Is it worth losing 40% to get cash?

21 Replies

I'm in the middle of a divorce. I'll be receiving between $250,000 and $300,000 from his 401 K, IRA and money market accounts. I don't have a retirement account and don't want to have to open one in order to receive the funds. I want cash to start investing in RE. I will need it for income after the alimony runs out, so a self directed IRA won't work from what I understand. I spoke with a CPA and was told that I would lose 40% in tax and penalties. Is there any other way, so I don't lose $100,000+?

@Maggie H.  

It is not very wise in my opinion to lose 40% to taxes. I would not pull the money out since you don't need them. If it comes to the point that you will have to pull some of the cash, you can do so then and only pay taxes and penalties on the amount that you pull out and not on the entire balance. 

@Maggie H.  sorry to hear about your divorce.

I agree with @Dmitriy Fomichenko that it costs too much to take that tax hit when you have other options. It is very easy to open an IRA account to receive the funds without taxes or penalties. Yes, it will still be retirement money, but it's still all yours. You will have an advantage in that lenders will consider retirement funds as cash reserves, which they really are. But I would only touch them in a dire emergency situation.

Patience is a very important virtue in REI. Take your time and explore options using other people's money that will cost you less than using your own retirement money. The penalties make it extremely expensive money to invest with. I'm sure Dmitriy can help you set up a Solo401k where if you put 100k (without penalties) you could use 50k for any purpose including active investing that you benefit from now.

Here's the question you have to ask yourself: should I invest with an HML who charges me 40% interest or look for a better option?

To make up for losing 40%, you would need to almost double your money just to break even. Doesn't make sense. Open a self-directed IRA and put 100% of the money in there. Search this site for "self-directed IRA" for more info.

**I am not a financial planner. Consult with your financial planner before making any decisions based on this recommendation***

Won't she lose 40% regardless because it's not her money she's getting? I'm assuming the 401K and IRA were not in her name.

And this is why I wouldn't marry in America...

Just put the money into another retirement account and either borrow against the account for the money you need or buy properties and hold them in the retirement account.

@Dawn Anastasi  

401(k) distributions under a QDRO (Qualified Domestic Relations Order), such as a divorce settlement, can be rolled over to an IRA, within 60 days of receipt of funds, without penalty and the tax will continue to be deferred.

That's good stuff to know.  Sounds like if I ever get married, it's in my best interest to have a per-nuptual agreement if someone could take half my 401k!

Unless you desperately need the cash I would not take it out of a retirement plan. Or, take only enough to cover the desperate need. Roll it into an IRA. You can invest in real estate in an IRA, though I think its not the best idea. Using it to make loans to rehabbers is, IMHO, a better alternative than actually owning real estate in an IRA.

You might look into a Solo 401k.

@Maggie H.  

I would definitely roll into an IRA, if only to keep your options open. You only have one chance to get this right. You can always take the money out of the IRA and pay the interest & penalty. Depending on your effective tax bracket, it could be less expensive to take it out over several years.

Besides the tax hit you would take now, I would consider the lost opportunity of tax-deferred compounding on a significant sum.  And we're all going to get to 59 1/2 some day.

You could also look into opening a solo 401(k) and roll over into that.  You could borrow up to $50K from the plan to use as a stake in investment outside the plan.

@Dmitriy Fomichenko  

@Robert Leonard  

@Kimberly H.  

Thanks so much for your input. 

Dmitriy and Kimberly, I think the idea of a self directed IRA is most likely the best way to go then, but may consider Robert's suggestion with regard to investing a small part of it once the divorce is final. What is HML? I'm a newbie!

One problem I will have at the outset is, I will need a place to live when I move back to Upstate NY. I have a SF home in a C class neighborhood, which was my primary home for several years before I met my husband.  I've had the same tenants there for 13 years. I'd sure hate to 1) Move into that neighborhood again after many years living in an A+ neighborhood   2)Have to kick my elderly tenants out. Any suggestions?

@Maggie H. you are in a dangerous situation here. Unless you really know what you are doing, investing in RE can be a way to lose the rest of your net worth. If you want to be a RE investor it is best to dip one toe in the water and see how it feels. In the meantime protect those assets by rolling them into another IRA.

Best to cut your living expenses to the bone and figure a way to generate some income other than those funds. It could easily take the rest of your life to replace those funds once they are gone. Good luck.

Some of your advice doesn't make sense to me being a newbie. What's the difference between a solo 401K and a self directed IRA? I like the idea of loaning to rehabbers and would like to know more about it. And borrowing from the plan makes sense. Perhaps I should invest in a financial planner to help me out. I'm a bit nervous about that, because who can I trust?

Dmitriy Fomichenko was your first response

I'm 53 years old and unfortunately, am limited physically when it comes to working an outside job. My original plan was to fix and flip. With help from Biggerpockets' books, blogs and community help, along with finding a mentor and creating a team, I believe REI is the best option for me. I'm not planning on going in blind. That's why I'm asking for advice!

Originally posted by @Maggie H.:

Some of your advice doesn't make sense to me being a newbie. What's the difference between a solo 401K and a self directed IRA? I like the idea of loaning to rehabbers and would like to know more about it. And borrowing from the plan makes sense. Perhaps I should invest in a financial planner to help me out. I'm a bit nervous about that, because who can I trust?

With a Solo 401k you can borrow up to $50k, but not more. In an IRA you can't borrow anything. So you have to determine if the $50k is worth it. It may be. It may not be.

I'm going to go against the grain here and say I'd cash it out.

