What Is The Difference Between An Ira And 401k
As outlined above, the key differences between an IRA and 401k are as follows:
- Anyone who falls within the income criteria can set up an IRA, whereas a 401k must be established by an employer.
- There are no income limits for investing in a 401k.
- Individuals can only invest up to $6,000 in an IRA each year vs. up to $19,000 in a 401k.
- Money can be withdrawn from an IRA at any time, whereas a person must have reached a distribution event before they can access their 401k savings.
- Investment selection may be more limited when investing in a 401k vs. an IRA.
How Can I Use My Retirement Account To Invest In Real Estate
Retirement investing in real estate is a broad concept that can involve many types of investment vehicles, varying amounts of risk, and different degrees of involvement required on the part of the investor. Here are a few examples.
1. You can invest your retirement account in real estate stocks, mutual funds or publicly traded REITs
This is the most common way of using a personal retirement account to invest in real estate.
If you own an IRA, you can simply use your account to purchase equity shares of real estate-related businesses. These could be publicly traded real estate development companies or mortgage companies, for example, or mutual funds or publicly traded REITs that are themselves invested in a basket of real estate businesses.
If you have a 401 through an employer, you might also be able to find real estate-related investment opportunities such as these in your plans available offerings. Generally speaking, however, an employer-sponsored 401 can have a more limited range of investment opportunities for you to choose from than your personal IRA might have.
This is the most passive and straightforward way to invest your retirement account in real estate. In essence, you can simply find stocks, bonds or mutual funds to purchase, just as you would with other types of traditional retirement investing. The only difference, in this case, would be that you have chosen real estate as the industry in which to invest.
What Are Alternatives To Buying An Investment Property
A middle-ground approach that many investors consider is using their retirement accounts to passively invest in real estate, for instance, via a real estate investment trust . Buying shares of a REIT is just as straight-forward as buying any other stock, and these shares can be purchased and sold with ease using most retirement accounts.
Another alternative, for those who may not have enough cash on hand to fund a down payment on their own, is to invest in rental property alongside a group of others. Here at Trion Properties, for example, you can invest cash or invest in deals using your self-directed IRAs. In either case, investing alongside others can reduce some of the risk involved, because the projects have been thoroughly vetted and are being managed by a highly-qualified sponsor.
Read Also: How To Get Your Money Out Of 401k
Solo 401 Real Estate Tips To Stay Irs Compliant
Remember, 401s are funded in various ways. There are funds that have been rolled over from another retirement plan, contributions you have made, and returns on investments, for instance. When all these funds are kept as one lump sum, it becomes difficult to show compliance with certain IRS restrictions.
The Rules For 401k Real Estate Investment:
The rules governing the use of 401k funds for real estate investment are not complicated. There are basically three rules that make sure you do not have a conflict of interest when making real estate transactions with your 401k funds. In addition, you have to make sure the real estate transactions you make are not prohibited by the Internal Revenue Service. The three basic rules for 401k real estate investment transactions are:
These rules allow for the purchase of mortgages with your 401k funds, which means you can purchase real estate using your 401k account. In fact, you can use your retirement funds to purchase real estate properties as much as you want. You might want to purchase fixer-uppers to repair and sell at a profit. Or, you can purchase discounted notes or rental properties to provide an income stream. You have many options available to you as long as you follow the 401k real estate investment rules.
Don’t Miss: How To Transfer 401k From Vanguard To Fidelity
If You Have An Old 401k Here’s What You Can Do
So, your options for investing in real estate are rather limited if you have an active 401k, meaning that you still work for the sponsoring employer.
On the other hand, if you have an old 401k, the possibilities are much greater.
While you can’t invest in real estate directly through an employer-sponsored 401k, you can choose to roll a former employer’s 401k account into an individual retirement account, or IRA. And while many IRA custodians don’t offer the ability to buy real estate, some offer an account type known as a self-directed IRA.
As the name implies, a self-directed IRA allows you to direct how your funds are invested, within the law. To be sure, there are some things you can’t invest in. For example, the law prohibits you from investing in collectibles with IRA funds. However, there’s nothing that specifically prohibits you from using a self-directed IRA to buy real estate.
- Things youcan buy with a self-directed IRA: Real estate, crowdfunded real estate investments, tax lien certificates, precious metals, cryptocurrencies, private equity investments.
- Things youcan’t buy with a self-directed IRA: Collectibles, such as coins, artwork, and antiques.
