I am not self-employed but want a Self-Directed 401(k) - ??
Rental Property Investor · Austin, TX · Member since 2015 · 280 posts · 176 votes
I am interested in transferring my 401(k) from my previous company into a Self-Directed 401(k) - NOT a Self-Directed IRA - for the purpose of investing in cash flowing rental properties. However, I don not have a business. Do I simply need to start a random business and, if so, is there a minimum I need to earn each year to keep my sole proprietor status?
Also, I know that - with a Self-Directed IRA - there are a lot of disqualification scenarios. With a Self-Directed 401(k), are those still there? For example, can my business simply be a property management company and I manage the properties in the
Self-Directed 401(k) for a small fee or is this not allowed?
Finally, I have had a sole proprietorship before and the taxes for one are relatively easy to incorporate into personal tax returns. However, I am not sure how owning rental property inside a Self-Directed 401(k) will affect it. Anyone have 1st hand experience? Also, how does the depreciation tax benefit roll into taxes - or does it not?
*If you have a Self-Directed 401(k) and are happy with the entity that helped you set it up, please PM me! I am also in Austin so if you happen to know anyone local, I would appreciate their contact information too. Thanks!
I am familiar with the argument you are referring to. Frankly, it misses the point.
Comparing investing in real estate with retirement funds to investing in real estate with non-qualified funds is apples and oranges. The tax treatment is entirely different, just as it is different investing in stocks with taxable and non-taxable funds.
The real question to ask as an investor is this: "If I understand real estate as an asset class, can I generate better results for my tax-sheltered retirement savings than if I left it in the stock market?"
To take a 40-60% cut in value of your investment capital by taking an early distribution of an IRA or 401(k) is a fool's bargain. Keep the full amount available to invest, invest in solid assets that you know and understand, and you will create a large sum of wealth to draw on in your golden years. It is not rocket science.
@Account Closed
Why the aversion to a self-directed IRA? As investment vehicles, the self-directed IRA and Solo 401(k) are largely similar, providing considerable flexibility and control. The rules surrounding self-dealing are identical in both plans. Everything must be done at arm's length and exclusively for the benefit of the plan.
The main advantages of the Solo 401(k) such as higher contribution limits will not apply if you are "creating" a business purely to have access to such a plan.
In our experience, creating a business simply to have a plan is a losing proposition. Yes, the bar is relatively low, in that you must have a for-profit business activity generating earned self-employment income. Such a business does not need to be large (though see above about contributions), but it does need to be ongoing. If the business activity ceases, then there is no longer qualification for the Solo 401(K) and the assets must be rolled to an IRA at that point anyway.
If one has solid qualifications for a Solo 401(k), it is a great program. About 70% of the clients we work with use the self-directed IRA and are very happy with the flexibility they have.
Have you considered simply cashing out your 401k, taking the hit, and then investing in real estate with the proceeds?
It just seems to me that real estate has one of the best tax advantages of any other investment vehicle out there, I'm not sure what you gain by investing in a self directed IRA. If anything, I think its actually worse.
Lets say you accumulate 10 houses in your self directed ira and when you retire, they are all paid off. Then you start selling them. I believe you will have to pay taxes as regular income when distributing those proceeds to yourself.
Now if you cash out and accumulate those same 10 houses, when you sell them later, you will only pay long term capital gains.
In addition, I am not sure how depreciation works with a self directed 401k. Since anything in there is technically non-taxable, do they allow depreciation to somehow lower your tax basis when you go to withdraw later on? Doesn't seem possible really so you're just giving depreciation away?
Again, there are lot of technical issues that I have no idea how they work but it seems wrought with roadblocks. The one issue that I can tell you is that you will not be able to get any money out of that account to yourself until you go to retire. That alone would be enough of an incentive for me to simply cash out the 401k and invest directly (which is exactly what I did 5 years ago when I switched jobs).
Everyone worries about that tax hit for early withdrawal. But if you have 100k in the account and withdraw it all, you're going to pay about 37k to 40k? So you'll be left with 60k or so?
