SD IRA or 401K vs taking the tax hit on early withdrawl

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SD IRA or 401K vs taking the tax hit on early withdrawl

Investor · Tampa Florida · Member since 2013 · 68 posts · 30 votes

Hi folks - first post. I'm in Austin and new to BP.

I have owned a few SFH rentals and would like to expand my investments and am open to other types of properties.

If you had 170k in a 401K what types of deals might you consider and how might you structure the usage of that money?

I see the choices as:

1) Take several early withdrawals while paying the tax + penalty over a period of years and use those funds along with other cash to buy several SFH as the down payments accumulate. Advantage here is that I've paid the tax + penalty and the forward income can be used before retirement. I'm confident that when I retire the retirement age will be set to 99, the money will not buy a slap on the back and income taxes will be 99.9999% so while this might be a bit of sarcasm, I don't have a lot of confidence in the forward purchasing power of equities locked up in USD by the time I retire (I'm 45).

2) Setup an SD IRA or SD 401K while being aware of UBIT for the IRA case and leverage usage.

3) Leave the money in the capable hands of our prudent and conservative managers earning avg 4 to 6% / year (they really are great people). I'm concerned with bail-in announcements in the US and EU and being Corzined in another big down turn but then again I imagine all asset classes including RE will not get away from the blast damage in such another 2008 crash scenario.

Some things that appeal are the possibilities of using a large down to leverage into a multi-family with say more than 3 to 4 units. I do realize that there needs to be enough money left over in the SD IRA or 401k vehicle to cover any and all expenses on a monthly ongoing basis.

Thanks for your time.

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Will BarnardPro Member

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Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes

Originally posted by @Robert Leonard:

There is also a short time period (5yrs) that you have to pay the money back into your solo-k.

This is not entirely true. If the borrowed funds are used for a mortgage, then you can have the loan at a 15 year term, so simply record a deed of trust against a property and it becomes a mortgage loan.

Now, on to the question, while this is all just opinion, I would not suggest paying the taxes and 10% penalty. First off, for every one hundred thousand you have, you not only lose on the taxes owed, but just the penalty alone costs you $10k and to get that back, you need to have the $90k left (leaving out the taxes part) earn you more than 11% on that money just to break even. I am fighting to do my best to get as much into a tax advantaged account and here you are wanting to go the other way. Not sure why anyone would consider that other than an extreme emergency.

I am also of the opinion that holding RE inside a tax advantaged account like an IRS or 401k is not the best use of the funds. Buying notes and making loans is much better, again, that is an opinion also held by several others on this board. We have had many discussions on this topic here so please do search for them for details.

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Dennis Tierney
Investor · Omaha, NE · Member since 2011 · 475 posts · 211 votes
12y
I would not cash out and pay the taxes early as that will significantly limit the amount available to invest. A SD401K buying the property would work. Of course you'd have to find a friendly bank that would do a nonrecourse loan (not easy but doable). Do you have one you work with now that you could feel out for nonrecourse financing? I have a SDIRA in which I own several apartments and it has worked for me, but, there are some on BP that favor buying notes instead and not owning the property. You'll have to decide which matches your comfort/ability level. Good luck.
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Robert Leonard
Investor · Lafayette/Baton Rouge, LA · Member since 2013 · 1k+ posts · 915 votes
12y
@Cory Adams I'm close to being in the same boat as you, I'm 44. I have a self directed IRA, but my situation is a little different from yours. All of my retirement money is in the ROTH category, so my analysis tells me I'm best off with a Roth SD-IRA as opposed to a Solo 401k. With a solo-k, as they are called, you can only borrow up to $50k max or half of your balance (whichever is less) to use for anything you want without the limitations that come with an SD-IRA. There is also a short time period (5yrs) that you have to pay the money back into your solo-k.

NOTE: The option to convert your 401k only applies, in almost all cases, to an account from a previous employer, not your current employer.

