The first step for investors looking into a rental property is obtaining sufficient financing. If you don’t have enough cash and don’t want a mortgage loan, then you may be considering cashing out your 401k to buy a rental property.
Dipping into your 401k has some implications, so before making this decision, there are several factors you must consider.
This article will cover the benefits and drawbacks of cashing out your 401k, how to buy a rental property with that cash, and alternative methods for financing your rental.
Key Takeaways
The IRS does not allow you to use your 401k to buy rental property directly. However, alternatives such as 401k loans, 401k rollovers, and a self-directed 401k will enable you to do so legally.
Using your 401k to buy rental property allows you to generate long-term, tax-free income for your retirement savings and diversify your portfolio. However, the process can be challenging and involves lots of paperwork, potential tax consequences, and limited access to your income.
There are alternatives to cashing out your 401k to invest in rental property, including existing home equity, HELOC, Roth IRAs, and a traditional mortgage.
Should You Cash Out Your 401k to Buy Rental Property?
While the IRS does not permit you to use your 401k to invest in real estate directly, there are other ways you can legally access these funds to invest. So while it is possible to cash out your 401k, you must consider if the rental property is worth the work involved.
Before deciding whether to use any money from your 401k, you must ensure you have enough funds in your account. Your 401k is supposed to be your nest egg after you retire, so carefully consider how much you have and are withdrawing.
If you decide to use these funds to buy a rental property, it could be a profitable venture if it’s managed well and does not put your retirement savings in jeopardy.
However, there are risks you must factor in, including tax consequences and general rental property risk, before you commit to this.
Benefits of Cashing Out Your 401k for a Rental Property
Deciding whether or not to use your 401k for rental property investments is a big decision. Here is a list of potential benefits of cashing out your 401k for an investment:
Stable Interest Rate
One of the greatest benefits of using a 401k loan versus a mortgage loan is the stable interest. When interest rates rise, mortgage loans become more costly. However, interest rates for 401k loans make it easier to pay off your down payment.
401k loan interest rates are typically around 1% higher than the prime rate, 8.25%. Your credit score doesn’t affect this rate, and the prime rate is stable, unlike the rising mortgage interest rates.
Mortgage interest rates are variable, but below-average credit scores and lower down payments can often exceed the 401k loan interest rates.
Another benefit of the 401k interest is that the money will return to your 401k account when you pay it off.
Tax-Deferred Status
When you cash out your 401k, the IRS does not qualify the money as income. The money is considered in “tax-deferred” status. This means you do not have to pay additional income tax for the loan.
Additionally, the income you receive from the rental property you invest in will not be taxed. The revenue does not go to you directly but is placed in your 401k account.
Buying Power
By diversifying your portfolio and retirement funds, you can strengthen your buying power as an investor. You can enjoy appreciation and long-term income, improving your finances without dealing with the typical income tax of other financing options.
Drawbacks of Cashing Out Your 401k for a Rental Property
Cashing out your 401k has tax benefits and is an appealing option for many investors. However, there are several drawbacks and intricacies to consider before making a decision.
The drawbacks are:
Paperwork, Paperwork, Paperwork
You need a lot of paperwork to successfully and legally withdraw money from your 401k and use it to invest. To receive the IRS's permission, you must complete several documents precisely and accurately.
To help you organize all of the required paperwork and ensure you fill out forms correctly, you can utilize the help of Trustworthy. Trustworthy is a family operating system that allows you to store and organize your financial documents safely and securely.
Fees & Tax Consequences
You may be hit with a significant withdrawal fee if you withdraw money from your 401k without taking out a loan. For anybody younger than 59 and a half, you must pay a 10% fee on whatever amount you withdraw.
The money you withdraw will also count as income, potentially pushing you into a higher tax bracket and costing you big time.
For example, if you need more than $190,750, you will be placed in the 24% tax bracket (if you file jointly as a couple).
Most people will also have to pay state taxes on the withdrawal. This could add up fast and take a huge chunk out of your savings, so it’s important to carefully consider all your options before taking money from a 401k.
If you cannot repay the loan, you may incur severe financial damages. So, it is crucial to consider if the risk outweighs the benefits of the investment.
Limited Access To Income
Since the appreciation and income you gain from your rental property investment flows back into your 401k, you can only access it in retirement. It’s important to understand that this investment will increase your retirement fund, and you won’t see any income you receive until then.
Rental Property Risks
Rental properties are subject to all kinds of unexpected costs, such as tenant damage, repairs, and capital improvements.
Without proper knowledge and experience in the real estate industry, it is easy to become overwhelmed by the costs, risks, and responsibilities of owning a rental property.
