Best Tax Strategy: Max out 401K or Save for Real Estate?
Karen ChenaillePro Member
Real Estate Agent · Sevierville, TN · Member since 2017 · 165 posts · 137 votesHi!
I am looking at real estate investing to reduce my tax liability and generate passive income. I have a 401K plan which I have been maxing out annually. My company matches 4% of the first 6% contributed. I have used the loan feature on my 401K to purchase my first investment property. Due to the 401K plan rules, I only have access to about 26K more. For my next move, I will need about $35K between repairs, closing costs and down payment.
I also have about $20K left on a vehicle loan.
Should I keep maxing out my 401K to get the max tax savings against my day job income or should I cut back to 6% and use the extra cash to pay off the vehicle loan and bridge the funding gap on second property?
Thanks for reading this!
If I were in your shoes, I would contribute just enough to max out the employer match.
401k loans are fine. Just be aware that you would have to pay it back or suffer a large tax hit if you were to lose your job with the company.
Ideally, a home equity line of credit is a better option if you are having trouble raising the large down payments.
Next, I wouldn't worry about the car loan if the interest rate is low. As long as you are earning 10% or more on your real estate, you come out ahead. Ex., car loan 5% cash on cash return 10%. Just like a bank, you borrow cheap and reinvest at a higher return.
Just be careful with expensive cars until you are set financially. I once sold an expensive car to help raise the cash for a closing. I simply bought a cheaper used one to replace the nice car.
Bottom line, I like having my rentals pay off my vehicles and other lifestyle items.
Lastly, not a fan of a self directed Ira for cash flowing real estate. Too complicated to get into it here. All I can say is you lose all the tax benefits of real estate and tie up your money till age 59 1/2 when you purchase cash flowing rentals to in your Ira.
Better to buy notes, private equity or land in the IRA. Plus, it might be a mute point if all your money is in a 401k.
Beware of financial advisors positioning life insurance as an investment. Just my opinion, mind you. You only need life insurance if someone will be harmed financially if you were gone.
Cheap term insurance fits the bill for 99% of people. For the 1%, you can use expensive whole life or variable/universal life to cover estate taxes. Works well if you have 10 million or more net worth.
Q? How many people became millionaire's investing in life insurance?
I'm sure I will ruffle some feathers with the latter two comments.
If your goal is passive income today/early retirement, keep doing what your are doing and shoot for 1 property a year over ten years. Coupled with a 401k, you would be set for life-assuming you don't screw it up!
@Karen Chenaille Car loans are bad debt. I would get rid of it and not make that mistake again. I would contribute to your 401k at least up to the match if not more. Then i would save the rest for RE.
You should be aware that taking "loans" from your 401K will result in double taxation (i.e. you borrow before tax dollars that are then paid back with after tax dollars, and then re-taxed upon qualified withdrawal). If your goal is to minimize your tax liability then you shouldnt be taking 401K loans. Might be worth it to buy the property through a self directed IRA.
to answer your question, you should compare the interest rate on the car loan with the expected annual return on your 401K.
If you simply plan to borrow the money from your 401(k) anyway, there is no point in contributing any more than the minimum that your employer will match. When you borrow from your 401(k), the money is no longer in your 401(k).
Its much more efficient to use the cash value of a permanant life insurance policy as your supplemental retirement plan. Just as with a Roth IRA, the cash value will grow tax free and you can access it tax free. But unlike a Roth, you can borrow against the cash value.
When you reach retirement age, the income you can take from a properly designed and funded life insurance policy will be about 2-3 times what you could take from the same amount of money in your 401(k). But the beauty is that you can leverage that cash value every day between now and the day you retire. You can't do that with an IRA or with your 401(k). I can explain why that is privately, if you'd like. Not enough room here. This blog post partly explains it: https://www.biggerpockets.com/blogs/7595/53705-thi...
Borrowing "From" and borrowing "Against" are two completely different things.
If I were in your shoes, I would contribute just enough to max out the employer match.
401k loans are fine. Just be aware that you would have to pay it back or suffer a large tax hit if you were to lose your job with the company.
