One common concern with physicians and dentists when it comes to maxing out retirement plans is the lack of liquidity until age 59 ½. Though everything is running smoothly at the moment, many wonder if they’ll be able to work at this pace until 60 and are concerned with contributing the maximum amount to a plan that restricts their access to cash.
This concern also begs the question as to whether those contributions could gain more than a portfolio of mutual funds and stocks over time if one were to pay the taxes and invest the money in real estate. In other words, is it possible to produce greater returns with more creative alternative investments using after-tax dollars than would be possible in a diversified portfolio of mutual funds with pre-tax dollars?
But what if it were possible to do both? What if you could make pre-tax contributions to your 401(k) and access those funds for alternative investments like real estate?
That scenario is made possible through something called a Self-Directed 401(k) plan.
SELF-DIRECTED 401(k) PLANS
There are two features to a Self-Directed 401k plan that address the two common conundrums explained above. The first feature is a loan provision that allows you to borrow from your own 401k. And the second feature, which I’ll discuss in detail below, allows you to buy alternative investments such as flips, rental property, and land just to name a few, within your Self-Directed 401k plan or IRA with pre-tax dollars.
As you might expect, there are many provisions, exceptions, and requirements to fully maximize such a plan. What follows is a somewhat comprehensive explanation of these provisions and requirements so that you can be as informed as possible when considering whether a Self-Directed 401(k) plan is beneficial for you and consistent with your financial goals.
Taking a Loan
First, you need to know what you are and are not allowed to “borrow” from your 401(k).
The loan feature is not truly a loan in the sense that you are not borrowing money from a lender. You are borrowing money from your own account, which means you avoid the loan approval process and the loan does not generate an inquiry against your credit or impact your credit score.
You can access up to 50% of your vested account balance or $50,000 - whichever is less - tax-free and without penalty. If 50% of your vested account balance is less than $10,000, you may be able to borrow up to $10,000 if your plan document allows it.
This is a cost-effective solution if you have a short-term need for capital because the interest paid on the loan balance is paid to your 401k rather than a lending institution. Plus, you avoid the typical administrative fees associated with borrowing from a bank. Since the interest you pay goes back into your account, the only real cost of borrowing from your 401k is the opportunity cost of those funds not being invested. When you borrow, the 401k account balance does not serve as collateral for a loan from an institution, which leaves the account balance invested.
When borrowing from a 401k, you must cash out of investments in an amount equal to the amount borrowed. Also, though you are paying an interest rate to yourself that is comparable to the interest you would pay on a consumer loan, this interest is not as beneficial as tax-deferred interest gained through investments in the 401k. The interest you pay to your 401k is paid with after-tax income, whereas gains from your investment holdings in the 401k are tax-deferred. However, the difference between tax-deferred gains and after-tax interest is a small factor when you consider the balance of the loan will be no larger than $50,000.
As for paying the loan back, the loan itself is not taxable and avoids penalties as long as you adhere to the repayment rules and loan limits. You are required to pay the loan back through post-tax payroll deductions on a 5-year amortization schedule unless you withdrew the loan to help with the purchase of your primary residence. In that case, you are allowed to repay the loan through fixed quarterly payments over a longer term.
Prior to the “Tax Cuts and Jobs Act of 2017,” you only had 60 days in which to repay or roll over the balance into another eligible retirement plan if you lost your job or changed employers. The Tax Cuts and Jobs Act of 2017 changed the rule from 60 days to the due date of the employee’s tax return for the year in which the distribution occurs, which includes extensions. Therefore, if you had an outstanding loan against your 401k in 2019 and lost your job or changed employers, you would have until April 15th, 2020 or if filing an extension, until October 15th, 2020 to repay the loan amount.
Investing your Self-Directed 401k in Real estate
A second feature available in a Self-Directed 401k or IRA is the ability to purchase alternative investments such as land, commercial, and residential real estate, as well as precious metals, tax liens, promissory notes, and private company shares.
This is not the same as holding these items in a mutual fund; rather, this is about actually buying property with the funds in your account. It’s important to note that this is only an option for those who are self-employed. However, many of you reading this will be able to roll your 401k, 403b, and 457 plans into a self-directed IRA at some point and, in that case, you will be able to participate in these types of investments. To be clear, Solo 401k, Self-Employed 401k, Self-Directed 401k, and Individual K are all names that can be used interchangeably to describe a plan that would be eligible to invest in the alternative investments mentioned above.
In fact, some of you may be able to periodically do what is called an in-service distribution from your retirement plan, which transfers the balance of your group 401k, 403b, and 457 plan into an IRA. Many plans require the participant to be over the age of 59 ½ to do an in-service distribution, so it may not be an option for a while. However, many of you are in control of the plan document and have a say in how it is written because you are a partner in your group. Eventually, if not already, you will have the option of transferring funds to a self-directed IRA, so this is relevant information that every physician and dentist should learn.
If you are self-employed, you can serve as the trustee of the solo 401k plan that you opened for your business. Serving as the trustee allows you to approve the investments selected for the plan. The fair market value of assets held in a Self-Directed 401k are reported on Form 5500-EZ and the fair market value of assets held in a Self-Directed IRA is reported on Form 5498. You can contribute up to $56,000 per year in a Self-Directed 401k plan. The IRA is limited to $6,000, but again, the Self-Directed IRA will likely come into play when you retire and will be on the receiving end of a large roll over from your previous employer plan. A few rules need to be understood before moving forward with using your Self-Directed 401k to purchase property.
You’ll need a third-party administrator that is familiar with buying real estate within a 401k. There are several rules to abide by and you’ll need help with keeping the plan compliant.
For example, neither the self-directed 401k or IRA funds can be used to invest in assets listed under I.R.C. 408(m). Prohibited transaction rules also prevent you from investing with certain people.
