Invest and loan from 401K or just save?

15 Replies

Strategy Questions:

I work as an 1099 for my "real job". I have an LLC and it is taxed as an S-Corp. I have recently stopped contributing to my 401K to use the money to save for real estate. But....I've been thinking....what will give me more "spending" money to invest in real estate?

As my own employer....I can set up a $2 to $1 matching contribution to my 401K.... so I could put in the max $18K and my LLC would contribute another $36K. Now...I know I do NOT want to hold real estate in my retirement account as I lose much of the tax advantages. However, I can "borrow" from my 401K to invest in real estate and then pay myself back with interest.

My question is: does it make more sense just to pull the money straight out of my LLC to invest in real estate, or should I invest in my 401K with matching and then loan from my 401K? Keep in mind that all the money is "mine" anyway, so by "matching" it's not like I'm "making" more money, it is just reclassified so to speak.

What are your thoughts and suggestions?

@Tara Kinney

Very thought out questions!

The actual calculations are somewhat more complex and depend on, among others: (a) how much salary your being "paid" by the S-corp and (b) the type of contributions you'd like to make to the 401k.

For W-2 employees of an S-corp (including owner-only S-corps): tax-deductible "employer" contributions can be made up to 25% of "employee" salary. Non-deductible contributions can be made up to the plan limit. Those non-deductible contributions, depending on your plan, could be converted to Roth (i.e., tax-free earnings) money.

401k participant loans may not exceed $50k.

The actual determination of which is optimal depends on an analysis of both objective and subjective factors, taking into consideration all possible configurations and their respective tax and investment implications.

@Tara Kinney Keep in mind, Solo 401k plans limit you to borrow the lesser of 50% of the plan's value or $50k. If you don't intend to borrow too much and plan to pay it back relatively quickly (typically, you're looking at a 5-year loan if the borrowed funds are not used to purchase a primary residence), this strategy may work. That said, there are other factors to consider, of course. It depends on your situation. 

@Bernard Reisz I currently have about $40K in my 401K. My LLC will gross around $180K and i pay myself aN $80K salary. So based on this, would it make sense to get my 401K up to $100K so I can borrow $50K for REI outside the plan, then use the other $50K for REI inside the plan? Then after that, stop contributing to the plan and just save directly for my investments? I’m thinking that by investing in the 401K it will significantly lower my tax burden this year so more money to use towards properties. THANKS!

@Tara Kinney

That may be an excellent approach...but the optimal approach depends on more factors than can be adequately addressed in a forum:

  • What is the value of the tax deductions? Tax deductions provide an immediate ROI
  • Do you intend to maintain your S-corp business? Will you qualify as a real estate professional for tax purposes? Passive real estate losses will not shield your business income from taxation unless you qualify as a real estate professional
  • How will the contributions impact your 20% pass-thru deductions? Depending on your tax filing status, Single, Married Filing Jointly, Married Filing Separately - you may be disqualified from taking this very valuable tax deduction based on your income and the nature of your business. Contributions to the 401k may preserve the 20% deduction
  • How big a portfolio do you intend to grow? Are you considering any other forms of real estate investing, such as private lending, mortgage notes/trust deeds? The tax benefits of real estate really kick-in with a continuously expanding portfolio. Real estate investments, other than buy-and-hold, do not benefit from real estate tax shields.
  • If you're going to pursue RE investing within the plan, you must have adequate "reserves" within the plan to cover unforeseen expenses

Those are some of the considerations. As you can see, there's much to consider - analyze, but analysis does have its limitations. Experience has shown that it's best to initiate the process based on current assumptions and then adjust accordingly. 

@Bernard Reisz Thank you for the advice! I will talk to my CPA and see if he can lend a little more advice based on the tax implications and if it would help me. Since I am a numbers person, I like to look to be able to compare scenarios to help build my strategy, but I have found it difficult (even hired a wealth strategy consultant) and have not been able to find anyone to give me such examples and scenerios. Perhaps when I build my portfolio I will find a niche in providing this kind of service to others as it seems this is lacking. Much things to consider! You gave me excellent food for thought!

@Tara Kinney

Glad to assist!

The questions you're attempting to address cross many financial disciplines. Unfortunately, the majority of competent financial professionals are experts in their area of focus and, at best, conversant in other financial disciplines.

BTW, what is a wealth strategy consultant? What do they do and what's their expertise? 

Originally posted by @Tara Kinney :

...I know I do NOT want to hold real estate in my retirement account as I lose much of the tax advantages...  