Ideally, a home equity line of credit is a better option if you are having trouble raising the large down payments.
Next, I wouldn't worry about the car loan if the interest rate is low. As long as you are earning 10% or more on your real estate, you come out ahead. Ex., car loan 5% cash on cash return 10%. Just like a bank, you borrow cheap and reinvest at a higher return.
Just be careful with expensive cars until you are set financially. I once sold an expensive car to help raise the cash for a closing. I simply bought a cheaper used one to replace the nice car.
Bottom line, I like having my rentals pay off my vehicles and other lifestyle items.
Lastly, not a fan of a self directed Ira for cash flowing real estate. Too complicated to get into it here. All I can say is you lose all the tax benefits of real estate and tie up your money till age 59 1/2 when you purchase cash flowing rentals to in your Ira.
Better to buy notes, private equity or land in the IRA. Plus, it might be a mute point if all your money is in a 401k.
Beware of financial advisors positioning life insurance as an investment. Just my opinion, mind you. You only need life insurance if someone will be harmed financially if you were gone.
Cheap term insurance fits the bill for 99% of people. For the 1%, you can use expensive whole life or variable/universal life to cover estate taxes. Works well if you have 10 million or more net worth.
Q? How many people became millionaire's investing in life insurance?
I'm sure I will ruffle some feathers with the latter two comments.
If your goal is passive income today/early retirement, keep doing what your are doing and shoot for 1 property a year over ten years. Coupled with a 401k, you would be set for life-assuming you don't screw it up!
If I were in your shoes, I would contribute just enough to max out the employer match.
401k loans are fine. Just be aware that you would have to pay it back or suffer a large tax hit if you were to lose your job with the company.
Ideally, a home equity line of credit is a better option if you are having trouble raising the large down payments.
Next, I wouldn't worry about the car loan if the interest rate is low. As long as you are earning 10% or more on your real estate, you come out ahead. Ex., car loan 5% cash on cash return 10%. Just like a bank, you borrow cheap and reinvest at a higher return.
Just be careful with expensive cars until you are set financially. I once sold an expensive car to help raise the cash for a closing. I simply bought a cheaper used one to replace the nice car.
Bottom line, I like having my rentals pay off my vehicles and other lifestyle items.
Lastly, not a fan of a self directed Ira for cash flowing real estate. Too complicated to get into it here. All I can say is you lose all the tax benefits of real estate and tie up your money till age 59 1/2 when you purchase cash flowing rentals to in your Ira.
Better to buy notes, private equity or land in the IRA. Plus, it might be a mute point if all your money is in a 401k.
Beware of financial advisors positioning life insurance as an investment. Just my opinion, mind you. You only need life insurance if someone will be harmed financially if you were gone.
Cheap term insurance fits the bill for 99% of people. For the 1%, you can use expensive whole life or variable/universal life to cover estate taxes. Works well if you have 10 million or more net worth.
Q? How many people became millionaire's investing in life insurance?
I'm sure I will ruffle some feathers with the latter two comments.
If your goal is passive income today/early retirement, keep doing what your are doing and shoot for 1 property a year over ten years. Coupled with a 401k, you would be set for life-assuming you don't screw it up!
I think you misunderstand the use of life insurance. Nobody "invests" in life insurance. If you are comparing contributing to a 401k or putting money into a high cash value life insurance policy, the life insurance policy will almost certainly provide more retirement income than the 401k. The rates of growth will be fairly equal. The problem is that most people think of life insurance solely as a death benefit and not as a tool for retirement planning.
When I speak of leveraging the cash value, it is a tool to earn greater returns on your real investment: real estate. Because the cash value securing the loan is still earning interest/dividends, anything you make with the loan is over and above the return on the cash value. This is simply a tool to accelerate your rate of growth on your assets.
Term insurance is a waste of money. Insurance companies sell it because they know it probably won't pay. Permanent insurance is a tool for wealth creation when used properly. You are thinking of it in isolation.
@Cory Binsfield...Thanks for taking the time to write back!
