Personal Finance

How Retirement Contributions Are Saving One Real Estate Investor $53K in Taxes

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retirement-contributions

Should I put money into my retirement account or should I keep the cash to buy more real estate? This is a question that every real estate investor needs to look at from time to time. The answer will undoubtedly differ drastically from investor to investor. Here is a scenario that may actually shock you:

“James” was a new client I recently met with. James considered himself somewhat of a newbie investor. After going to medical school for many years, he was very excited to begin his career in the medical field. However, after practicing for only a few years, he quickly realized that medicine was not his passion in life.

Shortly after this realization, James came to learn about the benefits of real estate investing — and in just a little over a year, he had built an online marketing machine that was bringing him more deals than he had ever anticipated. For his first full year of being in the real estate business, James was projecting that his income from wholesaling deals alone would be close to $200,000. Sounds wonderful, doesn’t it?

Related: Bookkeeping For Investors: How to Keep Your Records Straight (& Maximize Tax Savings)

Well, if you add that to his already high W-2 physician income of $300,000, the total income of $500,000 puts him in the highest tax bracket for IRS purposes at 39.6% and for state tax purposes in California at 12.3%. For James, although it seemed like he would make a ton of money, this was only on paper. The net amount that he would get to keep after paying upwards of 52% in taxes was closer to $260,000. Can you imagine writing a check of over $200,000 to the IRS? Ouch!

As we dove into the tax planning side of things with James, we looked at one of the most powerful ways to reduce taxes — retirement strategies! Right as we started to discuss retirement planning strategies, James immediately indicated that this was not a road he wanted to go down. James was not fond of retirement contributions, and here is some of his reasoning:

  1. James wanted to keep his cash to invest in real estate, not in the stock market.
  2. His immediate goal was to purchase as many rentals as possible using leverage.
  3. James was a young guy in his early 30s. He felt there was still plenty of time to plan for retirement.
  4. James wanted to keep some of his cash since he and his wife planned on purchasing a primary home before the end of the year.

Now, some of you may agree with James’s assumptions above; however, tax strategies are never one-size-fits-all solutions. What works for one taxpayer may be a terrible idea for the next taxpayer. We convinced James to at least take a look at the numbers to get a more in-depth understanding of his options before deciding either way about putting money into a retirement account. Let’s take a high level look at what this all means.

tax-savings

Are Retirement Contributions Limited to the Stock Market?

With retirement strategies, there are ways to get a tax deduction, as well as ways to use the money for real estate investing. What we suggested for James was a self-directed Solo(k). This type of retirement account allows James to fund up to $53,000 into the account. Making a $53,000 contribution can save James close to $27,000 in federal and state taxes immediately. If James’s wife helped out in the wholesaling business, it may be possible for her to also fund up to $53,000 into her self-directed Solo(k) and reduce their combined taxes by another $27,000. What this does is it allows James and his wife to reduce current taxes due by over $54,000 immediately.

Furthermore, James and his wife would then have $106,000 in a retirement account that can grow on a tax-deferred basis. That can be an annual savings of up to 52% each year as compared to the alternative, which is to invest with regular after-tax dollars.

Can Retirement Investments Use Leverage?

One of the things that James did not know was that retirement money can be leveraged to purchase additional real estate. For example, James can use $53,000 of the money he just contributed into his self-directed Solo(k) as a down payment on a rental property. His retirement account can then obtain a loan and purchase a rental property worth $150,000. All of the income generated by the rental property can be earned by the retirement account and grow on a tax-deferred basis.

Related: Tax-Saving Strategies for Real Estate Investors: How to Pay Less & Keep More This Year

Just as an investor can borrow money and use leverage to purchase real estate, a self-directed retirement account may do the same. James’s self-directed Solo(k) is an ideal type of retirement account for this particular strategy. Keep in mind that other types of retirement accounts such as self-directed IRAs may also use leverage to acquire real estate; however, there may be some costly tax pitfalls associated with that, so make sure you work with your tax advisor accordingly prior to making any purchases within your retirement account.

Is James Too Young to Start Looking at Retirement?

