Diversifying assets to include real estate can help you spread risk across a mix of investments. Whether buying property for direct use or for rental income, your 401(k) might be a funding source. The way you use a 401(k) for real estate investments determines any tax or penalty consequences you may face. It also can leave you with less money to fund your retirement.
If your plan rules permit loans, your 401(k) can help you finance a real estate purchase. According to the Internal Revenue Service, you can borrow as much as $50,000 or half of your balance, whichever is lower, including any outstanding loan balances. Unless the loan finances your main home, you have to repay it within five years to keep it tax-free; 401(k) loans to buy a principal residence can be repaid over a longer time period -- up to 15 years -- if your plan allows. The interest you pay adds to your 401(k) savings, but cannot be listed as an itemized deduction on your tax return.
A hardship withdrawal from your 401(k) can help you cover home purchase-related expenses. As with loans, plan guidelines dictate the availability of a hardship distribution option. Unlike loans, 401(k) hardship distributions reduce your savings: They cannot be repaid, increase your tax liability and, if you are under age 59 1/2, trigger a 10 percent early withdrawal penalty. They also restrict your ability to continue deferring income into the 401(k) for at least six months. You must limit your hardship withdrawal to your contributions. For example, if $1,000 of the $16,000 in a 401(k) is interest income, only $15,000 is available for a hardship withdrawal. Nor can you make new contributions -- and have them grow -- for at least six months.
401(k) Rollover to a Roth IRA
You can avoid the 10 percent early withdrawal penalty and restrictions imposed on a 401(k) distribution by rolling over as much as $10,000 that you've earmarked for building or buying your first home into a Roth IRA. However, because 401(k) funds are pre-tax contributions and Roth IRA contributions are post-tax, you must pay income tax on the money transferred to the Roth IRA. That means increasing your federal withholding, which will reduce your take-home pay.
For investors who want real estate as an investment choice for their retirement savings, a self-directed 401(k) allows them to buy land, commercial property and residential property and have any income generated grow tax-free. Self-directed 401(k)s are do-it-yourself retirement plans; you, not a broker, manage the plan. In addition to being savvy about the real estate market, participants must abide by limits on the types of transactions they can undertake. Self-directed 401(k)s cannot involve property bought or sold to relatives or property in which the participant lives, and participants cannot influence the fair market value of any purchase made through a self-directed 401(k). However, they can use non-recourse loans -- loans without personal guarantees -- to buy investment property that costs more than the money in their self-directed 401(k).
- CNNMoney: Amateur Investors Tap 401(k)s to Buy Homes
- Internal Revenue Service: 401(k) Resource Guide - Plan Participants - General Distribution Rules
- Kiplinger: Borrowing From a 401(k) to Make a Down Payment
- Internal Revenue Service: Retirement Plans FAQs Regarding Hardship Distributions
- Internal Revenue Service: 590 Individual Retirement Arrangements (IRAs)
- Asset Protection Society: Self-Directed 401(k) and Real Estate
Trudy Brunot began writing in 1992. Her work has appeared in "Quarterly," "Pennsylvania Health & You," "Constructor" and the "Tribune-Review" newspaper. Her domestic and international experience includes human resources, advertising, marketing, product and retail management positions. She holds a master's degree in international business administration from the University of South Carolina.