Cut back on 401K contributions to free up investment capital?

Question

I'm just about to close on my first rental property -- a duplex.  Currently, my wife and I contribute the yearly maximum to our employer 401K plans to decrease our taxable income.  However, now we are considering reducing our 401K contributions to the employer match, thereby freeing up extra capital for future investments.

We already have capital to buy more rental properties, but saving up the extra capital to invest still seems to be the better approach.

I'd be interested in hearing what others think about this subject.  Is it financially better to pay the extra tax and have that extra capital to invest in the near term?

Brett Russell · Answer

@Mark Nugent , I would definitely agree with the idea of only contributing up the match.  That assumes you are able to invest the money in good deals.  Even if you don't use leverage, you still would likely have similar or better return on that money than in a 401k and once you use leverage, your cash on cash return will go up and you'll get magnified returns with any appreciation as Account Closed mentioned.

But really don't forget about the huge tax advantages you can get from holding rental property.  You likely won't have to pay much, if any, tax on all the income from your rental property and might even have enough paper losses to offset some of your active income (if you income is below the cutoff).

Account Closed · Answer

I suggest only contribute to get the maximum company's match and not a penny more.  The rest of the money should be invested in real estate.  If history is any indication, your real estate portfolio will blow your stock portfolio out of the water.  Of course, timing is critical to your success given that your housing market can be cyclical.

Example.  $25k down on a $100k real estate investment.  A 3% annual inflation/appreciation would give you 12% return on your investment not including the monthly positive cashflow and principal pay down.  Historically speaking, stocks give you 10% return on your investment including dividends reinvested.

Good luck.

Walt Payne · Answer

@Mark Nugent After seeking professional advice, here was how I dealt with that question. It may or may not work for you. I set up two LLCs. One is a partnership for holding the properties, the other is for doing the rehabs, and maybe flips. This serves two purposes. It keeps my holding LLC from being declared a dealer if I do flips, and it lets me split off the rehab expenses in a controlled fashion so I can have a legit business to hang a solo 401k (that can invest in RE). I then put as much in the solo 401k as I can through my personal deduction, and balance the profit (by how much I charge the holding LLC) to keep taxable income to a minimum.

I also have a company sponsored simple IRA at work which allows me to funnel that contribution, with matching funds, to my 401k. The best of both worlds. But talk to an accountant because the costs of maintaining a LLC vary greatly. Ask anyone in CA about their costs.

Dmitriy Fomichenko · Answer

@Mark Nugent

If you are willing to pay taxes now vs. contributing into 401k, consider contributing into Roth Solo 401k.  You pay taxes now, but all of your rental income and capital appreciation (and any other income your Roth Solo 401k will generate) will be tax free forever!

Colleen F. · Answer

One of the factors here is tax impact. Consider things like if you pay AMT and if the 401k deduction has any influence on that.  Also if you are someone with a day job and real estate is not your primary occupation there are differences in how rental income/deductions are treated.   If you live in  some states the state or local tax may have an influence but that is usually a factor for flips more then buy and hold.

There may be a balance in what you do based on these factors. I don't suggest using taxes as your only motivation for one decision or another but weigh it in.

Of course you can take money from a 401k loan to invest in real estate now but the loan periods are  shorter and the limit is lower.  That gives you extra money and tax advantages from what you have already put away. Understand your plans limits if you do that. There may be a pay up if you leave the company clause but there may not be.

In the end  if you don't put it in a 401k then having the discipline to not use it for things other then investments is key.

Brant Richardson · Answer

I made this decision years ago.  As others have said, contribute however much your employer matches.  I feel I can get better returns outside of my 401k.  The important part of this strategy is self discipline.  Will you really invest that money if you have access to it or will you feel cash rich and start buying non investments?  If you are dead set on doing everything in your power to build a portfolio of rental properties then you need that cash for acquisitions.

Katharine Chartrand · Answer

Depending on what the money is for, you can take the opposite approach and try to maximize your contribution to a 401K until you have enough money to use the 401k funds to invest in real estate.

If you have 401K's you can roll over from previous employers, you can get to critical mass more quickly.

If you don't need to live on the money, then you are better off contributing pre-tax to a solo 401K (you get more money to invest) and then delaying paying taxes for a while.

Admittedly, if you are doing rentals, its passive income and you don't face the 35% ordinary income tax that sent me scrambling.

You can read up on solo 401K's at my favorite solo 401K consultant, mysolo401k.com and on this site.

Mark Nugent · Answer

Thanks for the feedback.  Brett, the cutoff makes me wonder.  If a married couple's taxable income exceeds the cutoff, but the property is purchased by the person making less income, will that person be able to qualify for the tax deduction if they file their taxes separately?  Hmmm.....

Cut back on 401K contributions to free up investment capital?

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