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Many people wish to get into real estate investment opportunities, but they don't have liquid cash to begin the process. Therefore, they often consider the financing options available. A common choice is a mortgage loan, but that's not ideal for everyone because there are limitations.
If you cannot get a mortgage, you shouldn't automatically give up. There are other options for purchasing an investment property. For example, you can invest in real estate through your 401(K). Whether you're buying it for rental income or personal use, it's possible, and this guide will help you understand the process.
Should You Buy Investment Property Assets with a 401(K)?
Before jumping into investing a 401(K) in real estate, we need to answer a serious question. Yes, you can do so, but is it the ideal option for you? Here are a few pros and cons to think about:
Benefits
Whenever the mortgage interest rates go up, a 401(K) loan might be a cost-effective way to get money. Currently, it's right above the prime rate, so this is affordable and can help you cover that large down payment on the investment property.
Plus, there's another advantage of borrowing money from the 401(K) for the down payment. With the 401(K) loan repayment, you are actually paying yourself with the interest, and it goes back into the retirement account.
Another reason to invest in real estate through a 401(K) is to benefit from the tax exemption that goes with 401(K) loans. If you borrow money from the 401(K), it's considered a tax-deferred status, which means you don't pay tax-related fees or have tax consequences.
For example, you withdraw money from an individual retirement account for a down payment on the investment property. This means you pay income taxes on that distribution. However, the money borrowed from the 401(K) is a loan. That means you actually don't pay income tax on it. The money won't count as income!
Drawbacks
Though you can withdraw money from retirement savings, such as 401(K) accounts, to cover the cost of purchasing rental properties, the purpose of them is to focus on long-term savings. Therefore, they discourage you from withdrawals through an early withdrawal penalty.
When you're withdrawing money from the 401(K) early for any purpose, including investing in real estate, you'll likely pay a penalty. The IRS does allow for "hardship withdrawals" in some situations, such as when using the 401(K) to purchase a primary residence. However, you can't necessarily use it for real estate investment.
Likewise, you should understand something else. If you decide to take out a loan against the 401(K), that loan has to be repaid by the specified deadline. Otherwise, it's taxed like an early withdrawal. Plus, you'll pay an early withdrawal penalty.
If you are unable to pay it back, the loan could cost significantly more than you bargained for, so it's wise to budget accordingly.
Before investing your 401(K) in real estate, it's important to consider that you might lose your retirement income. That's what the 401(K) is all about.
How to Use Your 401(K) to Invest
Though it's confusing to understand taxable income, non-taxable income, and the real estate market in general, these are the things you have to know if you expect to use your 401(K) to purchase real estate. Here are a few ways to do it:
401(K) Loans
The first option that allows you to use the 401(K) to invest in a rental property focuses on taking out a loan against your retirement savings. However, some plan rules don't allow this. If yours does, you can access the funds needed to finance your goals.
Overall, the IRS lets you borrow the lesser of these:
- $50,000
- Half of what's in the vested account balance or $10,000 (whichever is more)
When you take out a loan from the 401(K), you don't incur an early withdrawal penalty, and it's tax-free money. That means you won't pay income taxes on the money you remove from the account.
You will have to repay your loan with interest, but that's like paying yourself back some of that cash. The repayment terms, including the interest rate, are designated by the 401(K) administrator or plan provider. Often, the maximum loan term you get is five years. However, if you use the loan to purchase your primary residence, you might get an extension.
While the loan payments go back to the 401(K), they won't count as contributions. Therefore, you won't get the employer match or a tax break from them. In fact, your plan administrator might not let you make any contributions to your 401(K) until the loan is repaid.
Careful planning is crucial here, and you could gain access to financing without any tax consequences while you build your nest egg. It's wise to speak with a financial advisor about your options, though.
401(K) Rollover to Roth IRA
Many experts recommend that real estate investors roll over a 401(K) to a Roth IRA. Earlier, you learned that doing this will keep your investment tax-free. Then, you can use the proceeds of your retirement funds to invest in rental properties.