Individual/solo 401k Investment In Real Estate
Individual and solo plans allow for certain investors to invest in alternative investments. When we say alternative investments, this will encompass the ownership of real estate. Self-directed plans are the option here because small businesses with just an owner and/or an owner’s spouse will fall into this category.
The Solo 401k is a great option because it allows for cash from the 401k to be used to purchase the home.
While this is great, the owner that uses these investment opportunities cannot:
- Directly access the investment income
- Use the funds for the direct benefit of a disqualified person
What does this mean? Let’s use an example to see how this all works. For example, let’s say that you purchased a small bungalow for $100,000 and now rent it out for $2,000 a month, or $24,000 a year.
This is a great return, but you do not have a legal right to use this money for your own benefit.
Rather, this money must be deposited back into the 401k plan. Rental expenses can be paid with these funds, too. You can even use some of the Solo 401k funds to pay for repairs to fix up a property that will then be rented.
Solo 401k plans also have something called the participant loan option.
What this option allows is for you to purchase a primary residence using your plan. The owner can borrow up to $50,000, or 50% of their 401k â whichever is less.
And the main benefit here is that the loan is tax-free and penalty-free.
You May Like: Can You Convert Your 401k To A Roth Ira
Selling The Property In An Ira
To sell your property, work out a sales price just as you would with any other real estate holding. Once both parties agree on a price and terms, request that your custodian sell the property on behalf of your IRA. All money will go back into your IRA, either tax-deferred or tax-free, depending on the makeup of your IRA.
One final consideration: liquidity. Just how easy is it for you to get out of the investment? With stocks, its relatively easy. Sometimes you can have your money back in seconds. In contrast, real estate is a notoriously illiquid investment. It may take a long time to divest, and you could lose money along the way. As eight million people learned in the Great Recession of 2008, you could find yourself with an asset worth less than the amount of money you owe on it.
Drawbacks To Using Your 401 To Buy A House
Even if it’s doable, tapping your retirement account for a house is problematic, no matter how you proceed. You diminish your retirement savingsnot only in terms of the immediate drop in the balance but in its future potential for growth.
For example, if you have $20,000 in your account and take out $10,000 for a home, that remaining $10,000 could potentially grow to $54,000 in 25 years with a 7% annualized return. But if you leave $20,000 in your 401 instead of using it for a home purchase, that $20,000 could grow to $108,000 in 25 years, earning the same 7% return.
You May Like: How Do I Take Money Out Of My Voya 401k
K Withdrawal / Investment Rules
Withdrawals from a 401k come in many forms, and since we just talked about the Solo 401k, let’s discuss the investment rules here. What’s important to understand is that:
- You’re borrowing money from the 401k plan.
Yes, you technically own the money come retirement, but until then, you really don’t own the money. When you take money out for alternative investments, you’re doing so with the understanding that the money is borrowed.
Using the example above, letâs say that you borrowed $50,000 to invest into a property.
If you borrowed this sum of money, you would be using a participant loan option. Under the terms of this loan option, you must:
- Pay back the 401k on a regular schedule
- Repay the 401k over a five-year period
- Pay interest rates
The interest rate is the current prime lending rate plus 1%. Ultimately, the money is yours when you retire, yet to ensure that you don’t dip into the retirement fund due to its tax-free, penalty-free basis, you’re forced to pay the loan back.
Investment rules for a 401k are defined under the Internal Revenue Code . What this code does is dictate what is not allowed to be invested in under 401k terms. What the Code, specifically Section 408 and 4975, does is disqualify persons from certain types of transactions. These persons are defined as Disqualified Persons.
These rules are not to limit an investor’s investments.
Instead, the rules are there to stop anyone in control of a 401k from taking advantage of their power.
Make A 401 Withdrawal
Your second option would be to make a direct withdrawal from your 401 account. As mentioned above, this is the less desirable of the two options.
An early withdrawal would be classified as a hardship withdrawal. The IRS considers any emergency removal of funds from a 401 to cover an immediate and heavy financial need as a hardship withdrawal. Whether or not the purchase of a home using your 401 counts as a hardship withdrawal is a determination that falls to your employer, and you will need to present evidence of hardship before the withdrawal can be approved.
Regardless, you will still likely incur the 10% early withdrawal penalty. There are exemptions in place for specific circumstances, including home buying expenses for a principal residence. Qualifying for such exemptions is difficult by design, however. If you possess other assets that could be used for your home purchase, then you likely wont qualify for an exemption. Even if you do, your withdrawal will still be taxed as income.
