Personal Finance

Growing Your 401k vs. Liquidating It to Invest in Real Estate: What’s More Profitable?

Expertise: Personal Finance, Personal Development, Real Estate Investing Basics, Landlording & Rental Properties
58 Articles Written
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Should you liquidate your 401k to start investing in real estate? This question has frequented the BiggerPockets forums over the past few years, eliciting mixed answers.

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Most financial advisors and older folks will tell you that it's better to contribute to your 401k and let it grow tax-deferred. Meanwhile, the younger folks in pursuit of early financial freedom are skeptical of this advice—and rightfully so.

The thought the young folks have is that if you are in your 20s and in pursuit of financial freedom, it is likely you will be financially free well before you hit the age of 60. Therefore, the amount in your 401k will not really matter. It will just be an added bonus as you hit your “golden years.”

As a Millennial, my initial thoughts aligned with these young folks. However, I do highly regard the advice of my elders, so before fully advocating for this, I figured it would make sense to do an analysis to see if the numbers make sense and to explore some other options.

In the first part of this article, I show you the analysis I performed comparing what your annual returns would need to be as a 25-year-old taking out your 401k to start investing in real estate.

You will see that at first glance, it may seem to make sense to liquidate the 401k, but be sure to keep reading, as there are better options. As a disclosure, I am neither a financial advisor nor a CPA. I am just obsessed with the notion of financial freedom and love exploring ways to expedite the journey.

Let’s dive in to the analysis.

Related: How to Use Real Estate to Retire MUCH More Comfortably Than Your 401K Would Allow

Assumptions

  • 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% annually

The Analysis

At 25 years old, you are probably taking your first steps in your journey towards financial freedom. Age 60 seems very far away, so you are likely tempted to take that out now and use it to expedite your journey towards financial freedom—especially after seeing the two tables below:

*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 assumptions mentioned above, the 25-year-old will have to earn 8.5% annually on his/her liquidated 401k to achieve the same type of returns as they would on their current 401k.

Is this achievable? Absolutely, especially with the wealth of knowledge here on BiggerPockets and the four wealth generators of real estate.

Hold on a second, though! It’s not black and white. Liquidate it or leave it. There are other things to consider including in your reserves, as well as other creative ways you can reap the high returns of real estate, tax-deferred.

First off, the reserves.

In order to qualify for any conventional-type loan that is sold to Fannie or Freddie, you need to have a certain amount of months of reserves (or liquidity). Lenders consider your 401k as part of your reserves, so losing ~40% of it through liquidation will be a huge hit. Not only that, but using what you have left for a down payment will be a double kill.

There is a high probability that this will either prevent you from taking out a conventional loan or at the least increase the cost significantly.

But don’t worry. There are better options.



Related: Real Estate Notes vs. 401k: Which Investment Wins Out Over 30 Years?

The Best of Both Worlds

In the analysis above, we assume your 401k is handled by a financial advisor and is diversified amongst a plethora of mutual funds, index funds, bonds, stocks, etc. that garner a return of 7%. The analysis suggests that despite the tax-deferred earnings, there is a high probability that you can attain a better annual return on a liquidated 401k (8.5%+) by investing it yourself.

Fortunately, there is a way for you to invest in these same high-yielding assets (i.e., real estate) with your 401k without taking the penalty. Rather than having your 401k held with a financial advisor and being diversified amongst asset classes that return ~7% annually, you can move it to a self-directed IRA or a solo 401k to manage yourself.

With these self-directed accounts, you can invest in almost anything. Even real estate.

Notice how I said almost anything. The one limiting factor is that you cannot get a conventional recourse loan with your 401k. That means that the low-down payment, owner-occupied loans are not available.

In other words, you CANNOT house hack with your 401k or self directed IRA. This is for investment property only so most lenders will require at least 15% down and sufficient cash flow.

But Crraaaiiiigg, I WANNA HOUSE HACK.

House Hacking with Your 401k

Good news! You can! Despite what I said above, you can still use your 401k to house hack. Just not directly.

How?

You can give yourself a loan from your 401k for the lesser of $50,000 or 50% of your 401k’s balance. This can help with your down payment on a house hack.

You will be paying your solo 401k interest of approximately 4.0%. This is certainly not the best use of your 401k money, but if you do not care much about the balance of your 401k and are looking to invest in real estate to achieve early financial freedom, this may make sense.

So, rather than going ahead and liquidating the 401k, use it to your advantage. The net proceeds you would get when taking it out and when taking a loan against it are almost equivalent. Still, by taking a loan against it, you are not getting penalized and your 401k is still growing tax-free.

Warning! Before making the loan request, be sure to talk to your lender. Taking a loan out against your 401k does reduce the amount of your reserves and therefore may impact your ability to get financing.

So, What Should You Do?

