How to Invest in Real Estate with Your 401(k) Funds

Estimated reading time: 8 minutes

Steady cash flow and capital appreciation. For real estate investors, these are two of the most appealing benefits of this long-trusted asset class. 

There’s one way to make real estate investing even more attractive – adding tax-advantaged growth to the mix by investing with your retirement funds. Unfortunately, many investors (even experienced investors) believe their 401(k) funds can only be invested in stocks, bonds, and mutual funds. 

This isn’t true. 

In fact, the IRS allows you to invest your retirement funds in dozens of other asset types, including real estate. Over the years, thousands of Entrust clients have invested their retirement funds in real properties to diversify their portfolios and potentially achieve higher returns.

If you want to invest in real estate with your retirement funds, you have two options at your disposal:

• Self-directed 401(k)
• Self-directed IRA (SDIRA)

Each type of investment account offers its potential benefits and considerations. In this article, we’ll break down the difference between the two, highlighting how each can be a powerful tool for taking control of your retirement portfolio.

Table of Contents

• Why Invest in Real Estate with Your Retirement Funds?
  
• Essential IRS Rules to Be Aware of
  
• Self-Directed IRA vs Self-Directed 401(k) for Real Estate Investing
  
• How to Move Funds from a 401(k) to an SDIRA and Start Investing
  
• Consider Whether an SDIRA is Right For Your Portfolio
  

Why Invest in Real Estate with Your Retirement Funds?

Before we break down the differences between a self-directed 401(k) and self-directed IRA, let’s examine the benefits of investing in real estate with retirement funds.

Diversification 

Real estate often performs independently of the stock market, providing a hedge against market volatility​. These investments can diversify your portfolio, reducing reliance on traditional assets like stocks and bonds. Diversification helps spread risk and can lead to more stable returns. 

Potential for Higher Returns 

Properties can generate a steady stream of rental income, providing consistent cash flow that can be reinvested for compound growth. Plus, real estate has the potential to appreciate over time, offering significant returns on investment. 

Tax Advantages 

Real estate investors typically face two primary sources of taxable income: rental income and capital gains.

In most cases, rental income is taxed as ordinary income, which can reach as high as 50% depending on your income level and state. Meanwhile, long-term capital gains are taxed up to 20% federally, with state taxes adding up to 14%.

Investing in real estate with retirement funds, such as those in a traditional or Roth IRA/401(k), can significantly reduce your tax burden:

• Tax-Deferred Growth: Using a traditional IRA or traditional 401(k) allows your real estate investments to grow tax-deferred, meaning you won't pay taxes on the earnings from your rental income or capital gains until you take distributions in retirement.
• Tax-Free Growth: Contributions to a Roth IRA or Roth 401(k) have already been taxed, so qualified withdrawals during retirement are 100% tax-free.
  
  

Control Over Investments 

Investing in real estate allows for greater control over your investments compared to traditional mutual funds or stocks. You can make decisions about property management, improvements, and leasing strategies. And if you have unique expertise over a real estate market, you may be able to spot undervalued properties better than the competition.

Leveraging Opportunities

With most 401(k)s and IRAs, you can’t take out a loan to purchase more shares of Apple or Nvidia. However when investing in real estate with your retirement funds, you can take out a non-recourse loan to potentially amplify returns. 

Essential IRS Rules to Be Aware of

Ultimately, Investing in real estate with your retirement funds requires careful adherence to IRS rules to ensure compliance and avoid the disqualification of your account. 

Here are a few key IRS rules to be aware of:

Disqualified Persons

In order to minimize conflicts of interest, certain persons are disqualified from transacting with the IRA or 401(k). These disqualified persons include the account holder, their spouse, descendants and ascendants (e.g., parents, grandparents, children), and any entities in which they have a controlling interest. 

Any transaction between the SDIRA or self-directed 401(k) and a disqualified person is strictly prohibited and could lead to the disqualification of the entire account.

Prohibited Transactions

Prohibited transactions are dealings that your SDIRA or self-directed 401(k) cannot engage in, which include certain types of self-dealing and transactions with disqualified persons. 

This includes, but is not limited to:

• Self-Dealing: Allowing disqualified persons, including yourself, to use the property for personal use.

• Furnishing Goods or Services to the Property: Performing services for the property, such as repairs or management.
• Extension of Credit: Using your IRA or 401(k) as collateral for a personal loan.
  
  

Fair Market Valuation Reporting

For the IRS, the price of one share of Apple stock is easy to determine – it’s a publicly traded security. The same is not true for real estate. So, the IRS requires an annual valuation of your account’s assets to determine proper taxation whenever a taxable event occurs. 

As an IRA or 401(k) holder, you must enlist a qualified, independent third party to provide an accurate fair market valuation (FMV) of the property to your custodian each year.

Unrelated Business Income Tax (UBIT)

UBIT applies to income generated from activities not related to the tax-exempt purpose of the retirement account, such as income from debt-financed property. 

