Real Estate Investing With Your 401(k)
Saving for your retirement is a great way to ensure you have a source of income even after you end your career. A 401(k) is a fairly standard way of doing this. With a 401(k), pre-tax dollars are taken from your wages and applied directly to your plan’s investments. Often, your employer will match this contribution, but it is not required. With a 401(k), your investments are limited to stocks, bonds, and mutual funds. This type of 401(k) is known as a “traditional” account.
If you would like to have more control and investment options, however, consider opening a self-directed 401(k). Also known as a solo 401(k)—or what the IRS calls a one-participant 401(k)—these 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(k). Let’s take a look.
Real Estate Investment with a Solo 401(k)
It is true – you could purchase real estate with the money in your personal bank account. Not only would this give you a more immediate payday, but you would have direct control over what you did with the property.
However, if you used your personal finances to invest in real estate, any gains would be subject to federal and state taxes, therefore reducing your actual profit margin. This is not so for a solo 401(k). When you use a solo 401(k) to invest in real estate, your gains are tax-deferred. This gives you a larger fund pool to use for future investment opportunities.
Easier Investing Through Your Solo 401(k)
A solo 401(k) is not the only retirement-planning vehicle you can use to invest in real estate. However, it does offer several features that make it easier and almost completely hassle-free when compared to other options.
- You do not need a custodian. If you were to use a self-directed individual retirement account (SDIRA), you would need to have a custodian act on your behalf when investing. These services are not free; the firms that specialize in solo accounts often charge large fees to provide this service. You can avoid this through the use of a solo 401(k).
- You have complete checkbook control. When you establish a business entity in the name of your 401(k), you are able to open a bank account with checkbook control. Because you do not need a custodian to approve your spending, this gives you complete and immediate control over your investment funds.
- Your solo 401(k) real estate investment is not subject to Unrelated Debt Financed Income (UDFI). At 40%, the UDFI tax is hefty. If you use 20% of your SDIRA, combined with a mortgage that pays the remaining 80%, to purchase a property – 80% of your gains will be subjected to the 40% UDFI tax! This is not so with a solo 401(k).
- You can utilize non-recourse business loans. Using non-recourse business loans to purchase real estate with your solo 401(k) can help to protect those assets from lawsuits, bankruptcy and more.
How Does This Work?
When using your solo 401(k) to invest in real estate, there are six basic steps that you will need to take.
- Open a solo 401(k) account. When you are planning to invest in property through your retirement account, it is important that your solo 401(k) account name is the only one associated with all purchase-related documents.
- Transfer funds into your solo 401(k) account. This may seem obvious, but it is an important step. Contributions can be made through roll overs, transfers from other qualified plans, or through your pre-tax deposit into the account.
- Decide how you plan to purchase property. There are three ways you can invest in a piece of real estate with a solo 401(k). The most basic option is a solo 401(k) cash purchase, in which you use only funds from your account to invest in the property. A tenants-in-common (TIC) purchase allows you to use both personal and solo 401(k) cash to invest in a property. (This option allows you to partner with individuals other accounts would consider “disqualified persons”, however you cannot use a mortgage or debt to purchase through a TIC.) Finally, you can also use a non-recourse business loan to purchase, or partially fund, your real estate investment. (This option protects your other investments and funds from bankruptcy or default should one of your properties fail.)
- Make an offer. This is where step one becomes vital – your solo 401(k) is the buyer of any real estate you invest in. Using your personal name on any documents related to the purchase is prohibited by the Internal Revenue Service (IRS).
- Make your deposit. As the purchaser, your solo 401(k) must make the deposit for the property. Make sure it has the funds it needs to do so.
- Complete the closing process as usual. As the solo 401(k) trustee, you need to submit any required purchase documents to your escrow agent, including the check from your retirement account. You should also personally retain copies of all documents in a safe place should you ever need them.
Expenses Related to Your Solo 401(k) Investment
When it comes to expenses related to your solo 401(k) real estate purchase, all payments must come from your retirement account. If you use your personal finances, the IRS will consider it an early distribution, resulting in penalties and taxes. This is easy, however, because of the checkbook control you get when you open a bank account in your solo 401(k)’s name.