James is correct that retirement for him will be many years away still. Although it may not be absolutely necessary for James to start funding his retirement today, there are definitely benefits to doing so. One of the benefits of retirement funding is the tax-deferred growth. This can be a very impactful benefit, especially for someone in a high tax bracket like James.

Instead of losing upwards of 52% of your return on investments each year to taxes, retirement accounts can allow 100% of your return each year to be reinvesting for growth. For real estate investors, there would no longer be a need to worry about depreciation or doing a 1031 exchange, as the income and gains would already be tax deferred. Based on James’s age, time is actually on his side, as he will have over 30 years of tax-deferred growth potential with respect to his retirement account.

Can James Access the Retirement Money Tax-Free and Penalty-Free?

One of James’ other reasons for not wanting to fund retirement account was because he and his wife planned on keeping some of that cash to use as a down payment to purchase a primary home. Once of the perks of having a self-directed Solo(k) is the ability to borrow from your own retirement account. For example, if James and his wife each contributed the maximum $53,000 into their retirement account for the 2016 year, they can potentially borrow up to $50,000 combined from their own Solo(k). That means rather than borrowing money from a bank and losing money on interest payments, James would essentially be paying interest to his own retirement account. The result is simply more money growing for him tax-deferred.

tax-extenders-2015

What Does This All Mean?

If we take a look at the numbers, James actually did not part with too much cash in this potential strategy:

-$106,000 Funded to retirement (outflow of cash)

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$53,000 Tax savings (inflow of cash)

$50,000 Solo(k) loan (inflow of cash)

-$3,000 Net cash outflow

After all that was said and done, James and his wife ended up parting with only a couple thousand dollars more in cash. What they did receive, however, was close to $53,000 in actual tax savings.

Please do keep in mind that we are not encouraging everyone to go out and pour lots and lots of money into retirement accounts. However, as you can see, retirement strategies can be a very powerful tool in the right scenario.

For more information on entities and tax strategies, check out Amanda’s book The Book on Tax Strategies for the Savvy Real Estate Investor — now available in paperback! For a limited time only, you will get access to TWO special limited time bonuses — “The Top 10 IRA Mistakes to Avoid,” an audio interview AND the video “How to Use a Self-Directed 401(k) to Fund Your Real Estate Deals.” That’s in addition to the standard pdf bonuses that are regularly available with purchase! Make sure to purchase by tomorrow, June 3rd, to receive access to these limited time bonuses.

Are you surprised by the numbers? Do you feel that James should contribute to his retirement account?

We would love to hear what you would do!

Amanda is a CPA specializing in tax strategies for real estate, self-directed investing, and individual tax planning with over 18 years’ experience. She is also a real estate investor of over 10 years with a focus on long-term hold residential and multi-family assets across multiple states. Formerly a tax advisor at the prestigious accounting firm Deloitte in the Lead Tax Group, focusing on tax strategies for the real estate industry and high net worth individuals, and at an international Fortune 500 Company in the high-tech industry in the Corporate Tax department, Amanda’s goal is to help investors with strategies designed to supercharge their wealth building. Amanda’s highly rated book Tax Strategies for the Savvy Real Estate Investor is amongst Amazon’s best seller list. A frequent contributor, speaker, and educator to some of the nation’s top investment and self-directed IRA companies, Amanda has been featured in prominent publications including Money Magazine, Realtor.com, and AllBusiness.com. Amanda was a speaker at Talks at Google and is a 40 under 40 honoree by CPA Practice Advisor, showcased amongst the best and brightest talent in the accounting profession. Her firm Keystone CPA, Inc. was awarded a two-time winner of the Top CPA of Orange County Award by OC Metro Magazine. She is certified by the CA State Board of Accountancy and is a member of the prestigious American Institute of Certified Public Accountants (AICPA) with clients across the nation.