For instance, if you use leverage to purchase real estate in your SDIRA or 401(k), the income generated by that portion of the investment may be subject to UBIT. This can reach as high as 37% in the top income bracket.

Required Minimum Distributions

If you have a traditional SDIRA or self-directed 401(k), you must begin taking required minimum distributions (RMDs) starting at age 73. If the retirement account holds real estate, you need to plan how to take distributions. This may involve liquidating part of the real estate or distributing the property in-kind.

Property Management and Income

All income generated by the property must go directly into the SDIRA or 401(k). Similarly, all expenses related to the property must be paid from the retirement account.

Self-Directed IRA vs Self-Directed 401(k) for Real Estate Investing

401(k)s offer higher contribution limits than IRAs, so 401(k)s are the way to go – right? It’s not that simple.

Here are three of the distinguishing features between self-directed 401(k) and self-directed IRAs to help you make the right decision:

Self-Directed 401(k)

• Higher Contribution Limits: Allows individual contributions of up to $23,000 per year ($30,500 if age 50 or older), with additional employer contributions possible. This makes it an attractive option for those looking to maximize their retirement savings.
• Participant Loans: With a self-directed 401(k), participants can take loans up to $50,000 or 50% of the account balance, whichever is less. 
• Complex Setup and Administration: Generally more complex to establish and manage, leading to higher administrative costs over time. These costs include setup fees, annual fees, and compliance-related expenses.
  
  

Self-Directed IRA

• Ease of Setup and Management: On the whole, SDIRAs are simpler and quicker to set up compared to 401(k)s, with lower administrative costs. 
• Lower Contribution Limits: For tax year 2024, traditional and Roth IRA contributions are limited to $7,000 per year ($8,000 if age 50 or older). This is significantly lower than 401(k) limits. 
• No Loan Provision: Does not allow borrowing against the account, which limits the leverage you can apply to your investments.

Find our comparison table below for a more comprehensive breakdown of the difference between these two accounts. 

What if you’re self-employed or a small business owner and want the higher contribution limits of a 401(k) without the administrative costs? 

You might benefit from a self-directed SEP or SIMPLE SDIRA. 

How to Move Funds from a 401(k) to an SDIRA and Start Investing

Moving your 401(k) funds to an SDIRA and investing in real estate can be done in five simple steps:

1. Open Your SDIRA: Select a reputable provider like The Entrust Group with decades of experience and expertise in the SDIRA industry. At Entrust, all you need to open an account is 10 minutes of your time and a copy of a government-issued ID.
2. Fund the Account with a Rollover: If your 401(k) funds are with a previous employer, completing a rollover is simple. A direct rollover ensures that funds are transferred directly from an old 401(k) to your SDIRA without taking possession of the funds. This method helps avoid any potential taxes and penalties.
3. Identify and Evaluate Real Estate Investments: Look for properties that fit your investment criteria, whether you’re seeking residential, commercial, rental properties, or raw land. Perform thorough due diligence. This includes evaluating the location, market conditions, potential rental income, property condition, and any legal issues.
4. Direct Entrust to Purchase the Property:  Once you’ve chosen a property, you need to instruct The Entrust Group to make the investment by submitting a Real Estate Buy Direction Letter. You can do this with a paper form or through The Entrust Client Portal. Then, we will complete the purchase on behalf of your SDIRA.
5. Manage the Investment: Decide whether to manage the property yourself or hire a property management company. Keep in mind that, as the account holder, you cannot personally perform repairs or renovations. 
   
   

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If Your 401(k) Funds Are With Your Current Employer

If the majority of your 401(k) funds are with your current employer, you may still be able to complete a rollover to an SDIRA. 

Some employers allow “in-service withdrawals,” which permit you to roll over a portion of your 401(k) funds to an IRA while still employed. This is not available in all plans, so you must check with your plan administrator.

If your employer does not allow in-service withdrawals, you will likely have to wait until you leave your current employer. Only then can you be able to roll over the 401(k) funds to an SDIRA. For a smoother process, opt for a direct rollover to avoid withholding taxes and ensure compliance with IRS rules.

For a detailed guide on the process, read our blog post, How to Rollover a 401(k) to an SDIRA.

Consider Whether an SDIRA is Right For Your Portfolio

Investing in real estate with your retirement funds offers many advantages, including diversification, potential for higher returns, and enhanced control over your portfolio. 

Whether using an SDIRA or a self-directed 401(k), understanding the IRS rules and following the correct steps will help you make the most of this strategy.

Have more questions about SDIRAs? Download our SDIRA Basics Guide. Inside, we’ve included a more comprehensive breakdown of the IRS rules, examples of what you can and cannot invest in, and a step-by-step process to get started.

Or, if you want specific stories from Entrust clients who have invested their retirement funds in real estate, check out these recent client stories from Chris De Celle and Carl Kaplan.