A transaction is deemed prohibited if it benefits you, as trustee/participant of the Self-Directed 401k plan, or other disqualified persons such as your beneficiary, spouse, son, daughter, father or mother, to name a few. Any transaction that provides a benefit to you personally or someone you know who is defined as a disqualified individual by the IRS will be deemed prohibited.
Here are transactions that are allowed under this rule:
Mortgages/Deeds of Trust
Tax Liens/Tax Deeds
Foreign Currency Exchange
Here are the transactions that are Disallowed under these rules:
The Self-Directed 401k cannot purchase property in which you or a disqualified person currently occupy or plan to occupy. If you invest money from your self-directed 401k plan into real estate, you are not subject to Unrelated Business Income Tax; otherwise known as UBIT. The income generated by the real estate is considered passive and grows tax-deferred; however, if you were to invest the money into an operating business like a toy store, the pass-through income would be taxed just like a business owned outside of the 401k. Exceptions to UBIT can be found under IRC Sec 511, but to keep it simple, you should not invest the funds of your Self-Directed 401k in a trade or business if you wish for the income to be tax-deferred.
You may not invest your Self-Directed 401k funds in private shares of your own company or a company of a disqualified person. Private shares are company shares that are not traded in a public exchange such as the NYSE or Nasdaq.
You cannot loan your Self-Directed 401k funds to a disqualified person, which are listed below.
Collectibles under IRC Section 408(m)(2) include:
Any work of art,
Any rug or antique,
Any metal or gem (with limited exceptions, below),
Any stamp or coin (with limited exceptions, below)
Any alcoholic beverage, or
Any other tangible personal property that the IRS determines is a "collectible" under IRC Section 408(m).
Qualified and Disqualified Persons
Your natural parents and/or your adoptive parents
Your natural grandparents
Your natural children and/or your adopted children
The spouses of your natural children
Any fiduciary of your Solo 401k
Any people providing services to your Solo 401k–such as your stockbroker–as well as his employees and both his and his employees’ blood relatives
Your Solo 401k trust document provider or administrator
Your brothers and sisters
Your Spouse’s brothers and sisters
Your spouse’s parents
Your spouse’s grandparents
Your spouse’s stepchildren
Your grandparent’s spouse, if not your natural grandparent
Your aunts, uncles, and cousins
Violating the prohibited transaction rules will receive the same treatment as an early withdrawal from the retirement plan. You will be required to pay federal, state, and local taxes, along with incurring the 10% penalty.
Protected from Creditors
You can structure the Self-Directed 401k so the investments are owned by a single member LLC. However, there’s little benefit in doing so because the 401k can hold the title directly and since the real estate is owned by a retirement plan, it is protected from creditors.
Investing with Others or Yourself
You are able to buy real estate with your Self-Directed 401k and utilize personal funds as well but in doing so, you must own the property as tenants in common as two distinct owners. Remember to consider the list of disqualified persons before investing your Self-Directed 401k funds with other partners.
The Self-Directed 401k can use leverage to buy property, whereas the self-directed IRA cannot. But the loan must be a Non-Recourse loan. A non-recourse loan essentially means that if you were to default on the loan, the bank would only be able to take the asset securing the loan, which is the property itself. They would not be able to take any recourse against other assets in the 401k or personal assets owned outside of the 401k. Given the terms of non-recourse financing involves considerably higher risk for the bank, they normally require between 35 – 40% down, so keep this in mind as you consider your budget when searching for property. Contribution deadlines will depend on the type of entity controlling the 401k as you can see below.
Annual Contribution Deadlines:
If the entity type is a Sole Proprietorship, C-Corporation, or LLC taxed as a Sole Proprietorship, the deadline is April 15, or October 15 if filing an extension.
If the entity type is an S-Corporation, C-Corporation, Partnership, or LLC taxed as an S-Corporation or Partnership (calendar year), the annual solo 401k contribution deadline is March 15, or September 15 if filing an extension.
Earnings and Expenses
All earnings must be kept within the 401k at all times. If you invest in a rental property, income from tenants must be deposited directly into the 401k plan. If withdrawn from the 401k or directed to a personal account, such will be considered a taxable distribution and subject to the early withdrawal penalty.
All expenses related to the assets owned by the 401k must be paid by the 401k. Anything paid by the participants personal account would also be considered a distribution. Though this seems restrictive, it is a major benefit to buying real estate with a Self-Directed 401k plan because the income generated by the property will grow tax-deferred and the expenses related to the property are paid with pre-tax dollars.
Avoids the need for 1031 exchanges to defer taxes on property earnings.
Just as the growth and dividends received from the stocks or mutual funds in your portfolio are tax deferred, the same is true with real estate assets held within the 401k. If you buy a property and sell it five years later, the capital gains will be tax-deferred. Normally, individuals selling investment property outside of a 401k are forced to do a 1031 exchange to defer paying taxes on any recaptured depreciation or capital gains, which involves hiring a 1031 intermediary and identifying a like-kind property for the funds to buy within a specific timeframe. The timeframe for reinvesting the equity can be problematic because you are likely selling because you believe the market is at a high, which is not the most opportune time to buy. In some instances, it would be nice if you could sell while the market is high, defer taxes on the gains, and hold cash until a bargain presents itself even if that’s two or three years from now. The Self-Directed 401k allows you to do exactly that and does not require the reinvestment of property gains when buying and selling in order to defer taxes.
Obviously, this is a lot of information to take in. But when Self-Directed 401k and IRA plans are used wisely, they can be of great benefit to your portfolio with minimal tax burdens.
Real estate consulting is one of the many services offered by our firm. If you are interested in discussing real estate or other opportunities afforded by a Self-Directed 401k, click the button below to schedule a meeting and we can walk you through the process, step-by-step.