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Using Your 401k for Real Estate Investing

Here are some options for using your 401(k) to invest in real estate from

Cashing out Your 401(k)

If you have an old 401(k) balance from a former employer, one option is to take a distribution from your 401(k), pulling assets from your plan altogether. Before you do this, think through the ramifications:

Income taxes: The second you pull money out of your 401(k) – without rolling over to an IRA or other 401(k) plan – you incur an immediate income tax liability on the entire amount of the withdrawal. You also lose the benefit of future tax deferral, although this isn’t the end of the world. Investment real estate has tax advantages of its own, including the deferral of capital gains tax through 1031 exchanges and just plain holding on to properties, rather than selling. However, rental income is generally taxable outside of retirement plans.

Warning: If you do take a withdrawal, you won’t get the entire withdrawal amount. The 401(k) plan sponsor will withhold 20 percent of the distribution and send it to the IRS to offset expected income taxes. To avoid this consequence, you may consider rolling into an IRA first, and then taking the distribution, if you want to remove money from the retirement account.

Penalties: You may get tagged with a 10 percent early withdrawal penalty if you are under age 59½. The penalty is waived if you are over age 55 and have left your job, however. The 10 percent penalty is on the full amount you withdraw, not just on the 80 percent you actually receive from your employer. So if you do have to pay a penalty, your real penalty isn’t 10 percent, but 12.5 percent on the cash you actually receive. This is over and above any income taxes due. Between federal and state income taxes and penalties, you could lose as much as half of your purchasing power just in the transfer.

Exception: The IRS allows plan sponsors to provide for hardship withdrawals for “immediate and heavy” cash needs, including the purchase of a first home. In this case, you may be able to avoid the 10 percent penalty on your 401(k) withdrawal. However, the exception does not normally apply directly to investment property. You could purchase a home, live in it for a couple of years, and then turn it into a rental property. You still need to deal with the income taxes, however, regardless of the 10 percent penalty.

Wealth Protection: Keep in mind that in most cases, assets in an employers’ 401(k) plan receive essentially unlimited protection against the claims of creditors. Even the IRS has a hard time collecting on debts from an employer 401(k) plan – they typically have to wait until you start getting distributions to get any money. If you are at risk of being sued – and nearly everyone is – be careful about moving assets into a non-protected asset class.

PMI: If your loan-to-value ratio on a property is less than 80 percent, expect to pay primary mortgage insurance premiums. This will likely run you about .75 percent of the loan value per year until you have the loan paid down below 20 percent. In some situations, it might make sense to tap your retirement funds to bring your down payment above the 20 percent threshold to avoid this cost. You can use the savings to repay your loan.

Taking a Loan From Your 401(k)

You may be able to borrow money from your 401(k) to jump-start your investment in real estate. Not every plan allows loans, but if your employer’s plan allows it, you can take a loan from your 401(k) plan, invest it in real estate, and take up to five years to pay the loan back with interest.

This will allow you to take the cash while still deferring income tax and avoiding early withdrawal penalties. Moreover, there’s no $10,000 limit – meaning you can take your entire down payment from your 401(k).

You do need to repay the loan. For most loans, a 5-year period is common, though many plans authorize longer repayment periods of 10 to 15 years for home purchases. In theory, the interest isn’t a big deal because you’re just transferring money from one pocket to the other. In practice, though, you are repaying pre-tax dollars with after-tax dollars. So you may have to earn as much as $1.25 or more to pay yourself back a dollar.

What’s more, in the event you lose your job, you will only have 60 days to repay the loan. Otherwise, you’ll get tagged with income taxes and penalties on the whole balance outstanding. This can be a problem if you have invested the whole thing in a relatively illiquid asset such as real estate.

One last option to consider is the self-directed IRA. You can use your funds from your IRA to purchase real estate without the need for custodial consent.

If you have any questions about using your 401(k) or self-directed IRA to buy real estate, please contact a tax expert @ 800.472.0646.

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Posted in Self-Directed IRA, Solo 401(k)