    David Roberts from Brownstown, Michigan
    Replied over 3 years ago
    What about a Roth Solo 401k? I think with what seems like the USA heading toward a socialist society, and growing government, I fear larger taxes in the future. Maybe it makes sense to pay today and grow it tax free. Do they have roth solo 401ks? Are the limits the same? By the way, I listened to your BP podcast yesterday and it really was something that clued me in. I was thinking to just pay taxes and keep my cash ‘freed up’, even though I knew i could get an SD solo 401k to buy real estate in. I am always worried the government will change the laws, that money being locked up is money that can be fee’d to death, etc.
    Amanda Han Accountant from Fullerton, CA
    Replied over 3 years ago
    Yes there are Roth solo k accounts and max contribution by the employee contribution is $18k.
    David Roberts from Brownstown, Michigan
    Replied over 3 years ago
    Why is the roth version only 18k contribution but the one you mentioned is 53k?
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied over 3 years ago
    DAVID, With the Solo 401k plan the contributions consist of two parts: 1) Employee elective deferrals 2) Employer profit sharing contributions The limit on the first part is $18,000 as Amanda mentioned above, plus $6,000 in catch up for those who are over 50 years of age for a total of $24,000 max. This part can be contributed pre-tax (you get tax deduction now) or post-tax into Roth account (you pay the taxes now and grow your account tax-free for the rest of your life). Please note that not every Solo 401k plan comes with the Roth account. The plan documents must specifically allow Roth contributions. I agree with you that the chances are the taxes are going to be higher in the future than they are now so the younger you are the more sense it makes to make post-tax contributions because you have more time to grow your wealth tax-free. Your concern about the government laying their hands on private retirement accounts has it’s grounds also. However, with the truly self-directed Solo 401k plan there is no custodian and you as the trustee of the plan has total control over the plan assets. In other words you remove the middle-man and eliminate any chances of someone other than you touching your retirement investments. Hope this helps.
    Cameron Benz from Puyallup, Washington
    Replied over 3 years ago
    One thing you don’t mention is what the business structure he was doing this in. An LLC? type S? Just curious.
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied over 3 years ago
    CAMERON, Amanda is correct, any legal business entity is eligible to adopt a Solo 401k plan. This includes LLC, S-corp, C-corp, partnership, sole-proprietorship, etc. But the business must be active rather than passive in order to show earned income. For example: an LLC that is holding entity for rentals would not be eligible because rental income in it’s nature considered to be ‘passive’ and not ‘earned’.
    Amanda Han Accountant from Fullerton, CA
    Replied over 3 years ago
    Cameron, there are no entity specific requirements. The key is having earned income. Thanks for reading!
    Ally H. Property Manager from SF Bay Area, CA
    Replied over 3 years ago
    Under these circumstances, is the 53K subjected to self-employment taxes? Thank you for the great article!
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied over 3 years ago
    ALLY, assuming that you elect to contribute entire $53K pre-tax (not Roth) – then entire contributing will be sheltered from taxes. Contributions to a retirement plan are dollar-for-dollar deduction for you on your personal tax return and write-off for your business on your business return. Amanda can clarify this for you.
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied over 3 years ago
    ALLY, assuming that you elect to contribute entire $53K pre-tax (not Roth) – then entire contributing will be sheltered from taxes. Contributions to a retirement plan are dollar-for-dollar deduction for you on your personal tax return and write-off for your business on your business return. Amanda can clarify this for you.
    Colin E Stevenson Rental Property Investor from Clintonville, WI
    Replied over 3 years ago
    Frickin’ awesome article Amanda! Why pay interest to a lender when you can pay it to yourself?
    Amanda Han Accountant from Fullerton, CA
    Replied over 3 years ago
    Thank you for the feedback colin. I also like paying myself more than paying banks. 🙂
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied over 3 years ago
    Hi Colin, I agree with you that generally it is better to pay interest to your own retirement account than to some other lender. When it would not make sense to do so for example is when you can invest your retirement funds and get 10% return on your money and if you could personally borrow say at 5%. In this case you’ll be better not touching your retirement funds and just get a loan.
    Bill Tanner Investor from Farmington, Maine
    Replied over 3 years ago
    Great article! So, your 401(K) solo can loan you money to buy a property. Can your 401(K) pay your construction company to do the rehab on your property?
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied over 3 years ago
