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Retirement Savings - How to invest in real estate with your 401(k)

Retirement Savings - How to invest in real estate with your 401(k)

Your 401(k) is a savings plan that is set up through your employer and is used by millions of Americans to help plan for their retirement. It is designed to work in a tax advantaged way to boost your savings and help ease your transition from working to retirement. Your investment choices within your 401(k) are limited to what is offered by your plan sponsor (employer) and the service provider. To invest in real estate, you will probably be limited to a REIT or real estate fund at best. However, there is another way.


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401(k) Basics: Most employers consider their 401(k) to be a major employee perk and is used to both attract talent and retain workers. If your employer has a 401(k) plan be sure to participate as soon as you are eligible to do so, or you are likely to regret it.


How it works: Your employer together with a service provider – usually a major financial institution (like Fidelity Investments, Vanguard, Charles Schwab, etc) – puts the 401(k) plan together and registers it with the IRS. It is a defined contribution plan and usually your employer will match (at least partially) the employee portion.


Retirement Savings - How to invest in real estate with your 401(k) | How it works

The IRS allows you to take a tax deduction at income tax time in the amount that you contributed. Right away this lowers the amount of income you have to pay tax on and may even drop you into a lower bracket, decreasing the amount of tax owing overall. Not only that but your investments will grow tax free while they remain inside your 401(k). If your plan is a Roth 401(k) then your contributions are made with after tax dollars so you don’t get to take the deduction but there is another benefit that will become clear when you make a withdrawal.


Contribution Limits: The maximum that an employee is allowed to contribute in 2020 is $19,500 (or $26,000 if the worker is over 50 years of age). The maximum joint – employee and employer - contribution is $57,000 (or $63,500 for those aged 50 plus). The average 401(k) is set up so that for every dollar contributed by the employee the employer will kick in 50 cents up to a limit. They are not all like this as they will vary from employer to employer so be sure to investigate the details of your particular plan.

Often the plan will look something like this: You can contribute up to 6% of your salary and if you do your employer will match that with a 3% contribution. If you participate in a plan like this then you are essentially giving yourself a 3% raise on your salary. You’d be crazy not to do this. Another way to look at this plan is that your retirement savings will earn at least 50% per year on its investments and that is before taking into account how the market has performed. Anyone will tell you that a 50% yearly return on investment is unheard of and truly astounding performance.


Withdrawals: Does it sound too good to be true? There is a catch. The IRS allows all these tax deductions and tax-free growth because they get their money when you make a withdrawal. When you pull money out of your 401(k) the IRS considers this to be regular income for your and you must pay income tax on your earnings. There is another catch as well. 401(k) plans are intended for retirement only. If you make a withdrawal before you reach the age of 59 ½ years you will not only have to pay income tax but also a 10% penalty as well.


Retirement Savings - How to invest in real estate with your 401(k) | Withdrawals

There are number of events that allow for a withdrawal without penalty.

  • Employee reaches age 59 ½ years.
  • Employee retires.
  • Employee dies or becomes disabled.
  • Employee experiences a specific hardship as defined under the plan.

You can also make a withdrawal if:

  • Employee leaves job.
  • Plan is terminated.

Because of the global COVID-19 pandemic, the CARES act allows you to withdraw up to $100,000 from your 401(k) plan without having to pay the 10% penalty. You will still have to treat the withdrawal as income and pay tax on that sum, but you will have 3 years to pay that income tax to the IRS.

If you have a Roth 401(k) then your withdrawals are totally tax-free. The IRS got their money before you made your contributions to the Roth 401(k) so they don’t take it again when you withdraw. This can be a huge bonus since you don’t pay tax on your investment gains within the Roth 401(k).

If you leave your job or the plan is terminated before you reach 59 ½ years of age the best thing you can do is to rollover your funds into a new 401(k) plan with your new employer or do a direct transfer to an individual retirement account (IRA). You will not have to pay income taxes if you do this.


Investment Options: The vast majority of service providers will only allow you to invest in their particular mutual funds, index funds or ETFs. While you cannot invest in real estate directly you may be able to buy a fund that pursues a real estate strategy. Something like the Vanguard Real Estate Index Fund, iShares US Real Estate ETF or the Schwab US REIT ETF for example.


Retirement Savings - How to invest in real estate with your 401(k) | Investment Options

Old 401(k)s: When you leave your job, or if the plan is terminated, rather than cashing out your investments (and having to pay tax) you should roll them over into a self-directed Individual Retirement Account (SDIRA). You have many more investment options within a SDIRA including real estate, crowdfunded real estate investments, tax liens, private equity placements, precious metals and even cryptocurrencies.

Your SDIRA will enjoy all the same tax benefits that your 401(k) did including not having to pay capital gains tax on any property that you sell within your IRA. And if you have a Roth IRA then you won’t have to pay any taxes whatsoever at any time. This can be a game changer since property can sometimes experience massive appreciation in just a few years.


Conclusion: While you can’t invest in real estate directly with your 401(k) you may be able to purchase your service provider’s funds that do pursue a real estate investment strategy. When the time comes for you to leave your place of employment be sure to rollover your investments into a SDIRA as you will have vastly more investment options to choose from. Investment real estate is an excellent choice as the returns can be even better than the stock market all while being more stable and secure. Real estate follows different market cycles than stocks and so can provide some much-needed diversity in times of unwanted stock market volatility. If you purchase rental property it can provide a steady stream of income into your retirement accounts that will protect you from inflation and provide for your golden years well into the future.


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