First off, I need to disclose again that I am neither an accredited financial advisor nor a CPA. I just love this stuff. While I am sure there are many ways to creatively use your retirement funds, I am sharing with you what I have learned and what seems to me are the most plausible scenarios.

The most optimal way to use your 401k is to either move it into a self-directed IRA/solo 401k or to take a loan out against the funds to help you invest in real estate. Which of those scenarios to choose is entirely up to you and dependent on your goals.

If your goals are to accumulate maximum net worth, then the self-directed account makes the most sense. Invest the solo 401k/self-directed IRA in real estate (or other higher yielding assets) tax-deferred. This way, you can experience both the phenomenal long-term returns of real estate as well as tax-deferred growth.

If your goals are to attain early financial freedom and you don’t care much about the returns of the 401k, it makes more sense to take the loan out against your 401k, use the proceeds from the loan to assist with your down payment, and pay your retirement account a relatively low interest rate of ~4%. Depending on the balance of your 401k, this will free up to $50,000 for you, which will be more than enough to get started on a house hack.

What’s your strategy of choice when it comes to the 401k—and why?

I’d love to hear from you in the comments!

Craig Curelop, aka thefiguy, is the author of The House Hacking Strategy and a driven pursuer of financial independence. Sta...
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    Mike Smith from Dayton, Ohio
    Replied almost 3 years ago
    Be Careful!!! I don’t know about all 401Ks but I know for a fact that they can be setup differently. One person I know of had a loan of about 25K out against his. The employer terminated the 401K program with almost no notice to employees. The loan of 25K was due immediately. He took a pretty good hit on this – had no knowledge that could happen. Point is call whoever administers your 401K (not just your employer but the company that administers it) and get all the facts about taking about a loan and what the exposure can be.
    Thomas Phelan Appraiser from Miami, Florida
    Replied over 2 years ago
    The Three Partners In A 401(k) Most of you realize that you, as a 401(k) Owner, are one of the partners. But are you aware you will have two other partners joining you at your Retirement Banquet Table? Partner #2, Uncle Sam. Partner #3, Wall Street. Which Partners control your retirement future? You certainly do to the extent of how much you contribute and can you weather the many seasaw storms of the Wall Street market over the next 20 – 30 years with up years of 20% (2017) and down years of 38% (2008) to finally arrive with an adequate nest egg. The difficulty with Uncle Sam as a partner is he can at any time and for any reason alter the percentage (tax rate) he expects to grab. With President Tump’s recent tax reduction from 39.6% to 37%, top rate taxes have never been lower except under Bush Jr. at 31%. However, low Fedreal income taxes are not the case over history. The top tax rate goes from 90% to 70% with President Carter to 50% under President Reagan. Before you spin you Quija Board to determine what taxes will be in effect 5, 10, 15 or 20 years from now read what the Congressional Budget Office says: “If Social Security, Medicare and Medicaid go unchanged, the rate for the lowest taxbracket would increase from 10% to 25%.” The CBO goes on to estimate a 25% rate would climb to 63% with the top rate skyrocketing from 34.9% to 88%. If Congress had evidenced tough fiscal restraint over the later 20-years I might consider the CBO statement exxagerated but with our current Congress having just added an additional 1.5 Trillion to an already bloated budget, the CBO prediction seems more likely than unlikely. The 2nd challenge is having Wall Street as a partner. If we look at the S&P 500, for example since 1999 and ending at the close of 2017, we see it has averaged 4.17% annual gain. Not bad when compared to a 1% CD or 2% Money Market account but during the past 18-years there have been many “Up” years and many “Down” years. If you had invested $100,000 in the S&P 500 in 1999 by 2007 you would have $117,000 and probably a good year to retire. But at the end of 2008 your $117,000 had been hammered down to $72,347, not a good year to retire at all. We all envision retiring when the DOW, NASDQ and S&P 500 are all all-time highs but counting on this is naïve, even foolish. What if you could convert your 401(k) money into future “Tax Free” income thereby removing an avarice Uncle Sam from your Retirement Banquet. You would never have to worry about Congress and tax rates again because they would be removed from your retirement equation. Can this be legally done? Yes, and the wealthy have known how for decades. What if you could convert your 401(k) money into a retirement vehicle that was indirectly involved with Wall Street, for example an Index Fund, but this fund never passed any losses on to you, only gains. You could have zero gain years but never years that refelceted a loss like the 38.4% by S&P 500 in 2008. Can this be legally done? Yes, and the wealthy have known how for decades. Finally, many posts tout how they have read numerous books about the financial and real estate markets but I have yet to see a book mentioned about how deceptive the 401(k) is even with Employer 100% matching funds. I suggest you begin to research such books and my first suggestion is; “The Power Of Zero” by David McKnight . In closing let’s see what the creator of the 401(k), a Mr. Ted Benna, has to say about his brainchild. “I knew it (the 401(k)) was going to be big, but I was certainly not anticipating that it would be the primary way people would be accumulating money for retirement 30 plus years later”. Mr. Benna was referring to the fact that the 401(k) was originally created by the wealthy to shelter highly taxed discretionary dollars. The 401(k) was not created to do the heavy lifting for retirement plans or serve as the primary retirement vehicle. It was designed to shelter highly taxes wages that could afford to be lost in risky Wall Street investments. The 401(k) was not created for middle management or employees. In a 2011 Smart Money magazine interview Mr. Benna where he candidly remarked about his brainchild: “My creation is a monster”. I leave you to your homework and remind you that creating active, even passive income is not the best or only answer. Having “Tax Free” Income should be the goal for all of us.
    Christopher Pound from Greater Denver Area, CO
    Replied almost 2 years ago
    I was faced with this very situation earlier this year, before reading this of course. In my case, I decided to liquidate and purchase real estate. I spent 5 years watching my 401(k) turned IRA go up and down between $123k and $133k. In my retirement years, I figure that any increase won’t be significant, and that this money can be better invested elsewhere. I could take any property appreciation, but also start enjoying cash flow immediately! Yes, I will have to absorb the taxes and penalty come tax time. i’m really looking forward to it. =) That said, I figure it’s a “cry once” situation, and in all my subsequent years I’ll be better off. Thanks for the article!
    John Murray from Portland, Oregon
    Replied almost 2 years ago
    I’m a multimillionaire, yup a real one. The concept is pay a minimum of taxes in all you do. Have multiple income streams and have the majority of your living expenses tax deductible. If you must have earned income reduce your tax liability as much as possible. Maximize your 401K and IRA allotment. Convert your 401K to an IRA as soon as possible. Convert your traditional IRA to a Roth. Pass through losses to pay for all your conversions. Emphasize capital gains the Feds give you a big tax break. If you can stay disciplined and give up luxuries you will become a multimillionaire. Take calculated chances based upon history because it will repeat itself. Here is a big hint, the years prior to Prohibition were driven by fear of immigrants changing the way of life in Middle America. Look at the fear in Middle America presently it is driven by immigration. I would have been a bootlegger.
    Frank S. Specialist from Chicago, IL
    Replied almost 2 years ago
    I think the article has good intentions, but there are some flaws. “Income Tax Rate: 30%” The Marginal Tax Rate and the Efective Tax Rate are two very different things. We pay the “Effecitve Tax Rate” not the 30% one. Becuase of thsi, the rest of the article loses strenght. The example given is for a 25 year old in the 30% tax bracket. This is such person, Single: $191,651 to $416,700 Head of household: $212,501 to $416,700 Take a look at the actual average income levels, 25-34 $39,416 35-44 $49,400 45-54 $50,024 “Annual Contribution to Other Liquidated 401k Investments: $2,100 because you save 30% less after the assumed 30% tax ” Again, “Effective Tax Rate” Other factors $3,000 at year 1 is not the same 35 years later based on simple inflation. It begs the question, why would someone making $190K – $415K contribute only 3K? Even if we disregard this, the actual compounded amount of $25K with a 3K contributions over 35 years at 7% is $710,654.92, not $490K. Compounding interest. Presented differently, 25K left alone will equal $266,914.54 at 7% compunding interest over 35 years. (No toilets, no managers, no insurance, no roofs, not midnight calls). I will be honest, accounting for inflation, this means $98,622 of today’s money with absolutely zero effort. Sure, you can sell your house in 2011 and take a hit or withdraw “parts” of your retirement in 2009. Here is where diversification, cash reservers, and bonds come to play. Presented it in a different way. This person making $191K to $416K maximizes the 401(K) contributions at $18.5K/year which compounded at 7% over 35 yeras. That means this person will have could have $3,003,313.54. Then, you expect the salary will increase as it’s very young. Then, this person can withdraw 4% at $120,000K per year and live just fine for the nest 30/35 years. A 401(K) is not the same than real estate, it is simply not a valid comparison. It would be like comparing the same 25 year old guy quitting his job at the $191K to $400K income presented and use only the $25K he had. In this case, is investing in your own job better than real estate, then? As I said, the article probalby had good intentions, Frank
    Michael Sherrill from Santa Monica, CA
    Replied 10 months ago
    Great discussion topic. Another consideration point for having 401k retirement assets is protections which can be useful if your rental business suffers a disaster (act of God, or man-made). 401k plans are covered under ERISA (Employee Retirement Income Security Act of 1974), so, that can offer substantial asset protection against creditors under federal law. Same logic folks use when suffering litigation and deciding to acquire a primary residence in Florida (primary residence in FL has better protection than elsewhere). If I were younger, I'd risk foregoing the 401k initially, to go more aggressive on RE, and use the RE income to drive a strong IRA-SEP. I think that provides a good antidote to future 401k worries, and even better, it's passively driven retirement investment vs 401k's active wage bias.