Tara, your statement about losing tax advantages when holding real estate inside of a 401k is inaccurate. You are comparing making investments inside of a qualified plan with personal investments, that is like comparing apples and oranges. When you hold real estate personally, all income you receive from the investment is taxed in the year you receive it, thanks to depreciation deduction you can offset some of that income and minimize your tax liability. However, when you hold real estate in your 401k all of the income is sheltered from taxes. There is no depreciation deduction because there is no income the deduct it from! 

Owning real estate personally offers great benefits such as appreciation, cash flow, and tax benefits. And you should build your real estate portfolio personally. But at the same time you have some funds in your retirement account and you need to have a strategy for investing those funds also, you need to be wise steward of those funds as well. What would be the best way those funds can work for you? Would it be in the stock market that you and I can't control, giving your money to the insurance company and have your earnings eroded by high commissions or invest in alternative asset such as real estate (BTW, you don't have to be the owner of physical real estate, you can be a private lender so your loan is secured by real estate, you can buy tax lien, invest in a syndication, private placement or note fund). Most of these options will return 10-15%. If you compare the results of investing in a taxable account vs tax-deferred in just 15 years the difference will be huge (hundreds of thousands $$$). So when making your investment decisions be sure to look at all aspects objectively. 

@Tara Kinney I understand the temptation to go "all in" in real estate. I used to be like that and I got involved in a flip 4 years ago that didn't go the way it was "supposed" to go and was financially damaging. Since then, I've taken a much different look at risk. I am more willing to take on partners to share the profits and losses. I also decided not to put all my financial efforts into real estate. I re-started contributions to my IRAs and kept most of it in stock and bond index funds. I have much greater diversification across asset classes and my retirement funds are not tied to my real estate ventures.

IMHO, you should refrain from  borrowing from your 401(k). Keep that money safe. This will also force you to make the extra effort to find capital partners for more deals.

@Tara Kinney

While I am not self-employed like you. I attempted something similar as a W-2 employee.

My Gross paycheck is as follows
$4,200 Gross
$300 FICA Tax
$1300 - Federal/State/City Taxes
$2,600 Net

One week I decided to put 100% of my paycheck into my 401K and take it out as a loan.
$3,900 went into my 401K and I took out 50% which was close to $2,000.

It was a no brainer for me not to do it. I only really lost $600 from my pay now but over $1,300 of extra money went into either investments in my name or in my 401K.

Obvious downsides of this is that you have to pay back the money if you decide to quit/get fired. So this is not for everyone.

Great discussions.  As for real estate in my 401K, I guess my biggest issue is that my goal is to replace my current income with passive income via real estate and I am on a 6 year plan to retire.   I would be 46 at that time and thus if my properties or cashflow is tied into my 401K then I would have to take a penalty to take it out.  I say "retire" loosely as I wouldn't quit my job completely but work mostly per diem as I do love what I do, just would like more freedom to travel on my own schedule.   

As for going "all in" with real estate... I'm not a fan of the stock market and hoping for some kind of return, I might have control issues....but that's another discussion...LOL! ;)  I do have part of my current 401K invested in an ETF that is tied to the NASDAQ so that is my form of "gambling".   I'm not into house flipping, but rather buy and hold for cashflow, thus whether the markets go up or down, as long as there are people needing a place to live, my investments should be safe and they are backed by insurance, which is more than I can say for anything I put in a stock market.

I do have an interest in doing some partnerships and have been looking into that possibility in the future, I am very analytical and like doing the property analysis and crunching numbers, however I have no desire to get into the rehab/swinging a hammer side of things so the biggest value I can bring to a partnership is generally being the "lender" or analyzing deals.  

Thanks again...I'll go crunch some numbers and do some thinking on what would work best with my goals. :)

@Tara Kinney I would just use the money to buy RE, not build up your 401k to take a loan to buy RE. You do get tax advantages by putting it into the 401k to then purchase, but you will kill your personal cash flow from the property by using a 5 year amortized loan from your 401k to buy it.

With you wanting to be FI prior to the 401k distribution age, there really isn't a reason to chuck it into the retirement vehicle first. Running numbers is a great exercise and I recommend it, but adding in all of the extra complexity so that you can give your 401k loan to yourself at 4% or some such just isn't going to be great.

Either way, best of luck!

@Tara Kinney

A popular option is make Roth solo 401k contributions and then invest those funds in real estate. All of the gains will grow tax free. You can also supercharge your Roth solo 401k contributions by making voluntary after-tax solo 401k contributions and then convert the funds to the Roth solo 401k.

I do see the tax free benefits of the Roth 401K, my issue with doing any real estate inside of a government retirement plan is that I cannot access my own funds without a penalty before I'm 59.  That's 19 years away... I plan to retire way before then...