Take the hit and you'll make it up with some good buy and hold investments - provided that you will be able to qualify for loans. 200k will go pretty fast if you are paying 100% cash for your properties.  

But lets say you're able to find 10 deals. Each one you pay 80k for a house that appraise out at 115k (70% LTV) and you can get by with putting down 25%. Thats 20k out of pocket per deal. That would let you buy 10 houses. Lets say those houses - after the 25% down payment - would each cash flow about $500/gross profit per month. So 300/month net?

That would give you a net worth of roughly 550k total (60k loan on each house that was worth 115k = 55k equity per house times 10).

So now you have 550k in net worth. You have income of 3k per month - almost all of which would be tax free. 

How's that for cashing out and taking the hit.

I'm not sure if it would work though because it obviously relies on you being able to qualify for the loans in the first place. Not sure if the alimony would be enough to do so.

But, if you could, then there is definitely a case to be made for taking the money out now and taking the hit. And then using the rentals as your retirement plan. That cash flow of 3k a month is only going to grow over time as rents go up and your payments stay the same.

550k in equity and 3k a month in tax free income is a pretty good return in my book on that money. 

Just saying...... :-)

@Mike H.  that's a real "pie in the sky" set of numbers you put up.  Do you think it's possible to go out as a financed buyer and buy 10 properties worth over 100k at a 30% below value with no repairs needed?  And in the end to have no cash reserve because you suggest spending every dollar available?

Rental income is taxable income.

This scenario does not present a strategy - it is wishful thinking.

@Maggie H.  One thing people are missing here is that it is not as though the money will be tax free later down the road.  It is not a question of 40% taxes or no taxes.

You wouldn't have the penalty.  That would save you some.  You may be in a lower tax bracket.  That would save you some.  But you'll still be paying taxes.

I plan on being in a higher tax bracket when I retire, so all I'd be worried about is the penalty.  (Yes, 401K grows tax deferred, but I can still do better non tax-deferred in real estate.)

So is the penalty, and maybe extra taxes from being in a higher tax bracket worth it?

@Maggie H.  

I personally recommend ignoring those suggesting you cash out. You are a self-proclaimed newbie (as am I) when it comes to REI. As it was mentioned above, you only have 60 days to roll over this money without incurring the penalty. Take some time to learn the math behind REI. Once you have an understanding of the math, you will realize just how hard it is to come out ahead if you cash out.

@Robert Leonard    Hmmm.  You're correct about the houses not needing repairs. I should have been more clear.  When I gave that 80k number, that was meant to be an all-in number (purchase plus repairs).

As for the rental income being taxable, you must not have any rentals.  By the time you add depreciation in, you're essentially showing little to no profit at all on your rentals based on those numbers.   

Again, it requires you to take out a loan so you have mortgage interest deduction. But essentially, you're not showing any actual profit at all - especially if you use accelerated depreciation.  Based on the numbers I gave above, I don't think any of the rental profits would end up being taxable - at least not in the first 5 years or so.

I've been doing this for 7 years and have yet to show a profit when factoring in depreciation. In fact, I've been able to use losses (and these are true paper losses due to depreciation) from my investing to offset my day-job income. 25k per year every year after year 3 (it took a few houses to get to the 25k number loss).

Bottom line is that if she were to cash that 401k money out and take the 200k and if she could qualify for the loans (that was one of the big caveats I put in my post), she would come out WAY AHEAD with real estate than with leaving that money in the 401k. At least if she did it the way a lot of people I know are doing it - including myself.

Not advising her to do that because I realize most people don't have the risk tolerance I have. But at the end of the day, the numbers are FAR better doing it than not.

And btw, I have the perfect example of what you can do with cashing out your 401. I did it! I actually cashed out 55k of my 401k about 18 months ago after I switched jobs. That 55k was used to pickup 13 more houses. I went from 17 to 30 houses in the past 18 months.  

And here are the numbers for just those 13 houses:
Total Appraised value: 1.8 million
Total loan amount for the 13: 1.16 million
Rents: 17,650/mo
Gross profits: 6,200/mo

Two key things. 1) I did use more than my 55k to buy the 13 houses. I was making about 4k in net profit from my other rentals as well so probably about 110k total went into the homes.  Although the first two I used quite a bit more because I thought the pricing model was coming to an end. I may pull a big chunk out of those two homes at some point. Normally, I only come out of pocket 5 to 10k per deal.
2) I buy with hard money and then refi into a commercial loan so I'm able to get into the homes with a lot less money than a traditional purchase.

But still. Do you think it was worth taking the tax hit on the 55k withdrawal to add those 13 homes? There's absolutely no way I could have done it without that 401k withdrawal.  In fact, I took the money out in such a way that I didn't pay taxes on the withdrawal until this year's tax returns. So I used every penny of that 55k.....  

55k. The tax hit was a little under 40% I believe. So 20k total? 
But I added almost 650k in net worth. A little under 4k a month in NET profit - ALL of which is tax free income as of last year's return.

So when you mention pie in the sky numbers, its hard for me not speak up a bit and maybe give you some more background of what really is possible out there.

I'm giving people some food for thought based on what I ACTUALLY DO. And, believe me, there is nothing special about the deals I get or the financing or my area. Every single one of my deals was off MLS!

And I am the least handy person on the planet so I am not someone that has any construction background at all thats giving them a leg up.   I truly am the perfect example of "if this guy can do it, anybody can".

So I ask again? Is it worth it? 
Well. It was to me...........................
I'd do it again in a heartbeat.