Avoiding 401K early withdrawal taxes, penalties ?

Question

So I’ve borrowed against my 401 k to purchase my first short term rental property. Fortunately it’s doing really well. I need funds for my next properties and I’m planning to liquidate my 401k so I can invest that money in rental property. I’m only 45 and was wondering if there is a way to avoid the tax and penalties? Help!

BTW, I need a CPA who is familiar with property, especially for STR's!

BTW, I need a CPA who is familiar with property, especially for STR’s!

Carl Fischer · Answer

@Mark Page

There are some really good responses on here! As many of the accountants have mentioned, its not likely that you will be able to avoid the early distribution penalty. So another option is a self-directed IRA (SDIRA) or 401(k). The 401(k) has some special requirements to be eligible-own a business and have no employees. The SDIRA does not have those requirements.

Most IRA types can be self-directed (Roth, Traditional,SEP, SIMPLE,HSA,ESA). These SDIRA's follow all the same rules for contributions and distributions as a plain Roth or traditional IRA. The self-directed adjective refers to the investments the account can make. Typical IRA's invest in things like stocks, bonds and mutual funds. A self-directed IRA can invest in things like real estate, notes, private lending and syndications. The investor picks their investment and performs their own due diligence on the investment and the investment provider, then they instruct their SDIRA custodian or administrator (usually by filling out a form) to make the investment from their IRA. The purchase is made in the name of the IRA, not in the name of the investor. All expenses incurred by the investment must e paid by the SDIRA. All proceeds generated by the investment go back to the SDIRA.

As @Bryan Scrivener mentioned there are some additional rules that apply regarding what can be invested in and who the investment is with. The purpose of a retirement account is for you at retirement age, so the proceeds of your investments stay in the account till they are taken out as a distribution. Can you take them out before age 59 1/2? Yes but you will likely be subject to the early distribution penalty and also be responsible for the taxes.

Bryan Scrivener · Answer

Carl will know way more about this than I, but what I did was roll my 401k over into a self directed IRA, which I am now investing in property. This way you aren't dispersing the funds to yourself, it's still in a protected retirement account, so there are no taxes or penalties.

The catch of course, is that you can't benefit from the investments directly until you reach retirement age and start dispersing them to yourself. So if your goal is to build wealth for retirement (while you keep your day job) it's a great option. If you are wanting to use that money to generate income now, it won't work.

Mark Page · Answer

@Carl Fischer can you break that down a little more me?

Carl Fischer · Answer

@Mark Page

Why not buy the real estate in your 401k? Tax free or tax deferred income dependent on your account type.

George Blower · Answer

Of course, if you take a distribution from your retirement account you will have to pay the taxes and (likely) penalties.

There are possible alternatives which would allow to you use these funds without paying taxes or penalties.

• First, you may wish to consider transferring the funds to a self-directed 401k or IRA which will allow you to invest in real estate without incurring taxes or penalties. Please see additional considerations below.
• If you are eligible to set up a self-employed Solo 401k (or have a 401k plan through an employer which accepts rollover contributions and allows for 401k participant loans), another alternative which would avoid taxes and penalties would be to transfer your funds to such a 401k plan and then take a 401k participant loan.  Please see additional considerations below.

401k Participant Loans [Note you can take a 401k loan from a Solo 401k for your self-employed business even if you have a 401k loan under your "day job" 401k]

• If your 401k plan allows for 401k participant loans, the maximum loan amount is equal to 50% of the balance up to $50k. The repayment terms for a 401k participant loan are equal monthly/quarterly payments of principal and interest (typically prime plus 1%) over a 5 year term (longer if used to acquire your principal residence).
• Please note that if you take a full $50,000 and then pay back the loan, you can't take another $50,000 until 12 months after the first loan was fully paid back.
• Per the loan offset rules that went into effect with the 2018 Tax and Job Act: if you leave your job and the loan is current at the time you leave your job but then the loan goes into default because you left your job, you will have until your tax return deadline (including any timely filed extension) to make the loan current by depositing the outstanding balance into an IRA (and thereby avoid the taxes and penalties that would otherwise apply).

Solo 401k vs. Self-directed IRA

If you are self-employed with no full-time w-2 employees, you can set up a Solo 401k & rollover funds from a non-Roth IRA as a tax-free direct rollover and then invest in real estate.