Not a recommendation, just what I would do if I were in your shoes. I would convert my previous employers 401k to a traditional SD-IRA and use 80% to purchase 5-6 properties from a reputable turnkey passive income investment property company and use nonrecourse loans to finance the properties. That leaves 20% held as a cash reserve. I would have to pay UBTI, but it won't be a massive amount because I won't be making a huge amount of money in the short term. 15 years from now, those properties will all be nearly paid for, if not paid in full and I would have all of the equity and income to use as I see fit in retirement. Then I would withdraw from the retirement in whatever way had the least negative tax consequences.
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Account Closed
Accountant · Philadelphia, PA · Member since 2013 · 303 posts · 210 votes
12y
You could do an analysis where you take the after tax and penalties and use your expected cap rate on rentals to get a future value. Then find the future value of the $170k with a growth rate of 4-6% and compare them.

I would personally go with the SD IRA/401k if I did not plan to access the cash before the defined retirement age.
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Will BarnardPro Member
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Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
12y
Originally posted by @Robert Leonard:
There is also a short time period (5yrs) that you have to pay the money back into your solo-k.

This is not entirely true. If the borrowed funds are used for a mortgage, then you can have the loan at a 15 year term, so simply record a deed of trust against a property and it becomes a mortgage loan.

Now, on to the question, while this is all just opinion, I would not suggest paying the taxes and 10% penalty. First off, for every one hundred thousand you have, you not only lose on the taxes owed, but just the penalty alone costs you $10k and to get that back, you need to have the $90k left (leaving out the taxes part) earn you more than 11% on that money just to break even. I am fighting to do my best to get as much into a tax advantaged account and here you are wanting to go the other way. Not sure why anyone would consider that other than an extreme emergency.

I am also of the opinion that holding RE inside a tax advantaged account like an IRS or 401k is not the best use of the funds. Buying notes and making loans is much better, again, that is an opinion also held by several others on this board. We have had many discussions on this topic here so please do search for them for details.
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Will BarnardPro Member
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Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
12y
So now to answer this question: "If you had 170k in a 401K what types of deals might you consider and how might you structure the usage of that money?"

I would look for performing notes, buy at a discount, and earn double digit yields. I would also possibly make small rehab loans to investors at 12% interest and when possible! get points too thus increasing the yield. It would have to be a good portion of this $170k but I would also consider doing one or two rehab flips a year with the funds. So long as the intent of the account is passive in nature, doing one flip a year would not trigger UBIT. This would help increase capital for more passive investments.
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Cory Adams
OP
Investor · Tampa Florida · Member since 2013 · 68 posts · 30 votes
12y
Thank you all that replied.

@Robert this particular account has been moved to a custodian that manages the account through the purchase of funds and equities (no longer tied to the original employer). I could easily move that one to an SD vehicle. When you did your research regarding both SDIRA and SD401K (assuming I could move this SD401k to my wife's small closely held company) what advantages did you find in the SDIRA over the SD401K? I thought that the SD401K was better because if leverage was used the income for that leverage was not subject to UBIT as it is in the SDIRA case?

@Will your strategy makes a lot of sense for my situation because it allows for some shorter time horizon deals in order to build up more equity to make bigger purchases down the road. On a related note do you foresee the Dodd-Fwwwwank act impacting your ability to make these rehab loans?
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Dawn AnastasiPro Member
Rental Property Investor · Milwaukee, WI · Member since 2013 · 6k+ posts · 4k+ votes
12y
Originally posted by @Will Barnard:

Originally posted by @Robert Leonard:
There is also a short time period (5yrs) that you have to pay the money back into your solo-k.

This is not entirely true. If the borrowed funds are used for a mortgage, then you can have the loan at a 15 year term, so simply record a deed of trust against a property and it becomes a mortgage loan.

I am pretty sure that 15 years is only available for an owner-occupied mortgage whereas 5 years can be for everything else.
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Will BarnardPro Member
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Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
12y
Originally posted by @Dawn Anastasi:

Originally posted by @Will Barnard:

Originally posted by @Robert Leonard:
There is also a short time period (5yrs) that you have to pay the money back into your solo-k.

This is not entirely true. If the borrowed funds are used for a mortgage, then you can have the loan at a 15 year term, so simply record a deed of trust against a property and it becomes a mortgage loan.

I am pretty sure that 15 years is only available for an owner-occupied mortgage whereas 5 years can be for everything else.