I looked at a HELOC. I live in an area where homes do not appreciate all that much. I owe $350K and it will only appraise at $500. Most banks insist on 80% equity in the property and then they will only do a HELOC against a portion of what remains after 80% LTV is met, so at the end of the day, I don't have much left over for a HELOC. Maybe $50K tops? Not sure it's worth the trouble. I'd be interested in your thoughts.
The bike loan is 2.5% interest, so it may not be worthwhile to pay it off...except it eats up quite a bit of post tax money that I could be setting aside to build up $$ for my next real estate down payment so I can get away from using my 401K. That would be the real benefit of paying it down..to free up $$ spent on paying off depreciating assets.
I do have a self directed IRA and I agree w/ your self directed IRA comment. We own a construction business so using the self directed IRA takes all the cost savings we would realize from doing the work ourselves away because you cannot be personally involved in any way with the renovation AND we don't get access to the cash flow the propertie(s) would generate.
@Sastry Srini Thanks for replying to my thread! I too dislike the double taxation on the 401K loan, but it was a means to an end and an easy way to get access to cash.
I think I will pay off the bike loan just so I can have that money to put towards real estate down payments so I can get away from using the 401K.
@Thomas Rutkowski I did not realize that was possible with cash value permanent life insurance policies. Is there a minimum value that must be in the account before you can borrow against it?
Thanks for the blog links!
Karen
@Matt B. Ugh! II took that loan before I came to my financial senses. I agree, debt for depreciating assets is not good to have, which is why I really want it gone. I am tying up serious money every month to pay for a depreciating asset.
I will be going w/ the 6% 401K contribution...that way I free up some $$ each month for RE and get the company match.
Thanks for the advice and pointing out the double taxation on the 401K payback...that didn't even occur to me when I took the loan :-( #rookiemistake
I would contribute only as much to your 401k as you can to achieve the full employer match. This is what I do. I find that my real estate returns are high enough to compensate for the tax advantages that a 401k provides post-match. I'd cut back on the 401k, pay the car off, then build up your funds and buy another property.
Also, I completely agree with @Cory Binsfield on not putting cash flowing real estate into IRA's. The tax advantages that go along with rental properties do not help you in a tax deferred/advantaged account. These investments are best served with after-tax income. However, if you're interested in flipping properties, using a SDIRA may work.
Something that really helped me out on this subject was a white paper that was done by Betterment. I'm not advocating investing with them but this paper really helped me understand the nuances of different tax strategies and their relative investments.
@Thomas Rutkowski I did not realize that was possible with cash value permanent life insurance policies. Is there a minimum value that must be in the account before you can borrow against it?
Thanks for the blog links!
Karen
Hi Karen - Its not so much about the amount. There won't be many potential investments for a very small amount of cash value. If you want a lot of cash value to leverage, you have to put a lot of premium into the policy.
You need to make sure that the policy is properly designed and overfunded. You literally want to purchase as little death benefit as you can for the premium you are paying. This maximizes the cash value and minimizes the sales commissions. You have to use a carrier that has an early cash value rider to really get the most bang for your buck. Ideally the carrier will also allow for variable loans immediately. These requirements narrow down the field of good prospects.
Even if there is no provision for variable loans, many banks offer a cash value line of credit. This is the ideal way to borrow against a policies cash value anyway.
@James Triano after reading all the insightful responses and thinking on it further I am going to proceed as your suggest :-)
Thanks for replying to my question!
Karen
At minimum, it may be best to contribute up to the amount that the employer will match.
Borrowing from a 401k does NOT result in double taxation. The folks on here that are stating this are incorrect. You borrow 10K, and you pay 10K back. No tax effect on either transaction.
Mike, CPA
I thought borrowing from your 401K means you pay back the loan and interest to yourself. I almost did it once when I had a 401K, but decided it wasn't a good idea for me (the loan application fee exceeded the interest I would have earned).
Hello everyone. I'm new here. I was just reading through and you guys are killing me with the 401(k) "loan." We need to clarify whether it is a LOAN or a WITHDRAWAL.