Should you be using your 401k to invest in real estate? - Irby Home Buyers

Should you be using your 401k to invest in real estate?

Should you clear your 401K to start investing in real estate? We get this question all the time from Irby LLC customers and potential customers, and we’re going to clear up what the answer is to this steaming question.

You can ask a majority of financial advisors and older people, and they will tell you to contribute to your 401K and allow it to grow tax-deferred. However, the younger generation is in pursuit of financial freedom now and are rightfully skeptical of this traditional advice.

Many young people think that if you’re in your 20s seeking financial freedom, it is probable to get there before you hit the age of 60. Therefore, it doesn’t matter what amount you have in your 401K. They look at it as a bonus when you run your “golden years.”

I can see how many millennials’ initial thoughts will align with this. However, it is still essential to take into consideration what elders have to say because they do make sense. You should do your analysis to see if the numbers are feasible or if you should explore other options.

The first portion of this article will show you an analysis that compares what your annual returns need to be at 25-years-old taking out your 401K to start investing in real estate.

At first, it may appear to make more sense to liquidate the 401K, but continue to read to see the other options you have. As a disclosure, in no way, shape, or form am I a financial advisor or a CPA. I love the notion of economic freedom and exploring ways to speed the process up.

Let’s get into the analysis.

Age: 25 years old
401k Balance at Year 0: $15,000
401k Return: 7% assumes 401k is held in stocks, bonds, mutual funds, etc.
Income Tax Rate: 30%
Capital Gains Tax Rate: 15%
Withdrawal Penalty: 10%
Annual Contribution to 401k: $3,000 pre-tax
Annual Contribution to Other Liquidated 401k Investments: $2,100 because you save 30% less after the assumed 30% tax
Tax Savings from Reducing Income by Contributing to 401k: invested and earning 7.0% annually

Financial freedom is probably just beginning if you’re 25 years old. You probably can’t imagine being 60-years-old because it seems far away so the two tables below may make you want to expedite your journey towards financial freedom:

*Calculated by (Investment balance X Tax Rate) + (W2 Savings – Taxes Paid on Gains)
*Calculated by (Investment Balance – Annual Contributions) X Capital Gains Tax
** Calculated by (Taxable Return Exclusive of Contributions + Contributions)

Given the example above, if you’re the 25-year-old, you will have to earn at least 8.50% annually on his or her liquidated 401K to achieve a similar type of returns you would on your current 401K.

Can this be achieved? Of course, especially with all of the knowledge you gain from Irby LLC.

But, hold on a minute because there are gray areas. Leave it or liquidate it. There are plenty of things you’ll need to consider including in your reserves and ways that can creatively produce high returns of real estate, tax-deferred.

Let’s discuss reserves first.

It would help if you always had a certain amount of months reserves or liquidity to qualify for any conventional-type loan. This is one way your 401K is considered by lenders as part of your reserves, therefore, losing 40% of it through liquidation will be a huge hit. Not only that but having to use whatever you have left for the down payment will be a double kill.

There’s a high chance that this will either increase the cost significantly or prevent you from getting the conventional loan.

Don’t worry. There are way better options.
Have The Best of Both Worlds

For the above analysis, we’re assuming your 401K is being handled by a financial advisor and is diversified amongst mutual funds, bonds, stocks, index funds, and more that will garner a return of 7%. Per the analysis, there is a high probability that you will be able to get a better annual return on a liquidated 401K if you invest it yourself even if it is tax-deferred earnings.

There are ways that you can invest in these same high-yielding assets such as real estate with your 401K without penalty. You have the option to have your asset classes that return 7% annually as a self-directed IRA or a Solo 401K you manage yourself; this is an excellent alternative to having a financial advisor. You can invest in nearly anything, even real estate, with these self-directed accounts.

Realize how I said almost anything. The primary limiting factor is that you can’t get a conventional recourse loan by using your 401K. All that means is the owner-occupied, low-down-payment loans are not available. What I’m trying to say is that you CAN’T house hack with your self directed IRA or 401K. This is only for investment property, so most lenders require at least 15% down and sufficient cash flow.

But Rhhheeennn, I WANT TO HOUSE HACK.
How to House Hack with Your 401K
I have some great news! You can! Regardless of what I previously said, you can still use your 401K to house hack, but not directly.

How do you do that?

Give yourself a loan from the 401K for 50% of your 401K’s balance or the lesser of $50,000. That will help you with your down payment on a house hack.

You’ll pay your solo 401K interest of approximately 4.0%. This isn’t the best use of your 401K money, but if you don’t care about your 401K’s balance and looking to invest in real estate to get early financial freedom, then this makes much sense.

Instead of liquidating the 401K, make it beneficial to you. Taking a loan out against it is equivalent to the net proceeds you get when taking it out. Even so, you are still not penalized by taking a loan out against it, and your 401K can continue to grow tax-free.

However, be warned, before making any loan request be sure to talk with your lender first. Taking loans out against your 401K does lower the number of your reserves and will impact your ability to get financing.

What Should I Do Then?
Again I am no accredited financial advisor or CPA. I love this kind of stuff. I’m going to share what I have learned and what seems like more plausible scenarios to me even though there are probably many ways to utilize retirement funds creatively.

The best way to optimize using your 401K is to either take a loan out against the funds to assist you to invest in real estate or move it into a self-directed IRA or solo 401K. Which scenario you decide to choose is entirely up to you and your goals.

If one of your goals is to accumulate maximum net worth, then a self-directed account makes the most sense. You should invest the solo 401K or self-directed IRA in real estate tax-deferred. That way, you can experience the extraordinary long-term returns of tax-deferred growth and real estate.

If your goal is to attain early financial freedom and you aren’t concerned about the returns of the 401K, it makes the most sense to take the loan out against your 401K. Go ahead and use the proceeds from the loan to assist with your down payment, and pay your retirement account with a relatively low-interest rate of 4%. It depends on the balance of your 401K whether this will be free or up to that $50,000 for you which will be more than enough to get you started house hacking.

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