According to info I have, that is not true, however, even if it was, simply record the lien against your personal residence, even if it is a third or whatever, now it is an owner occupied loan and better yet, guess what! You can now deduct the interest you pay yourself (your 401k) as mortgage interest (until the government takes that away from us).
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Will BarnardPro Member
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Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
12y
Originally posted by @Cory Adams:

On a related note do you foresee the Dodd-Fwwwwank act impacting your ability to make these rehab loans?

Not at all my friend, rehab loans will only go to non owner occupants for investment properties only and the new regs only affect owner occupants and second homes.
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Dawn AnastasiPro Member
Rental Property Investor · Milwaukee, WI · Member since 2013 · 6k+ posts · 4k+ votes
12y
Originally posted by @Will Barnard:

According to info I have, that is not true, however, even if it was, simply record the lien against your personal residence, even if it is a third or whatever, now it is an owner occupied loan and better yet, guess what! You can now deduct the interest you pay yourself (your 401k) as mortgage interest (until the government takes that away from us).

Meaning, used to purchase a primary residence (not simply slap a mortgage down on it), you have longer than 5 years. Otherwise you have 5 years.

Can you please cite the information that you have? I was referencing:

Investopedia

Wall Street Journal

IRS

I like to have sources to cite when getting information that conflicts with what I've read in the past.
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Will BarnardPro Member
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Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
12y
It has been a while since I looked at this so I don't remember what or where the info is to cite. I will have to dig that up.

As per your reference to the IRS doc which, of the three, is the only one that matters, note the first word in the paragraph:

"Generally, if permitted by the plan, a participant may borrow up to 50% of his or her vested account balance up to a maximum of $50,000. The loan must be repaid within 5 years, unless the loan is used to buy the participant’s main home."

It is true that "generally" 401k plans have these rules, but when you form a solo 401k plan, you as the administrator make the rules, I.e. Interest rates, how often you can borrow, terms, etc. Obviously you can't make any rules that violate any of the IRS rules. Employer 401ks are the most common and in general, the most restrictive. With a solok plan, you lose all those employer restrictions.
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Will BarnardPro Member
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Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
12y
@Steven Hamilton II perhaps he can chime in on this. It is possible I have incorrect info, after all, there was that one time when I was wrong! :)-
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Cory Adams
OP
Investor · Tampa Florida · Member since 2013 · 68 posts · 30 votes
12y
@Will Barnard the idea of borrowing against your SD 401k for a second/third against a primary residence with interest deduction is absolutely brilliant but I think the reading of that the second sentence stands on its own. It says 5 years unless used to buy. But wait there's more: Looking at the link for Pub 575 it doesn't look like you can take the interest deduction either... Look for Denial of Interest Deduction. I would really like you to be correct but I think @Dawn Anastasi has the correct reading, although we could ask 5 different IRS agents the same question and receive 10 different answers.

@Robert Leonard I don't want to loose your insight and research on which vehicle is better, in your opinion, within this thread.
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Will BarnardPro Member
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Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
12y
Cory, I just read IRS Pub 575 and there is a section that denies the interest deduction, I stand corrected and in the exemption for the loans, Dawn was correct that it must be for the "purchase" of a primary residence (it may be for down payment) and not just slapping a lien against an already owned primary home. This makes two times in my life I have been wrong! :)

Damn, now I have to find all the times I gave out this advice on this board and correct it, it was all wrong info. I will also have to find the x!@&# person who gave this info to me originally and give him a beat down!
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Robert Leonard
Investor · Lafayette/Baton Rouge, LA · Member since 2013 · 1k+ posts · 915 votes
12y
@Cory Adams while there are nearly no restrictions on how you spend/invest the solo-k funds you can borrow, you would only be able to use 50k of all of your money without restriction- that's pretty restrictive when you have a 170k account!

While I recommend maintaining a cash reserve, you can invest nearly all of your funds in the SD-IRA! I'm a disciplined investor and I like the opportunity to make some attractive returns on my retirement savings within the restrictions of the SD-IRA!

Why do I prefer owning properties as opposed to notes?

