your home goes down and then you're upside down. Actually, I guess he wouldn't be upside down at that point, because he'd be paid off. But the loss of the value of your house. Anyway, I think in this case save the money. Don't pay off the mortgage.
Brokamp: And this is a case that I think he could not use a self-directed IRA. Like you couldn't use it to buy your own bar that you are then working in, or could you?
Gates: I think in this case you can...
Brokamp: You can...
Gates: ... because it's an enterprise, and you could set it up like a limited liability corporation, or something, where he got shares in the bar ...
Brokamp: Got it. And one of the things that he's clearly worried about is if you take the money out of your retirement accounts before you're age 59 1/2, you could pay taxes and a 10% penalty. But there are, actually, many ways to get around that. It can be for a qualified first-time home purchase. It could be for qualified higher education expenses. These are different, by the way, if it's a 401(k) or an IRA, so you've got to know the rules.
But there's also something called "substantially equal periodic payments," which is very complicated. Look into it, though. It is a way for people who are younger than 59 1/2 to get money out of their retirement accounts and not pay that penalty.
Gates: And I think a lot of people get trapped in trying to figure out what type of account to save in. A 529 is for education. A 401(k) you max out for the match, and that's for retirement. Is there a business account?
When there is just a brokerage account which is a catchall, and it's available at any time, it's a great resource to go to if you have extra money saved there. Because, as you said, it's liquid and there are no penalties associated with it when trying to get it out for the goal that you haven't associated with it. If it's for education, you have to pull it out for education. This account can be for anything.
Brokamp: You just want to watch the tax consequences of what you invest in. Maybe favor stocks that don't pay dividends over the stocks that do. Don't do a lot of day trading or short-term trading. Buy a good solid company that doesn't pay a dividend you can hold onto for many years, and you basically don't pay any taxes until you sell.