Yet if you turn around and buy three 150k houses for say 110k apiece with that money by putting 20k down on each one (using leverage and bank loans), you'll end up with a net worth of 180k - which is almost double the 100k that was in your 401k.
i.e. Purchase price of 90k with 20k rehab on each house. You put down 20k on each of the 3 houses so your loan ends up being 90k and you'll have 60k in equity on each. 60k x 3 = 180k
And here's the best part. You'll get to pocket your rental income today. AND for the first few years (7 to 15 maybe depending on rents, taxes, etc), that rental income will be tax free too.
And if you do decide to sell the homes after a couple of years, you will only have to pay long term capital gains of what, 15%? Or you could 1031 them into other properties and pay zero taxes with the sale.
Bottom line is that I would much rather take the one time hit on the 401k and get the money in real estate now so that I can benefit from all the tax advantages real estate affords us AND so that I can pocket the rental income today.
Plus, once those houses are paid off, if I do want to cash them out, I'll only have to pay long term capital gains on the profits (although I will have to pay recaptured depreciation as regular income). But that pales in comparison to a sale after I retire where I would have to pay taxes as regular income on the entire value of the house.
@Account Closed A SDIRA has nothing to do with owning a business. Anyone can open a SDIRA account and fund it with new money and or by rolling funds from another IRA. The fees are high and there are a lot of little rules to follow when you start investing through it.
@Account Closed my apologies. I didn't catch it the first time. A Self Directed 401K can shield up to $17K per year from self-employment, but you would have to make at least $17K that year in the business to put it in there. You can't join an MLM group, make zero dollars, and contribute $17,000 from other W2 income into your solo 401K. If that is what you are trying to do.
I would rather pay the taxes now and invest my money how I see fit than to put it under the IRS' control until I'm 59.5 before I pay taxes on it anyway.
@Account Closed my apologies. I didn't catch it the first time. A Self Directed 401K can shield up to $17K per year from self-employment, but you would have to make at least $17K that year in the business to put it in there. You can't join an MLM group, make zero dollars, and contribute $17,000 from other W2 income into your solo 401K. If that is what you are trying to do.
I would rather pay the taxes now and invest my money how I see fit than to put it under the IRS' control until I'm 59.5 before I pay taxes on it anyway.
The employee deferral limit is actually $18,000 for 2017 (for participants under age 50). The limit goes up periodically and next year it will be $18,500. If I recall correctly, it hasn't been $17,000 since 2012. The total limit that can be sheltered is $54k if under age 50 and $60k for those age 50 and older. This does require significant SE income, of course.
Quite often when people are trying to become eligible for a Solo 401k, their main goal is transferring and investing with existing retirement funds rather than making significant contributions. Your point about limited contribution ability in this scenario is correct, though, Anthony.
@Brian Eastman The largest drawback to me for the Self-Directed IRA - which is what I was originally gravitating towards - is the UBIT tax on income gained from leveraged debt. Also, I do not like the idea of having to 'direct' a third party to issue checks on my behalf. Moreover, there are long-term savings to be had with a Self-Directed 401(k) over a SDIRA as you do not have to pay a third party fees - SD401(k) plan's cash just sits in a designated account and you, under a trust, control access to it. I have a significantly large 401(k) balance and estimate my SDIRA fees so be nearly $2k per year - outlandish if you ask me considering the alternative option.
Going the SD401(k) route, I can enjoy the exact same - and better with leveraged debt income - tax advantages as a SDIRA. I can also simply pay a small up front 'advisory' fee to setup the SD401(k) versus having to pay various fees that can total a couple thousand dollars per year. Finally, with an SD401(k), I have personal access and control to my money and do not have to rely on a third party's timeliness in transactions.
@Mike H. I have considered cashing out my 401(k) plan but the hit is too large for me and would take a long time to recover. I suspect your '150k to buy 3 houses' scenario is flawed because your net worth does not increase simply because you have the properties because you are leveraged on those properties. Your net worth should only go up once the property values go up and the spread between the amount owed and the sale potential increases. Nonetheless, I think you are on the right track but with me cashing out, I would loose over 200k in todays dollars which I could better use as leverage in a tax free account to build a larger portfolio. I am not really interested in long term rentals in my tax free account, just purchase, rent for 2-4 years, and then sale for appreciation. Once the account balance grows then I can consider cashing out. Once I cash out, then I will take full advantage of RE Tax strategies that otherwise were lost to me in the SD401(k). I still have 30 years before I can retire so I think I will be ok.