A Solo 401k has several advantages as compared to a Self-Directed IRA including the following which specifically apply to your situation:

• Unlike a Self-directed IRA, you can have the account for the Solo 401k at a bank or brokerage that does not charge maintenance fees and where you will have checkbook control.
• Unlike a Self-directed IRA, if you use leverage (which must be non-recourse financing in either case) to acquire real estate with your Solo 401k the income will not be subject to Unrelated Debt Finance Income tax

General Considerations Re Investing Retirement Funds in Real Estate:

1. If you purchase via an IRA (as opposed to a 401k), you will need to open an IRA account at a specialty trust company which allows for investments in real estate. Unless you invest via an LLCowned by the IRA, you will not have checkbook control over the funds which means you need to run transactions (e.g. income, expenses, etc.) through the trust company who will need time to process the transactions and generally charge fees for each transaction. On the other hand, keep in mind that there are costs associated with maintaining an LLC (such as the $800 annual franchise tax in California).

2. If you are self-employed with no full-time employees, you can set up a Solo 401k through a 401k provider which allows for investing in real estate. In that case, you can simply have the account at a bank or brokerage where you will have direct checkbook control.

3. In either case, all of the income and expenses will need to flow in and out of the retirement account.

4. In either case and if you will you debt to acquire the real estate, it must be non-recourse financing. See more at the following link: https://www.biggerpockets.com/blogs/9552/70408-ira... If debt-financed real estate is acquired via an IRA, any income attributable to such investment will generally be subject to unrelated debt finance income tax.

5. In either case, you can't live on the property or otherwise use it for personal use.

6. In either case, you can't work on the property as it must be a passive investment (e.g. you must hire someone to fix the toilet and can't pay the expense with non-retirement funds).

7. In either case, you must purchase/sell real estate from/to an unrelated person and the real estate can't be titled in your name personally (e.g. in the case of the 401k, it would be titled in the name of the 401k and you would sign as trustee of the 401k).

8. In either case, you should verify that you are eligible to transfer the funds from your existing retirement account (e.g. if the funds are in your current employer 401k, you will likely not be able to transfer until you quit your job).

Basit Siddiqi · Answer

@Mark PageAs others have mentioned, it is not normally suggested to withdraw from a 401K early.The distribution would be subject to federal income tax, state income tax and 10% penalty.There are ways to avoid the 10% penalty under certain exceptions. However, it doesn't seem likely that you will qualify for one of them if you plan to use the funds to invest in real estate.With that said - if you find a screaming deal and can get a property for less than 10% of its fair market value, it wouldn't be the worst trade off.

Eamonn McElroy · Answer

@Mark Page

Generally it's not optimal to liquidate a 401k account from an income tax perspective.

If no exception applies generally you're going to get hit with a flat 10% penalty on the gross amount, plus federal and state income tax on the gross amount.  Usually a 401k liquidation will push a taxpayer into higher tax brackets.  For taxpayers in the highest bracket in my state (Georgia), this would mean you're taking a 53% haircut just to access more capital...not ideal.

A loan from the 401k is the more income tax efficient route OR roll the 401k into a Solo 401k or SDIRA and invest in real estate from one of those vehicles.  If you're still working at the company and they don't allow you to do an "in-service rollover" the latter may be off the table.

If you're looking for a local CPA I recommend asking for a referral from investors in your area or asking around at your local REIA.  If you don't mind working remotely there are plenty of CPAs on this subforum that are familiar with real estate taxation.  If you're investing in STRs make sure to ask questions pertaining to STRs when interviewing.  STRs are a little bit of a different animal when it comes to the passive activity loss rules.

Mark Page · Answer

@Ashish Acharya Yes the return on the property could average a gross 100k a year!

Thanks sir!

Jacob Sampson · Answer

I don't think there is any real way to avoid the fees.  Not that you asked but I would be pretty uncomfortable cashing out my entire retirement account based on having owned 1 investment property.  Remember, one significant edge the stock market has over real estate is that in the market you can only lose what you put in.  In Real estate you can lose an infinite amount.  Anyway congrats!

Zachary Bohn · Answer

@Mark Page unfortunately if you liquidate the 401K you'll owe tax on that and you may have an additional issue with the loan balance. You'll be hit with the penalties as well. You're only other option is rolling it into a self directed IRA and using that to invest in real estate but there are drawbacks to that as well, and you'll still owe tax on your 401k loan balance

Avoiding 401K early withdrawal taxes, penalties ?

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