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Investing in real estate is a great way to create wealth while diversifying your portfolio of stocks, bonds, and other securities. But if you’re considering using a 401(k) or IRA as a vehicle for investing in real estate, you need to consider what you get and what you give up in doing so.
There are many ways to invest in real estate. Keeping these investments in a retirement account can sometimes work, but it can also be a big mistake.
Do not purchase physical assets directly
You can use a voluntary IRA or 401(k) to purchase physical assets, but that’s probably not a good idea. That’s because investing in rental properties has some great benefits, but is somewhat limited if you own them in your retirement account.
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The first advantage is cash flow. A good property investment will generate positive cash flow most months. Unless you have major repairs or extended vacancies, you’ll find yourself getting steady rent checks coming in that more than offset the costs.
You can use that cash flow to invest in more rentals or buy assets such as stocks and bonds. , and pay for what you need. Investing in a rental property through your retirement account limits your cash flow options. Unless you’re old enough to withdraw your money without penalty, you’ll need to reinvest it in something else.
The second benefit is the tax savings on rental properties. You can offset your earnings with many expenses. This includes mortgage interest paid and depreciation of assets (even if they actually appreciate in value). With a tax deferred retirement account, you don’t have to pay taxes until you withdraw your funds, but you also can’t take advantage of some tax benefits. Therefore, you may end up paying more taxes in the long run as a result.
Other considerations
In addition, another advantage of investing in physical real estate is that you can move to the property if you need to. If you held property on a 401(k), it would be prohibited. It also means you can’t qualify for the lower interest rates offered to people buying prime residences. It cannot be moved into the property for two years before the sale.
Not being able to live in a property held under a 401(k) or IRA also means that investment strategies like live-in flips won’t work. Again, a big benefit of this investment strategy is minimizing taxes. As a result, you may not be able to take full advantage of the benefits of a retirement account.
Two Great Ways to Invest in Real Estate for Your Retirement Account
That said, there are ways to gain exposure to the real estate market that are better suited to retirement accounts. That’s because you don’t get the tax benefits of buying and leasing physical real estate directly.
If you are looking for exposure to an individual real estate investment, you can write a private memo through a self-directed IRA or 401(k) for other investors. For example, someone investing in a rehab project may not be able to get a fixer upper conventional mortgage. , may be able to generate very high returns.
The advantage of doing this with an IRA or 401(k) is that you can defer income tax on the interest collected on these notes. Unlike direct investments in real estate, there is no way to offset the returns.
Similarly, you can invest in a REIT with a 401(k) or IRA. REITs must pay 90% of their taxable income as dividends to shareholders. These earnings are passed on to shareholders and are therefore generally not subject to the lower qualifying dividend tax rates. Investors must pay normal income tax rates. By holding a REIT in your retirement account, you can defer taxes, save more money to invest in the short term, and lower your tax rate in retirement.
If you want to put real estate in your retirement account, the best way to go is with income-generating assets without tax benefits. Investing in physical real estate is great outside of a retirement account where you can maximize your tax benefits and cash flow.
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