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Posted about 4 years ago

Deciding between 401k contributions or real estate? Choose both!

"I am thinking about contributing less to my 401k so I can use the money to invest in real estate." I hear these words from people all the time.  Why not do both?  When you invest in a traditional 401k you get the benefits of reducing your taxable income, but you also miss out on the many tax writeoffs you get from investing in real estate.  Consider a 401k loan.  You are allowed to take up to 50% or 50,000 whichever is less from your 401k as a personal loan to do whatever you please with.  There normally is only a small administration fee, typically between $25-75, and you can repay the loan through payroll deductions. There is ZERO underwriting for the loan, so you can get access quickly and the loan does not show up on your personal credit report which also does not affect your debt to income calculation if you are looking to purchase a home.  The interest will not exceed the prime rate by more than 2% but GET THIS.  That interest is being paid back into your 401k, so it's not even a true fee like a  bank loan.  If you pay 6.5 % interest, you are essentially growing your 401k by 6.5%.  The only money you never see back unless you can't pay the loan back is the administration fee.  If you can't trust lending money to yourself who can you trust? Let's use two examples:

First scenario:

A new graduate from college had  high DTI to begin with and no downpayment.  This client of ours needed roughly 8,000 to purchase a duplex they wanted with FHA financing.  They had over 16k in their 401k because they were taught at a young age to max our their 401k and pension.  So we had them take out 8,000 which did not affect their debt to income because it was not on their personal credit report.  That enabled them to get a higher preapproval to buy a duplex.  After taxes, insurance and a utility bill they ended up still paying about 200 dollars a month with the renters covering most of their debt obligations on the property.   They ended up saving $1000 a month on rent, while their 401k monthly obligation was roughly $156.53 a month over 5 years.  Rather than pay the loan back faster they decided to use the savings to buy another property down the road.  With the $850 savings a month minus maintenance and repairs that gives them the opportunity to save up to $10,000 a month where as before they would have taken years to save that up because of high local market rents.

Second scenario:

Investor paid off student loan debt.  (Bad choice)  They actually came to me to borrow money on a flip but they didn't have enough money to pay for the purchase or the rehab which was about $90,000 total.  They were new to the game and even if I did decide to lend them all the money they needed I was going to charge more points (finance charges equating to 1 percent of the loan amount) and a higher interest rate. Instead what I suggested to them was to borrow from their 401k for the rehab funds because they had high balances.  The buyer got hard money financing ata much more reasonable interest rate and loan fees for 90% of the purchase price.  The rehab funds then came from a 401k loan.  In this situation the 401k loan allowed them to get better terms on financing, while at the same time growing their 401k with the interest they were paying.  

So now you're going to tell me probably a couple of things.  The first response I get is well if I leave my job then I have to pay back it back immediately.  My response is in both of these scenarios the use of the funds were short term to buy an ASSET, NOT AN OBLIGATION.  That's a big difference. If you are buying a car, then yes that's a bad move.  The second response I get is, well then I am getting taxed twice on that money I borrow.  Once when I pay it back with after tax money, and two when I actually withdraw it when  I retire.  Let's debunk this thought process.  If I borrow money that was not taxed, why would I get another tax deduction for paying it back, and secondly you are always going to get taxed when you withdraw it so you are not creating another taxable event unless you do not pay, and then it is treated as a early withdrawal.

While this situation may not apply to everybody and has its limitations you have to evaluate the scenario.  The 401k loan or Solo401k loan (setting up my next blog post) are powerful tools to help you achieve financial freedom.  

About the Author:

Charles Kao started his family with his dog in 2006, before adding a wife and 3 kids in the ensuing years.  He has dabbled in standup comedy, and is currently growing his hair out because he can.  He enjoys the great outdoors, real estate, traveling, cooking and all of the previously stated with his family in the eyes of God even more.



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