Don’t Miss: Is There A Limit For 401k Contributions
Make Sure You’re Buying A Home For The Right Reasons
“Don’t buy real estate because rates are down or because of the pandemic buy real estate because it’s the best choice for you,” Roberge says.
Low interest rates don’t always add up to savings in your pocket. Over half of home offers tracked by Redfin in August were part of a bidding war, which can mean that the overall cost of the home is higher. While the interest rate may be low, if you’re paying a higher price overall to secure the home you want, it could end up costing you more in the long run.
If you’re considering buying a home in the current market, look at your savings levels before you browse listings, Roberge recommends. Do you have your cash reserves for emergencies set aside, plus money available for a down payment outside of your retirement savings?
“If not, it’s probably not a good idea to raid your 401 in order to make that down payment,” he says. That’s because when you take money out of your retirement accounts, it doesn’t “magically grow back,” Roberge says. “It’s money you’ve removed that you’ve worked so hard to save. By putting that money into real estate, it’s a coin flip on whether that’s going to be a good investment or not.”
When you’re buying a home to live in, it’s not an investment in the same sense as buying stocks, Roberge says. “It’s looked at as a utility. It’s a place to live…You’re building equity, which is a fantastic thing. But it’s not this secret solution that’s going to magically make your financial life better,” he says.
Rules You Need To Know
If you want to become a real estate investor through your IRA, there are a few rules you’ll need to follow. Recall in the previous section that I mentioned that you and your IRA are considered to be two separate entities. As a result, the following rules apply:
- Any real estate you buy with a self-directed IRA needs to be purely for investment purposes. There are some definitions of the term “investment property” that allow for a small amount of personal use, but this is not the case with the property you own through an IRA.
- Property expenses must be paid by the IRA, not by you directly. For example, if the property needs a new roof, the check needs to come from the IRA. For this reason, it’s very important to leave some funds available in the IRA to cover any unforeseen expenses.
- You can’t use any personal possessions in the property.
- Any rental income needs to be paid to the IRA, not to you.
- You can’t buy a property that is currently owned by you or a relative in a self-directed IRA.
Recommended Reading: How To Diversify 401k Portfolio
Real Estate Investing With Your 401
Saving for your retirement is a great way to ensure you have a source of income even after you end your career. A 401 is a fairly standard way of doing this. With a 401, pre-tax dollars are taken from your wages and applied directly to your plans investments. Often, your employer will match this contribution, but it is not required. With a 401, your investments are limited to stocks, bonds, and mutual funds. This type of 401 is known as a traditional account.
If you would like to have more control and investment options, however, consider opening aself-directed 401. Also known as a solo 401or what the IRS calls a one-participant 401these accounts allow you to invest in much more, including precious metals, private placements, foreign currencies, and real estate.
For many, the opportunity to invest in real estate is the primary reason they switch to a solo 401. Lets take a look.
What Are The Penalties Fees Or Taxes Involved In Borrowing From Your 401
If you borrow the money, youll be required to repay the loan, typically within 5 years. Youll be paying interest while you do it, which is generally at the interest rate of 2 points over prime rate. But the interest will be used to pay yourself, which makes it a bit less onerous. However, remember these loans are paid with after-tax dollars so youre missing out on the tax benefits that make 401 accounts so attractive in the first place.
And note that if you use a 401 loan and then leave your job, the full amount must be repaid before you file taxes for the year in which you left your job . If you dont, it’s considered a withdrawal, which means it will be taxed at ordinary income tax rates.
Don’t Miss: How To Transfer 401k When Changing Jobs
A Note About The Cares Act
Signed into law on March 27, 2020, the $2 trillion dollar Coronavirus Aid, Relief and Economic Security Act emergency stimulus bill was drafted to help those affected by the coronavirus pandemic. Under the act, 401 account owners can make a hardship withdrawal of up to $100,000 without paying the 10% penalty. The bill also grants the account holder 3 years to pay the income tax, rather than it being due within that same year.
To Invest Or Not To Invest That Is The Question
Weve gone over many of the reasons to invest in real estate as well as some of the major risks. Please, do more research and reach your own conclusions. It is important to make an informed decision.
If you are not deterred and if youve decided that real estate is right for your portfolio, you need to figure out how you want to invest in real estate.There is no right way to invest in real estate. What is most important is that you know your goals, then figure out how to set up your retirement account to achieve those goals.
You May Like: How To Find Old 401k Contributions