@Justin Windham Am I understanding this correctly? Basically, I have limits to the amount of cash I can contribute to my SD401(k) - up to the IRS limit of $18,000 (2017) so long as my contributions are greater than or equal to my contributions up to $18,000. However, any income earned from real estate inside the SD401(k) is NOT considered a contribution, correct?
You also said"Quite often when people are trying to become eligible for a Solo 401k, their main goal is transferring and investing with existing retirement funds rather than making significant contributions." This is EXACTLY my goal - to unlock my retirement funds from my current plan administrator so that I can direct investments into RE. I have small hobbies (i.e. buying/trading vinyl records) that generate a few thousand dollars each year so maybe I can just create a company with a bland, generic name like "Larry Endeavors" or something that allows me to claim any and all income I receive from whatever I happen to do in the year to earn it, allowing me to have the SD401(k)?
Finally, do you have any good resources for walking me through the process of setting up an SD401(k)?
@Larry Hawkins
A checkbook IRA LLC eliminates the need to have a custodian handle each and every transaction, thus providing the same level of direct control as the 401(k).
Yes, an IRA is subject to Unrelated Debt Financed Income taxation on leveraged real estate while a 401(k) is not. For most investors, the tax cost is less than $300/year. As such, going out of your way to create a business to eliminate that burden may not be worth the effort, or a 6 to one, half-dozen to the other type of scenario with respect to cost-benefit.
Don't get me wrong, the Solo 401(k) is a great tool - if there is legitimate qualification. It is also entirely over-promoted and oversold by web marketing firms and document mills. I suggest you speak with one or more professionals who can provide meaningful information specific to your situation and help you determine which strategy will work best for the long term.
@Brian Eastman On a side note - and just thinking outside the box here - but would it be advantageous (if even possible) to convert an Employer Sponsored 401(k) into a SD Roth IRA/401(k), build up your portfolio tax free and, when ready to cash out, simply take the 10% penalty, essentially avoiding short/long term capital gains tax which is higher?
I.E., I buy a property using ROTH SDIRA or SD401(k) funds, I rehab it and sell it under a year. the profit remains in the retirement account un taxed. The next year, I decide to cash out my account. Instead of having to calculate Basis and paying short term capital gains tax on that property I flipped, I should be able to only pay the early withdrawal penalty of 10%, correct?
@Account Closed
Flipping houses in an IRA has the potential to create tax liability inside the IRA through UBIT if done regularly.
If you take an early distribution from a Roth IRA, the initially converted basis can be withdrawn tax-free, but any income above the basis will be taxed as regular income plus the 10% penalty.
I would not recommend this strategy.
A self-directed IRA is a means to diversify an IRA for long term wealth building in a tax sheltered umbrella. If you can create more growth and stability investing the IRA in real estate than in stocks, then it is a good tool. It is not a tool for "today" money.
@Account Closed
Hmmm. I guess you may be missing something. Your net worth increases on your purchase because you are not paying 150k for houses that are worth 150k. Thats not investing.
For me, my typical deal is a house thats worth 150k that I'm able to buy for say 90k and put in 15k or 20k in rehab. So my total costs are 105k to 110k all in and the house is worth 150k. On paper, I gain 40k to 50k to my net worth the day I close on a house.
And yes, I am leveraged on those as my loans end up being 100% of my purchase plus rehab. The only thing I come out of pocket is the hard money lender's points (4) and closing costs (1,500 to 2k). So I come out of pocket roughly 6 to 8k and then I end up with a loan of 105k on a house worth 150k.
But the additional detail probably changes my thoughts a bit. I would not suggest taking the hit on the 401k unless you're going to buy right and unless you were looking at more of a buy and hold strategy. Not sure it makes sense if you're paying closer to retail and planning to sell in a shorter period.
The only issue I would have with that though is that where is your profit coming from if you aren't looking at getting that much of a discount and aren't going to hold them for the long term?
