Should I Use Funds from My 401(k) to Invest in Real Estate?

You'd like to buy an investment property, but dread the idea of going through a bank for traditional financing. If you have an old 401(k) balance from a former employer, one option is to take a distribution. But 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 59 1/2. 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 employer's 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 five-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.

Opting for Self Direction

Another option — less well understood — is to open a self-directed retirement account and buy real estate directly within it. If your 401(k) plan allows an in-service distribution, you can execute a rollover into an IRA, and then have the IRA buy real estate, says James Hitt, principal of American IRA LLC, a third-party administrator based in Asheville, N.C. that specializes in servicing self-directed retirement accounts. Currently, about 4 to 5 percent of IRAs are self-directed, says Hitt. This option isn’t for everyone, but it may make sense for those with specific expertise in real estate investment.

Some things to consider:

  • Down payments for investment properties within IRAs tend to be high: 35 percent and more, plus reserves, says Hitt.
  • You can’t take money out of the IRA. Any rental income you receive must be reinvested in the IRA until you reach age 59 1/2, or you may face penalties.
  • You can’t take depreciation deductions on property within an IRA.
  • You can’t write off passive income losses in investment property in an IRA, nor can you claim a capital loss on property you sell at a loss in an IRA or other retirement account.
  • You can only contribute up to $5,000 to an IRA in any given year — plus an additional $1,000 in catch-up contributions if you are over age 50. This means that any repairs, renovations or other expenditures over that amount must be paid for with funds already inside the account.
  • You cannot use the property for your own benefit — even for an overnight stay. Nor can your children, grandchildren, parents and grandparents. Siblings, however, are no problem. “A lot of people get confused by this rule, thinking that because it’s a rental property, they can stay in it for up to two weeks. That’s not the case,” Hitt warns. Failure to abide by these rules risks having the entire IRA disallowed by the IRS, resulting in a 100 percent distribution of the entire account value, complete with taxes and penalties.
  • You can convert to a Roth IRA — which renders future streams of income after you turn 59 1/2 tax-free — in exchange for paying the income tax now.
  • You aren’t restricted to IRAs. If you have your own business, you can elect to set up a self-directed retirement account by using a SEP, SIMPLE or Solo 401(k).
  • Retirement accounts aren’t completely 100 percent tax-deferred or tax-free. If you invest in leveraged real estate in your IRA, or have a share in a partnership that uses leverage, your IRA could have an unrelated business income tax liability.

The rules governing self-directed retirement accounts can be tricky, and are not well understood by advisors who don’t specialize in this area of financial planning.