    Hello BILL, Assuming that the plan documents for your Solo 401k plan allow it, you as the plan participant may be eligible to take a personal loan from the plan. The loan is limited to $50K or 50% of the account balance, whichever is less. The loan proceeds can be used any way you wish, including buying a property. If you do this – this property becomes your personal asset, not an investment of the 401k therefore you can not use 401k funds to pay for the rehab of the property. If you have a self-directed Solo 401k plan however, it can buy an investment property. In this case the plan owns the property and the plan then pays all of the expenses related to this property, including rehab cost.
    Mike Lemieux Multi-family Investor from Somerville, Massachusetts
    Replied over 3 years ago
    Great article Amanda! We just funded are first Solo 401k and will be using it as our bank to continue building our portfolio. We used an firm that specializes in assisting with these structures on the first one, which cost us $1500, but it seems straight forward enough that we can do the next one on our own. Would you see any reason that an individual investor should not set up the account on their own once they have a custodian already in place?
    Mike Lemieux Multi-family Investor from Somerville, Massachusetts
    Replied over 3 years ago
    Great article Amanda! We just funded are first Solo 401k and will be using it as our bank to continue building our portfolio. We used an firm that specializes in assisting with these structures on the first one, which cost us $1500, but it seems straight forward enough that we can do the next one on our own. Would you see any reason that an individual investor should not set up the account on their own once they have a custodian already in place?
    Nicole Hui from Newark, California
    Replied over 3 years ago
    This was wonderful – thank you for the insight!
    Meagan Ruxer from Indianapolis, Indiana
    Replied over 3 years ago
    Great post! I am sad our government is going towards a possible socialist way. I feel making great money as a travel RN and investing in real estate I will be able to contribute toward 401k to reduce my tax bill next year. My boyfriend is a physician so I am going to inform him of these strategies. I only have about 17k now in my retirement due to a decrease in stock market, but I own an investment property.
    David Roberts from Brownstown, Michigan
    Replied over 3 years ago
    The thing i worry about with locking money up in accounts like these are you do lose some control even if it is self directed. If these institutions start asserting more/new fees what can you do? It happens now with employer 401ks. Pay the fees or take a distribution and pay thevtaxes plus 10% fee or whatever. Its something i worry about worry this stuff. Sounds great but there are always drawbacks too. The more this country moves toward socialism the more likely institutions will try to change the rules for money thar is locked in accounts like this.
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied over 3 years ago
    DAVID, your concerns are legitimate but there is a solution, with the truly self-directed Solo 401k plan you will eliminate the middle-man, the custodian or TPA and the risk of someone mishandling your money or just taking it away. This article explains the benefits in details: https://www.biggerpockets.com/blogs/2810/blog_posts/21298-solo-401k-advantages
    Jignesh Shah Real Estate Investor from Herndon, VA
    Replied over 3 years ago
    Amanda — As far as I know Solo 401k plans need earned income for contributions to such plans, hence how can the doctor’s wife contribute the maximum 53k when you’ve got 200k coming from this wholesaling business and the federal limit on his wife’s contribution, assuming 50% share of such income allocated to the wife which is perhaps a too-generous assumption, would be 20k (20% limit on her 100k share) only?
    Amy Hebdon from Seattle, Washington
    Replied over 3 years ago
    I have the same question. Even if he’s claiming the full $200K as his own income, he wouldn’t be eligible to contribute $53K for his own retirement using an employer deferral. Add his spouse to the mix and it re-divides, not multiplies, the contribution cap. I’m not a tax expert and I’m not saying these calculations are wrong, but I would love an explanation of how they are correct given contribution limits.
    Cassidy Burns Real Estate Agent from Washington DC, DC
    Replied over 2 years ago
    Hi Amanda, I have a question regarding the solo(K) contribution. Is this a good strategy to use for investors interested in monthly positive cash flow? If the property is owned by the retirement account will the cash flow go directly into that account or will the investor be able to access the cash flow to continue to gain financial freedom? Thank you!
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied over 2 years ago
    If the property is owned by the retirement account all income belongs to the retirement account. If you need income now you should be looking at buying a property outside of a tax-deferred account.
    Cassidy Burns Real Estate Agent from Washington DC, DC
    Replied over 2 years ago
    Thank you @Dmitriy Fomichenko
    Amanda Han Accountant from Fullerton, CA
    Replied over 2 years ago
    Hi Cassidy, Dmitriy is right, it makes more sense for those who do not need the cash flow right now for living or other needs as the goal is for the money to grow tax-deferred within the retirement account.