Hello my friends and welcome to another episode of Ask Marco where I answer your investing related questions.
Today’s question comes from Sarah. Sarah says, hi, I stumbled across your article on IRAs and real estate investing. I’m wondering if you have information on the pros and cons for using my 401k from a job 15 years ago for investing in rental properties. We currently have two rentals, wondering if it’s even an option to use the 401k investment for purchasing rental properties and the pros and cons in doing so. I’m assuming one major contributing factor is how the 401k is growing currently.
Okay, Sarah? Well, thanks for the question. There’s some things I just don’t know that you haven’t given me as far as information to be able to thoroughly answer your question, but I’ll give you a 30,000 foot view answer to the question because you’re going to have to check with your tax advisor about some of the options you have.
But it’s good to know what some of those options are. So I’m assuming from your question that when you mentioned a job 15 years ago, I’m assuming that you don’t mean that you’ve been in this job for 15 years, you just have held onto the 401k from a previous job and you haven’t done anything with the funds and that’s all well and fine if you are getting a good rate of return and you’ve just kept it in there. So one option is to roll the funds over into an IRA individual retirement account. Here’s what I mean by that. So 401k plans are essentially longterm savings account and they offer tax advantages at least during the growth period of it to grow. Whatever savings you put in there between you and your employer. But with a 401k, you typically can make transfers or take loans against the 401k to access the funds and the investment because you can’t pull the funds out without paying a penalty and taxes on it prior to age 59 and a half.
So what you’re going to need to do here, especially if you are still employed in this 401k, is under management’s being managed by your company or your retirement plan administrator. You’re going to have to talk to them about this, but your 401k is restricted by law from investing in real estate. However, if you have this 401k and you’re not tied to the original employer, so it’s just sitting there and you haven’t done anything with it, what you can do is you can roll it over, roll over your 401k into an IRA. Now, although you cannot invest directly in real estate with a 401k account, rolling it over into an IRA tax free, a self directed IRA will allow you to use those proceeds to invest in real estate. So that kind of frees up the shackles of what you can and can’t do with it.
So that’s something to seriously consider. Now, if that’s not an option, you can usually borrow half of the value of your account up to about $50,000 if I’m not mistaken. However, if you purchase real estate with those funds outside of your 401k, you no longer have any tax advantages that are attached to the purchases made from the funds coming out of your 401k. Again, I’m going to repeat this a few times, but you need to talk to both the plan administrator for your 401k as well as your tax advisor because there are other rules and regulations and tax codes that come into play here. So you know this is a tax related question by far. If you roll it over into an IRA, then you are now able to self direct that IRA and purchase and invest in real estate income producing real estate within that IRA.
But if you do that, you need to monitor the cashflow. That’s very important because if you purchase real estate through a retirement account, like a self directed IRA, all the funds used to purchase the property must come from that account. It all has to be arms length and any proceeds such as rental income or sales proceeds. If you sell that property must be returned back into the IRA. If you follow these restrictions, which is essentially what they are, your real estate investment will have little or no tax ramifications just like any other investment that you do within your IRA. Now as a side note, kind of a tax comment if you will, the disadvantage if you will, of putting real estate in a retirement account, any kind of registered retirement account like an IRA is you cannot take advantage of the depreciation of the property over the 27 and a half years that the IRS allows you to depreciate that property over.
You cannot take that personally, meaning it will not flow through and out of the IRA to your personal tax return. So if you have other types of income or gains that you’d like to reduce the tax impact on or eliminate the tax impact on from the depreciation of that real estate, and that would include the real estate itself that you have in your IRA. You cannot take that depreciation and apply it to anything you have. Because again, what happens in the IRA stays in the IRA. It has to be completely separate. So for some people that doesn’t really mean a whole heck of a lot, but for many people where they have gains that they want to defer shelter or protect from any kind of taxation, you need that depreciation. Now another option, possible option, which I had mentioned before, is to take that 401k and this can apply to an IRA as well, but you can take the existing 401k and cash out some or all of the savings or the funds that you have in the 401k and pay the penalty.
Now why would I bring this up? I’m not suggesting you do this again, this is a mostly a tax related question. You have to pencil out the numbers and do the math and find if this is an option that makes sense, and I’ve done this myself, but for some people it’s actually worth paying the 10% early withdrawal fee. So here’s how it works. Most distributions from a 401k plan and even IRAs are subject to a 10% early withdrawal penalty if you take the funds out before you reach the age of 59 and a half. However, like a lot of tax rules, there are exceptions, some exceptions that allow you to withdraw those funds earlier without paying a penalty. Again, talk to your tax advisor, but let’s just assume that you withdraw the funds and you pay a 10% early withdrawal penalty and let’s just say there’s little to no tax impact on this because you have lost money or the value of what you’ve put into that 401k has not changed.
It’s the same. Well then you have no gain and so you’re not going to have a tax impact. Again, you do the math. For some people this makes sense because what you lose paying that 10% early withdrawal penalty you will make up. And then some in the right investments you can get just buying a property, all cash with a cap rate of six, seven, eight, maybe 9% although that’s a little bit high today, you can get those returns unleveraged right out of the gate. So with leverage, your cash on cash return would be higher. And when you start to factor in equity growth from the amortization of the loan and the appreciation over time, you will easily outstrip that 10% you should be in the 20% even 30% range in terms of total return on investment on the right real estate investments. So you’re taking a step back paying that 10% penalty, but you’re taking a step forward when you get 20 30% plus gains on your property over each year over time.
So think about that. And again, this is a tax and math problem that you need to solve and you don’t need to do it on your own. You could do it with your tax advisor. I hope that helps. So your two options are rollover the 401k to an IRA. Use a self directed IRA to invest in the IRA with income-producing real estate. Yes, you can do that. The other option is to cash out some or all of your funds in that 401k. If you don’t have other better options, you may or may not have a penalty on it depending on your age, but if you have a penalty, then you just have to pencil out the numbers and see if that really is the best option and that’s what makes sense. Not a complicated problem, just a math problem, but talk to your tax advisor and just think through what your options are. All right, Sarah, I hope that helps. I appreciate you and I appreciate the question for everyone else. If you have any questions about investing, finance or real estate that you’d like me to answer on the show, just go to the website, passiverealestateinvesting.com click Ask Marco, send me your question and I will answer most if not all on the show here. If you haven’t already subscribed, remember to subscribe. I appreciate you.
Thanks for listening. I will see you on our next episode.
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