"I suspect your '150k to buy 3 houses' scenario is flawed because your net worth does not increase simply because you have the properties because you are leveraged on those properties. Your net worth should only go up once the property values go up and the spread between the amount owed and the sale potential increases. "
@Account Closed
...I would rather pay the taxes now and invest my money how I see fit than to put it under the IRS' control until I'm 59.5 before I pay taxes on it anyway.
Anthony, your statement above is incorrect and misleading. With the truly self-directed Solo 401k plan I (not the IRS) have total control over my funds and how they are invested and can even access my funds prior to 59.5 if needed (there are several available loopholes available depending on what your strategy is).
@Dmitriy Fomichenko It's not misleading, it is my opinion, which is always 100% correct. Putting money into a "tax shelter" is giving the IRS a say in how you can use your own money. The trade off of paying taxes now or paying taxes later, in my opinion, is not worth the hassle of following all of the IRS rules and restrictions. If you have to use loopholes created by someone else, you are not in control. In my opinion.
@Justin Windham Am I understanding this correctly? Basically, I have limits to the amount of cash I can contribute to my SD401(k) - up to the IRS limit of $18,000 (2017) so long as my contributions are greater than or equal to my contributions up to $18,000. However, any income earned from real estate inside the SD401(k) is NOT considered a contribution, correct?
You also said"Quite often when people are trying to become eligible for a Solo 401k, their main goal is transferring and investing with existing retirement funds rather than making significant contributions." This is EXACTLY my goal - to unlock my retirement funds from my current plan administrator so that I can direct investments into RE. I have small hobbies (i.e. buying/trading vinyl records) that generate a few thousand dollars each year so maybe I can just create a company with a bland, generic name like "Larry Endeavors" or something that allows me to claim any and all income I receive from whatever I happen to do in the year to earn it, allowing me to have the SD401(k)?
Finally, do you have any good resources for walking me through the process of setting up an SD401(k)?
You do have limits as to what you can contribute to the 401k. With lower amounts of self-employment income, you'll be limited to that income amount rather than the $18k (or $54k) limit. Any earnings from investments within the 401k do not count toward the contribution limit. Many plans are created by sole proprietors with no business name separate from themselves. No plan provider can make the decision as to whether or not you have self-employment activity on your behalf, but if you intend to take that stance, you want to have something more than a "hobby." If you are already generating thousands of dollars a year from the activity, you may be on the right track, though. I do think it is a good idea to be aware of the "legitimate self-employment concept" that Brian is pointing out in his posts. If you want to PM me, I can send you the additional resources regarding the setup process that you asked about.
@Account Closed
The following IRS website does a good job in outlining the self-employment requirements. The key is that material services are performed, whether under an LLC, sole proprietorship or corporation, for example.
https://www.irs.gov/businesses/small-businesses-se...
Following are the similarities and differences between the solo 401k and the self-directed IRA.
The Self-Directed IRA and Solo 401k Similarities
The Self-Directed IRA and Solo 401k Differences
@Account Closed had the best advice. Cash out, pay the 10% penalty and taxes now. Or if you can spread the cash out over several tax years. Then you can use leverage and deprecation to your advantage moving forward.
If you are looking to move your 401K and keep it in the equities markets I highly recommend transferring it to an Interactive Brokers account and then buying some REITs with it. Then on a monthly basis reinvest the money from the REITs to buy more shares. My only caution would be to stay away from apartment REITs.
I am familiar with the argument you are referring to. Frankly, it misses the point.
Comparing investing in real estate with retirement funds to investing in real estate with non-qualified funds is apples and oranges. The tax treatment is entirely different, just as it is different investing in stocks with taxable and non-taxable funds.
The real question to ask as an investor is this: "If I understand real estate as an asset class, can I generate better results for my tax-sheltered retirement savings than if I left it in the stock market?"
To take a 40-60% cut in value of your investment capital by taking an early distribution of an IRA or 401(k) is a fool's bargain. Keep the full amount available to invest, invest in solid assets that you know and understand, and you will create a large sum of wealth to draw on in your golden years. It is not rocket science.
I agree, @Brian Eastman. Investing in real estate with retirement funds can be an excellent way to increase your returns, even when considering UBIT or UDFI.