I havent followed the other threads that have argued the merits of either strategy, but heres my reason for my choice. I like making money as many ways ethically possible when I invest. If you follow my thinking, your retirement account gets five dimensions of growth for every property you invest in (just like regular buy/hold investments done right)!

1. Equity (that is added to your personal net worth from buying at a discount)

2. Income from rent

3. Tax benefits from depreciation and other write offs

4. Debt pay down by the tenant that builds your equity

5. Appreciation in value which normally happens over the long term when you buy in the right areas

When you buy notes, you get interest income and some added value from buying at a discount. Your liability risks are lower because you only own paper. But that's two dimensions of growth for each investment and the better the quality of the note the lower the discount(return).

It comes down to a matter of your personal risk tolerance. I'm a buy/hold investor inside and outside of my retirement plan. That's my thinking. Theres a wealth of knowledge that follows these boards, so Im sure if Im missing something, we'll both find out shortly!
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Joel DeLuca
Rental Property Investor · Longview, TX · Member since 2012 · 23 posts · 1 vote
12y
Is there tax benefit from depreciation when holding RE inside a SD-IRA? I understand that there is not since funds in an IRA are already tax advantaged.

This is a significant part of the profit equation, so I am asking to clarify.
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Will BarnardPro Member
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Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
12y
@Robert Leonard

You can eliminate item #3 from your list because the IRA or 401k is already a tax advantaged account and thus, you lose the tax depreciation benefits, one of many reasons why holding RE in this type of account is a disadvantage. Other disadvantages include your lack of ability to use leverage (finding non recourse lenders is difficult and can incur UBIT from UDFI), the IRS rules (as grey as they are) have many restrictions on items like usage, working on the home yourself as the IRA owner, disqualified parties, self managing, etc.

In buying notes, you can do so at a discount thus accomplishing item #1 & 2 from your list and item #4 from your list when the note is paid off early, thus increasing returns, so #5 is the only item on your list that you lose. Losing #5 in notes is outweighed by all the issues and responsibilities in holding RE, in my opinion.
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Will BarnardPro Member
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Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
12y
@Joel DeLuca

Per my post above, you are correct, no depreciation tax advantages inside the IRA account when holding RE.
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Robert Leonard
Investor · Lafayette/Baton Rouge, LA · Member since 2013 · 1k+ posts · 915 votes
12y
I do not see how you figure that you are getting anything more than 1 & 2 out of notes. We'll call that a difference of opinion. I was obviously wrong about #3. I'll still take my 4 out of 5 as better than 2 out of 5. That's just my opinion.
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Will BarnardPro Member
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Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
12y
Since item #3 does not exist here, the total on the list is now 4, not 5, so with holding, you get 3 of 4. With notes, bought at a discount, you get the first 2 and the appreciation is gained in notes (in comparison, not actual appreciation) when a borrower pays off a note early. Getting the principle back early allows the note holder to increase the return (to take the place of appreciation) and allows the note holder to buy another note at a discount again. I would estimate that when this happens, it outperforms any appreciation you would get in holding over the long haul. Lastly, you have a managerial and semi passive investment with holding, you have a totally passive investment with notes and very little chance to violate any IRS rules as opposed to land lording inside a retirement account. So the notes also get 3 out of 4 and stay totally passive (other than the purchase DD which takes place on both notes or holding)

Those are my arguments, we can certainly agree to disagree.
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Robert Leonard
Investor · Lafayette/Baton Rouge, LA · Member since 2013 · 1k+ posts · 915 votes
12y
If you read my original suggestion, I said to buy a turnkey property from one of the reputable turnkey passive income investment property companies that provide rehabbed occupied properties with property management. That's totally passive. I never suggested trying to do any of the things that I know are not allowed in an SD-IRA. That negates all of what you call "disadvantages."

Okay, if you take one out of my 5 points, if your sources are right? That still leaves 4/4 that are accurate. Is this becoming a disagreement about elementary math?

Do you think that an early payoff of a hold investment wouldn't be reinvested? Why not? You're introducing a new factor (early payoff) without considering that the early payoff of a non-recourse loan, could be reinvested just like you use to add a point to your course of action. So your +1 = my +1 too - It's a moot point.

