How to Use Your Retirement Funds for Real Estate
by Hugh Bromma
In this articles, we will examine how one can use the tax-deferred money in
their retirement plans to take advantage of real estate investing opportunities.
This article explains how you can use your 401(k) funds to diversify your
portfolio mix into real property.
The 401(k) Plan
First, it is important to understand some basic features of a 401(k) program.
The 401(k) is a subsection of the Profit Sharing Plan section of the Internal
Revenue Code. It allows for employee deferrals on a pre-tax basis. Employers may
make this type of plan available to their employees by adopting an acceptable
format forsuch a plan. There are limits of how much an employee can contribute.
Adoption of such a plan also permits the employer to match employee
contributions and to make profit sharing contributions (at the employer's
discretion).
An individual employee may contribute up to about 20% of annual compensation, to
a maximum of $9,500 per year. Employers may make matching contributions (such as
25 cents on the dollar) up to 8% of total compensation for each employee.
Sometimes profit sharing contributions may also be made and, under certain
circumstances, one may have a combined package of 401(k), match and profit
sharing/money purchase up to $30,000 in a given year. All of this is variable,
and one rule does not apply for all cases.
If you are an employer, you can design the features of the plan and provide the
investment alternatives for yourself and your employees. If you are an employee
(not defined as an employer), you are permitted to operate your deferrals and
investments as established by your employer. If some of the features we discuss
here are not available to you as an employee, you may wish to discuss them with
your employer to determine whether they can be adopted by your 401(k) plan. If
your present plan does not permit the flexibility we are about to discuss,
remember any plan may be amended and restated to make such capabilities
available.
How to Use the 401(k) for Real Estate and Notes
After all this, how can the funds in your 401(k) plan be used for real estate
transactions? Once you have found out that your 401(k) plan funds can be used
for real self direction, and the trustee of the plan also permits such
transactions, the rules are simple:
You can purchase assets into your plan which are not prohibited. Real estate is
not prohibited. You may not deal with yourself or members of your family (other
than siblings).
All Transactions Must Be Arm's Length
This means that you can purchase mortgages with your plan assets. This means you
may purchase real property in your plan for income purposes. While debt-financed
properties may be subject to unrelated business income taxes, in almost all
investment cases we are aware of this has not applied.
How It Works
How does it work? First, you find the property or note. These are self-directed
plans, and no one is going to give you a list of real property to chose from.
It's all up to you. Remember, you take all of the risks and receive all the
benefits. Neither the employer or the plan trustee has any obligation to you in
a properly designed plan. Second, you request that the administrator of the plan
ask the trustee of the plan to purchase the asset you have selected for your
benefit in your plan. All this is performed through written documents. Third,
the security interest in the asset you have asked to be purchased is perfected
for the benefit of your plan account. Income and expenses are allocated to your
account.
How Often Can You Do This?
As often as you like. Some people like to buy distressed properties, fix them
up, and then sell them. Others buy discounted notes. Some purchase income
streams. There are as many options as one can think of, provided you follow the
rules.
Typically, employers will use the completely self-directed option for compliance
with 404(c) of the code for self trusteeship safe harbor. Some combine the
complete self direction along with a number of mutual fund choices, making
complete self direction available on a non-discriminatory basis to all
employees. There is a cost associated with this.
As can be imagined, the process of purchasing notes and real property is a labor
intensive process; the process of purchasing mutual funds in a daily valuation
environment is almost fully automated. Your 401(k) administrator can provide you
with the costs. If your administrator doesn't handle complete self direction,
there are some that will. It's up to you, as an employer or employee to ask. You
may be surprised at the answer.
Bio:
Hubert (Hugh) Bromma is CEO of Entrust Administration, Inc. He has decades of
experience on the cutting edge of investment education. His business philosophy
is providing quality education to enable his clients to enhance their
investments. Hugh has written several books on tax-free and tax-deferred
investing and has an extensive background in economics and investing.