My 401k was getting, on average about 3-5%. I knew almost nothing about how to maximize returns in the mutual fund market and the handful of funds I could invest with through my former employer made it pretty frustrating.
I invest in leveraged real estate with my SD401k, so UDFI isn't an issue for me, but I have plenty of clients who invest with their SDIRAs, and it still isn't an issue.
Just as with other rentals, the properties cash flow just fine, but after depreciation, there is a tax loss. So while the IRA has to file a 990-T, there is no tax to pay.
My clients have told me that my fee to file the 990-T plus the annual cost to maintain the account is still a better deal than the hedge fund managers that were siphoning off fees, many of which were barely or insufficiently disclosed.
I see returns in the 8-11% range now, just like with my other real estate holdings. Plus, I understand real estate A LOT better than I understand mutual funds and the stock market in general.
@Dmitriy Fomichenko It's not misleading, it is my opinion, which is always 100% correct. Putting money into a "tax shelter" is giving the IRS a say in how you can use your own money. The trade off of paying taxes now or paying taxes later, in my opinion, is not worth the hassle of following all of the IRS rules and restrictions. If you have to use loopholes created by someone else, you are not in control. In my opinion.
I'd like to respond with my opinion, which also happens to be 100% correct. :)
$100k cashed out of retirement funds leaves you with about $65k cash. $65k invested with a very modest 15% return, with taxes eating into it every year, ends up being $200k.
$100k left inside a retirement account for the same 10 years and the same 15% return ends up being $400k. Pull it out and pay tax - you have $300k cash left.
So, $200k or $300k? What you're saying is that you'd rather settle for $200k for the sake of being "free from the IRS tyranny."
Also, I intentionally used 15% return - which is pretty dismal for RE investments. With higher returns, the tax-free compounding power of IRAs becomes even more dramatic.
This is before we start talking about Roth, by the way. Your freedom is rather costly.
All you guys have it all wrong..... All you need to do is cash out your retirement accounts and buy powerball lottery tickets. That way you are in control of your earnings and you're sure to win if you buy that many tickets. Snowball your winnings into another powerball and repeat. Its like BRRRR but called CIPWRWR.. (Cashout, invest in powerball, WIN, Reinvest,WIN,reinvest...) no brainer.....
The thread is getting a little off topic. I feel the need to add my 2 cents. I hear this all the time buy homes put 20% down.
Example 100k buy 5 houses throwing 20k down on each house use leverage. There is one minor problem with this theory.
If you are talking 1-4 family homes, you must have the income from your job to get these loans. In my example 5 houses at 100k each you are leveraging 400k. When you are talking rentals, the bank will make sure you can float the payments if your rent stops for whatever reason. Banks dont like risk. Now if old uncle Fred has the 400k to lend to you then the problem is solved.
I guess I would question your 15% rule. Again, I'm not suggesting you take 65k and buy a 65k house with it here. Then maybe you'd only see 15% or something minimal like that. But that kind of deal is NOT what I consider investing in real estate.
To me, investing in real estate is when you buy at a discount of 25 to 30% and you put as little money into the deal as possible. The real returns for real estate come with the ability to leverage your money.
So if you cash out 100k and it becomes 65k, then take that 65k and buy 6 houses with it. 6 houses worth 150k that you are able to pick up for 110k and end up with 10k apiece in them - i.e. 100k loans on houses worth 150k each.
So right off the bat, you're 100k in the 401k is actually worth 300k in equity in the homes. You can do that in 1 or 2 years if you're on top of the market and putting in offers.
So to suggest that you're going to pull out your money and it drops to 65k and then you'll make 15% on 65k, isn't what I would call investing it in real estate. If you want turn around and use all your cash on a 65k house thats only worth 65k, thats fine, but its not investing in real estate. Its investing in turnkey real estate at best.
The assumption has to be that you're going to use that 65k to invest in real estate the right way. And that by leveraging money and buying right, you can turn that 65k into 300k in equity right off the bat. And in 20 or 25 years when those 6 homes are paid off, you're going to be sitting on a chunk of homes worth 1.8 million (historically houses double every 20 years in most average areas).