There are 7 non-recourse lenders found on this page:

http://www.sensefinancial.com/non-recourse-lenders/
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Ali Boone
Real Estate Coach · Venice Beach, CA · Member since 2012 · 6k+ posts · 3k+ votes
12y
I would definitely change the money into a self-directed IRA and buy through that or I would just take a loan out on the 401K. The interest you pay on that loan only goes back into your own account, so you are just paying yourself interest.

If you take an early withdrawal and have to pay those taxes and penalties, that will severely cut into your profits from an investment property.

But, I'm with you on that 99.9999% tax thought for the future. So, it may be a toss-up. Lol.
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Cory Adams
OP
Investor · Tampa Florida · Member since 2013 · 68 posts · 30 votes
12y
Just a quick point of clarification I was originally asking Robert why he thought the SDIRA vs SD401k was the way to go. I was not comparing borrowing against a 401k and moving the 401k into an SDIRA. From what I have read if you have a closely held company that you can move an existing 401k to (from a previous employer you have left) to either a SDIRA or SD 401k. The SD401k was not subject to UBIT if you used leverage buying with a non-recourse loan. Thanks again folks and great posts.
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Will BarnardPro Member
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Developer · Santa Clarita, CA · Member since 2008 · 15k+ posts · 10k+ votes
12y
Robert, there is no need to get defensive, we are strictly having a general debate between investing retirement funds in holding RE vs. notes or similar. Your personal situation or how you personally buy from turnkey sellers is irrelevant. Your math comment is also out from left field. I am not at all saying that your way is wrong and mine is right.

With that said, I was merely pointing out that a self directed IRA or 401k owner must be aware of all the IRS guidelines regarding buy and hold RE and be careful not to violate any. Further, I pointed out that some of these rules have many grey areas so an unintentional violation can more easily take place than with investing in notes. It was not to say that you would or have violated any of the rules yourself.

Lastly, you make a valid point that when the equity position grows high, you can pull out via refi and buy more thus matching one of the note advantages. So from a total possible advantage number of 4 from our new list, holding retains them all while note investing or similar only holds 3 of 4. Now, one could argue that of each of the 4 possible advantages, one may utilize each of the 4 advantages better, thus making the total count not as important in factoring which way wins or loses.

For example, having property management, an IRA owner must still manage the manager and make decisions that are not solely in the hands of the PM. This takes some time, effort and responsibility that does not exist in notes on a month to month basis. Having less to worry about IRS guidelines, though a tiny benefit to notes over holding, is another. Lastly, and most importantly, finding buy and hold RE at a 10 cap or better is not an easy task. I could easily argue that the higher that cap got (thus creating more cash flow), the lower the chances of any appreciation. Conversely, it is not difficult at all to find over 10% yields on performing notes or trust deeds, thus, the advantage of cash flow for each appears to be more advantageous on the note side in my opinion..
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David Beard
Investor · Cincinnati, OH · Member since 2010 · 1k+ posts · 928 votes
12y
@Cory Adams somewhere you made a comment about moving your 401k funds to a SD401k under your wife's business entity. This is not possible. The sponsoring company needs to be yours, and you need to be the sole employee. That said, it's very easy to set up a tiny business of almost any sort to be the sponsor, and I would strongly encourage you to go this route.

You can have checkbook control with an SD401k, without having to set up an LLC (with its ongoing fees) as you do with an SDIRA. In fact, there is not one advantage I am aware of for rollover qualified funds, for an SDIRA versus a SD401K. I used www.mysolo401k.net to set mine up, and have been very happy. They'll even set up any loans you take against the 401k for no additional charge. You avoid ongoing custodial fees (and LLC fees if you want checkbook control, and believe me, YOU DO) with the SD401K, just run everything through an account at your local bank.

There is also "ROBS", rollover for business startup, a creation of the tax code that allows you to use your retirement funds to invest in a business. This is more expensive to set up and requires a C-corp, but you might want to include it in your research. The large majority of new franchise businesses are being funded at least partially with ROBS money these days, as many laid off corporate execs start businesses. So it's a very common thing and plenty of CPAs and attorneys can advise on this. It's really the only way you can keep your qualified funds inside the account, while still creating a way to generate salary income for yourself.
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