How Retirement Contributions Are Saving One Real Estate Investor $53K in Taxes
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?
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:
- James wanted to keep his cash to invest in real estate, not in the stock market.
- His immediate goal was to purchase as many rentals as possible using leverage.
- James was a young guy in his early 30s. He felt there was still plenty of time to plan for retirement.
- 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.
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.
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.
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!