Suppose you roll over $10,000 that's set aside to buy your first investment property into the Roth IRA. In that case, you'll avoid the 10 percent early withdrawal penalties and all the restrictions imposed on your 401(K) distribution.
However, be aware that 401(K) funds are pre-tax contributions, and Roth IRA contributions come as post-tax. Therefore, you will have to pay taxes on the money you transfer to your Roth IRA.
Some people wonder if a traditional IRA works the same way; it doesn't. In a traditional IRA, the contributions you make are tax-deductible within the year they're made to reduce your gross income. Therefore, it might be better if you believe your tax rates will be lower in retirement. However, the process for rolling over a 401(K) into a traditional IRA is different.
You may have lower tax deductions, but the tax benefits don't outweigh the amount of income tax you'll pay. If you already own an IRA, you may consider using that to buy your real estate without the 401(K).
Self-directed 401(K)
Beginner real estate investors must understand that a traditional 401(K) doesn't let you directly invest in real estate. Therefore, you require self-directed retirement accounts. In a sense, it's a DIY retirement plan that you can manage yourself. Most people think it's the best way to invest in real estate with a 401(K).
However, you may also consider a self-directed 401(K). This will let you purchase residential income property, commercial property, and land. Plus, the income generated from it will be tax-free.
Still, there are limits on the transaction types investors can make on a self-directed 401(K). For example, they cannot involve properties sold or bought to relatives and those in which they live. Overall, using this option is only advisable if you're real estate market savvy. Most people aren't.
Self-Directed IRA
A self-directed IRA lets you choose from many investment options as long as the IRA custodian allows it. You're not restricted to traditional investments, including mutual funds, bonds, and stocks.
Overall, a self-directed IRA allows you to fund various alternative investments, such as oil, private mortgages, intellectual property, gas limited partnerships, and even real estate.
When you use a self-directed IRA to invest in real estate, remember that the process is very involved. Here's a short recap:
- You cannot live on the property or actively run it.
- The property is only used as an investment. It's not a home for your kids, a vacation home, a second home, or a business office.
- You can't purchase your property from any disqualified person, such as grandparents, parents, spouses, IRA service providers, and entities that would retain 50 percent ownership of that property.
- The custodian of the self-directed account must hold the property's title, and you can't be the custodian.
- A third party must handle the operations.
- All revenue generated by that property, including sales proceeds and rental income, have to flow back into the IRA to preserve your tax-deferred status. You can't pocket the profits.
REITs for Investing in a Rental Property
A middle-ground approach to buying a rental property is to invest in a REIT (real estate investment trust). This is similar to mutual funds, except that they're restricted to mortgages, real estate, and real estate-related assets. There are countless REITs available, as well.
Some REITs invest in broad portfolios of real estate across many geographies and asset classes. However, others focus more on a particular niche, such as office, multifamily, or retail.
There are certainly advantages of investing in REITs. For example, it's a liquid investment. You can purchase and sell REIT shares like you would traditional stocks on the stock market. Owning real estate outright is illiquid.
Likewise, REITs allow people to become passive investors. You won't deal with the daily responsibilities of a landlord.
On top of that, REITs are required by law to pay 90 percent of the profits to shareholders as dividends. Therefore, most investors can rely on immediate returns for an outstanding passive stream of income.
However, there are a few drawbacks. Earnings made from a REIT are taxed and treated just like income. Therefore, you don't have the tax benefits you would if you owned the property outright. Likewise, REITs require hefty management fees compared to mutual funds.
Bottom Line
Can you invest a 401(K) into real estate? Yes, you can! However, the question you should ask yourself is this: should you do so? It all depends on your investment portfolio strategy, personal goals, and how you look at the pros and cons of this method.
It's generally best to speak with an accountant or retirement advisor to make sure you've considered everything. Your personal financial situation might be different from someone else's, so you shouldn't compare.
However, when you're ready to become a landlord, DoorLoop is here to help. You can learn about the rental laws in your state and even create rental forms and templates to ensure that things are done legally.
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