Both the real estate market and the stock market have been on a tear lately—driving home prices up and generating huge gains for investors. For some, this has presented a dilemma: Should I invest the money I’ve saved into real estate, or should I focus on maxing out my retirement accounts?
What most people don’t realize is that this doesn’t have to be an either-or dilemma: You can use both your 401k and individual retirement account (IRA) to invest in real estate. In addition, contrary to popular belief, you can do so without suffering from steep withdrawal penalties. Here’s what you need to know about using retirement accounts to invest in real estate.
9 Things to Know About Investing in Real Estate with Retirement Accounts
#1: Requirements Vary for 401Ks and IRAs
The primary distinction between the two types of retirement accounts is that 401k plans are funded through pre-tax dollars, as are traditional IRAs. Contributions to your Roth IRA are from after-tax income. As such, the requirements for how each type of account can be used vary slightly.
#2: There’s a Lot of Paperwork Involved
One of the reasons that people don’t use their 401k or IRA to invest in real estate is because of all of the paperwork that’s required. Careful planning is required to meet all of the IRS requirements around doing so.
#3: You Can Borrow Against a 401k, But Not an IRA
One of the ways to invest in real estate using your 401k is by taking out a loan against it. Most plans will allow you to do so, but not all, so be sure to check with your plan administrator before pursuing this option. If it’s allowed, most plans limit you to taking out a loan of $50,000 or 50% of the value of your 401k—whichever is less. Most plans require you to repay the loan in full within five years. These funds can be used to purchase real estate.
You cannot borrow against an IRA.
#4: You Have to Pay Interest on the Loan
Taking a loan against your retirement account isn’t like getting “free” money—or is it? Yes, you’ll have to pay interest on the loan you take out. Usually, your plan administrator will tack 1-2 percentage points on above prime. However, your interest payments go back into your retirement account, so you’re really just paying that interest back to yourself.
Is it a good idea to use your 401k or IRA to invest in real estate? Find out on the #BuildiumBlog! Share on X#5: First-Timers Can Withdraw $10,000 from a Roth IRA
In order to support the goal of homeownership, the IRS allows people to withdraw up to $10,000 in principal and earnings penalty-free from their Roth IRA to put toward buying their first home. However, there are strict requirements for doing so. For instance, the Roth IRA account must have been open for at least five years before this kind of withdrawal can be made. In addition, funds must be used directly toward the acquisition of the property (e.g. the down payment or closing costs). You can only do this once in your lifetime for it to be considered a “qualified distribution,” which allows you to avoid paying income tax and early withdrawal fees. Married couples, as long as both meet the criteria individually, can borrow up to $10,000 each to put toward the purchase of a single property.
#6: You Can Withdraw Unlimited Principal from a Roth IRA
What many people don’t realize is that they can withdraw the principal from their Roth IRA at any time, without paying taxes or penalties. That’s because your Roth IRA is funded with after-tax contributions—so if you’ve stored away substantial cash in your account, you can use an unlimited amount of the principal to invest in real estate. You do not have to be a first-time homebuyer. Just don’t touch any of your earnings—doing so will result in taxes and steep early withdrawal penalties.
#7: You Can Purchase Real Estate Directly Through an IRA
Pursuant to the Employee Retirement Income Security Act of 1974 (ERISA), the custodian of a self-directed IRA is free to invest their money however he or she pleases. If your IRA is managed by a third party, the custodian may not allow you to invest in real estate—but there’s no legal reason why you can’t. A growing number of financial firms are offering self-directed IRA plans that make it easier to invest in real estate through your IRA.
The rules around buying real estate through your IRA are somewhat complicated. The government wants you to have at least an arm’s length of distance from the investment. As such, if you purchase real estate through an IRA, you cannot live in or actively manage the property. Technically, the title to the property is held by a custodian for the benefit of the IRA (and you can’t be the custodian). You must also hire a third party to handle all operations. Lastly, any revenue generated by the property—whether it’s rental income or sales proceeds— must flow back to the IRA to protect the tax-deferred status of the account.
What if you’ve been socking away money into your 401k and don’t have an IRA? No worries—you can roll over your 401k into an IRA tax-free, then use the proceeds to invest in real estate that way.
#8: Using Retirement Accounts to Invest in Real Estate Has a Downside
First and foremost, you need to realize that if you take out a loan against your 401k, the loan must be repaid by the deadline. Otherwise, the loan is considered and taxed as though it were an early withdrawal. So, if you lose your job or are otherwise unable to pay up, this loan could cost you more than you bargained for. You should always budget accordingly.
Second, there’s no guarantee that your real estate investment will generate a higher return than the stocks, mutual funds, and ETFs that your retirement plan is already invested in. The stock market has been on a tear lately, generating a 23.2% return over the past year, according to Morningstar. The bull market certainly won’t last forever—but if you had taken out a $50,000 loan last year, you would have forfeited an estimated $11,600 in returns (plus the interest that you would have paid on that loan). So unless you think you can do better in the real estate market, you may not want to touch your retirement account right now.
#9: Passive Investors May Prefer a Middle-Ground Approach
Owning income-generating real estate isn’t for the faint of heart. If you don’t want to take on the responsibilities of a landlord, there are more passive ways of using retirement accounts to invest in real estate. For instance, you could buy stock in a real estate investment trust (REIT). There are also are a growing number of crowdfunding platforms, such as Realty Mogul and Patch of Land, that allow people to invest through their self-directed IRAs.
Still not sure which strategy for using retirement accounts to invest in real estate is for you? Consider sitting down with your accountant or retirement advisor. Investing in real estate—via a retirement account or other source of money—should always be evaluated in the context of your larger retirement goals.
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