Landlord-tenant laws can vary from state to state, so it is important to understand all terms that could come into play with your particular investment strategy before taking money out of your 401k.
How To Buy A Rental Property With Your 401k
Unfortunately, the IRS does not allow you to invest in real estate with a 401k directly. Your 401k account is usually connected to your employer, and a limited amount of funds are available for employees.
However, using your 401k to invest is not impossible; you can safely and legally use your account to fund an investment in a few different ways.
Here are easy steps to follow to buy rental property with your 401k:
Step 1: Cash Out Your 401k
The first step to purchasing a rental property is acquiring the funds from your 401k, which you can do in different ways. It is best to consider each option closely before making a decision.
401k Loans
The most common option is to take out a loan against your 401k. This option allows you to avoid the early withdrawal fee and is granted tax-deferred status.
The IRS grants you two options for how much you can withdraw:
“The maximum amount that the plan can permit as a loan is (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less.
For example, if a participant has an account balance of $40,000, the maximum amount that he or she can borrow from the account is $20,000.”
The interest on your 401k loan is paid back into your account; however, you will face a hefty fee if you cannot repay the loan in time. It is also worth noting that not all 401k plans allow you to take out a loan.
401k Rollover
The next option is to roll over funds from your 401k into a Roth IRA account. This option allows you to access the funds and avoid withdrawal fees and initial tax. You will then have access to the money in your Roth IRA to invest in a property.
You will have to pay taxes on the money you transfer into your Roth IRA account but at a much lower rate than an initial income tax.
Moving your money into a traditional IRA account would allow for less tax deductions from the transfer but higher income tax.
For this reason, if you already have a traditional IRA account, it may not be worth it to use the funds in your 401k.
Self-Directed 401k
For more experienced investors, you can open your own 401k account and have fewer limitations on your withdrawal. The money you get back will still be tax-free and can be stored in your account.
However, a self-directed 401k limits your investment options. You cannot invest or purchase property in which you or your family has lived, meaning you must find a property yourself that will generate profit to get a good return on your investment.
Step 2: Paperwork
Once you select the best financing option, it is time to start the application process. Like other loans, you must get approval from several official bodies before accessing your funds.
The IRS requires a lot of paperwork during this process, and it can be challenging to stay organized and prepared. You can utilize Trustworthy’s Family Operating System to store your documents safely and have them easily accessible during your application.
Step 3: Finding The Right Property
After finalizing the paperwork, the next step is selecting the rental property you wish to invest in. A property that you invest in has the potential to provide a great return on investment and supply you with income for years.
The criteria for a suitable property include location, condition, current management, and price. It is essential to conduct thorough research on multiple properties and locations to find the best option for the best return.
Alternatives To Cashing Out Your 401k
For some, there may be better options than cashing out your 401k. If you want to invest in rental property but can’t use your 401k, here are some other alternatives for you to consider:
Existing Home Equity
If you own a home and already have considerable equity, you can take out a second mortgage to finance your investment. However, you don’t want your second mortgage to create too much debt. With too much debt, you might not be eligible to receive a new home equity loan.
HELOC
If you already have a home equity line of credit on your home, you also have the option to use this equity as funding. It is crucial to carefully calculate the loan payments and interest to make sure you can comfortably pay the loan back.
Roth IRA
As I mentioned earlier, a Roth IRA account is an alternative to your 401k. Your money in your Roth IRA is tax-exempt and will allow you to avoid withdrawal fees. However, this option involves directly tapping into your retirement funds. You must carefully consider how much you are willing to withdraw to make your investment.
Traditional Mortgage
A traditional mortgage is another way to finance your rental property. By taking out a loan with the bank, you will have an extended period in which you can pay it back and also be able to use tax deductions for qualified interest payments (depending on what type of investment property).
Frequently Asked Questions (FAQs)
Can I take money out of my 401k to buy a rental house?
You can withdraw money from your 401k to buy a rental property. However, you may face a withdrawal fee and income tax for the amount you take out, depending on your withdrawal process.
Should I move my 401k money to cash?
You can move your 401k money to cash, but you will likely have to pay a large fee and an increase in taxes depending on the amount you withdraw.
How can I withdraw money from my 401k without penalty?
To withdraw money from your 401k without penalty, you can utilize a 401k loan or a 401k rollover that transfers funds to an IRA account.
Is it wise to use 401k to buy a house?
Most financial advisors say using a 401k to buy a house is not the best idea. You may face several fees to access the funds, and there are safer alternatives to consider.