And if you sell those homes in one swoop, you'll pay recaptured depreciation at regular income rates on about 600k of that (assuming 100k tax basis) and long term capital gains at about 15% on about 850k (I'll assume the rest goes towards closing/holding costs and some rehab).
To me, its an absolute no brainer. You can turn 100k in your 401k into 300k in net worth in several average homes if you use your money right and invest in real estate the right way - and thats in 1 or 2 years.
And then you'll get to pocket the rental income from those homes over the next 20 or 25 years mostly tax free. And you're still going to end up with a larger chunk of net worth than if you'd have just kept it in a 401k and waited 25 years to start accessing it.
The downside? You have to manage those properties for 20 to 25 years. There's a reason why the returns are so much greater in real estate - it takes effort. But in terms of whether you'll get more by investing in real estate outside of some retirement vehicle, its not even close.
To me, the numbers aren't even close. Returns have to be in this order:
1. Cash it out and invest in real estate the right way
2. Move to self directed and invest in real estate but still using leverage (this is better than 401k but not as good on returns as just cashing it out)
3) Leaving it in a 401k like sheep, hoping you live til your 68 to even touch any of it, and then start pulling it out and paying tax on it as regular income rates.
Thanks for the feedback! I need someone to educate me a little more on the topic since it appears I am not thinking through this correctly. I was under the assumption if you want to invest in real estate, don't do it in a retirement account. So maybe I have been misinformed on how to use funds. I have been learning through the Rich Dad Advisor's and might have misinterpreted some of the material. I am coming to that same cross roads where I will have the opportunity to use the combination of 401K and IRA money. Currently I hold a dividend portfolio but was thinking of doing the cash out to buy cash flowing real estate. Can you help me understand what I am missing? My natural inclination would be to pull the money out now and pay the penalty and taxes and then use that money for down payments and never pay taxes again on the cash flows. So my overall return calculations are based on three principles: Does this move increase my ability to use banks to borrow more money in the future (am I increasing my income)? What will be the cash flow effects net of taxes? Will taxes be higher in the future?
the analogy that @Michael Plaks used will work with any hypothetical return, 5%, 15% or 30%. The bottom line is that you will end up with more wealth if you invest in tax-deferred environment, the investment can grow quicker and the end result is that you will be better off by not taking huge tax hit and penalties hit by taking early distribution from your IRA.
And I'm not sure where you got the number 68??? You are allowed to start taking distributions from an IRA at age 59.5. However, if you wish to have access to those funds earlier - you can. One strategy is to use IRS 72t rule. The other one is do a Roth conversion.
re: 68
Ha. Yea. Probably from my misinformed belief that you had to be 68 to retire. But i'm guessing thats only for social security. :-)
Shows what little i know about all the crazy rules that run around those 401k plans. The problem I still have with real estate in a 401k plan is that real estate, by its very nature, is very heavily tax friendly to begin with, so you aren't really gaining as much sticking it in a retirement account.
And when you do cash out, you're going to be taxed as regular income coming out. But if you sell a house that is not in one of those plans, you only get taxed as regular income on the recaptured depreciation amount and the rest gets a much lower rate under the long term capital gains rate.
Not only that, but you're still talking about waiting til your 58 before you can pull it out? That blows.
My aunt just passed away 3 months ago. She had literally just retired in january of this year. She had saved all her life and socked away a nice chunk of money in all these retirement accounts to where she was making 90k a year when she retired - which was as much as she was making at her job.
So for 45+ years of sacrifice, she got to enjoy it for a whole 9 months. Now I already made up my mind years ago on why i felt this was the way to go with real estate. But that only confirmed my thoughts.
I'm getting money today that I can use to enjoy a better life. And in 20 or 30 years, I'll still have way more in net worth than I could have ever amassed even if I had max'd out every retirement option there was.
So again, I would say. Cash it out. Invest in real estate the right way (i.e. buying right so you're getting investor discounts, and leveraging bank money to maximize your returns) and nothing else can come close to it........
You'll end up with way more money that way than anything else out there. And its not even close. And better still, you'll get to see some of that money now while you're young enough to enjoy it.