401ks and Roth IRAs are extremely useful for growing your savings and investing in things like real estate. However, each retirement account type has different requirements for investing in properties and land. So, what is the difference between the two accounts, and which is better for investing in real estate?
You can use a 401k funds and a Roth IRA for real estate. Investing in real estate with your 401k requires that you withdraw your funds early and results in you having to pay taxes plus take a 10% early withdrawal penalty. A Roth doesn't incur fees for removing funds to purchase a house or land for investment purposes.
In the rest of this article, I will discuss how each of these accounts functions, how these accounts are able to be used to invest in real estate, plus the pros and cons of 401ks and Roth IRAs. So, if you want to learn more about these investment accounts and how to utilize the funds for real estate, read on.
How a 401k Works
A 401k is a retirement investing plan offered by one's employer. Generally, these plans are only available through larger companies with 100 or more employees.
What makes a 401k unique is that funds from your paycheck are automatically allocated to your 401k savings account based on how much money you've agreed to put away with pretax dollars, which reduces their taxable income for the year. Your employer may then match a previously disclosed percentage. These funds will then grow compound interest once invested, and you will be able to withdraw from these funds when you reach the age of retirement.
Additionally, employees receive a tax break on the funds placed in their 401k. However, upon withdrawing the money, income taxes need to be paid.
Contributions
When it comes to contributing, employees can contribute up to $20,500 of their salary per year (as of 2022). This number is significantly higher compared to a Roth IRA. Along with your contribution, your employer will also match that contribution with a set percentage you have agreed upon.
Distributions
Regarding withdrawing your 401k funds, it's best to withdraw the funds after the retirement age of 59 ½. By waiting, you avoid early withdrawal fees and don't have to pay a penalty on top of paying taxes on the amount immediately.
However, it can be lucrative to withdraw money from your 401k early to invest in things like real estate. By doing so, you may be able to deduct SDIRA contributions, ira deductions, and other investment expenses on your tax return. You can take a loan or withdraw money directly from your 401k account. Loans may have many rules attached to them, but are tax free, while withdrawals have taxes and penalties associated with accessing the funds.
401k Pros and Cons
| Pros | |
| Contribution flexibility | |
| Higher contribution cap | |
| Earnings are tax-deferred | |
| Employers add to your savings | |
| Free investment guidance |
| Cons | |
| Fewer investment opportunities | |
| Higher withdrawal fees | |
| Income is taxed after withdrawal | |
| Difficult to access funds early | |
| Distribution is required at age 72 |
Utilizing a 401k can be an excellent way to save your money for retirement and get a nice tax break during your working years. Additionally, because 401ks allow for higher contributions, this type of savings account is excellent for investing and growing your funds. Plus, many employers add to the money you save every month.
Though your 401k money is tax-deferred, you will have to pay income tax when you finally withdraw the money, which is fine unless you are now in a higher tax bracket and have to pay more taxes than you would have if you had invested in a Roth IRA or other type of account. Additionally, 401ks make it incredibly difficult to access funds early since penalties exist. Still, a 401k can be a valuable tool for saving for retirement if used appropriately.
Using a 401k for Real Estate
Utilizing a self-directed 401k loan for purchasing real estate can be complicated. You are taking a loan from yourself that must be paid back with interest. How much interest you need to pay is dependent on your 401k company's rules. Generally, you will have no more than 5 years to pay the loan back to your account, or you will incur an early withdrawal penalty.
However, it's essential to ask yourself if it's wise to utilize your retirement this way. For example, purchasing a home outright can be a strategic financial move, but it can also deplete your 401k. Additionally, it may be better to borrow the down payment and take on a home loan, depending on how much money you have saved for retirement.
All things considered, using a 401k loan for real estate investing can be a great way to grow your retirement savings. Just be sure to weigh the pros and cons before making any decisions.
How a Roth IRA Works
A Roth IRA is a popular investment savings account that you can use to grow your savings. With a Roth, you place up to $6,000 of after tax dollars into the account per year.
You then invest this income in things like:
- Stocks
- ETFs
- Mutual funds
- Cryptocurrency
- Real estate
Depending on the company you have chosen to open your Roth account with, you can get guidance on what type of investment will be the most lucrative for you. Typical investment brokerages offer Roth IRA’s and permit you to buy stocks and bonds, while self directed IRA custodians permit you to invest your Roth IRA into things like real estate and private businesses.
For example, if you're looking to invest in multifamily properties, you'll want to find a self-directed IRA custodian that permits such investments. Once you've found a custodian that meets your needs, you can begin researching which multifamily properties would be the most lucrative for your portfolio.
Flipping properties can be a great way to generate quick cash flow, but ensuring you have the time and resources to manage such a strategy is essential. If you're more interested in long-term appreciation, rental properties may be better.
Again, it's essential to do your research and work with a professional to find the best properties for your portfolio. No matter what type of investment you're interested in, there's likely a way to use your Roth IRA to fund it.
Contributions
Contributing to your Roth IRA is pretty simple. However, Roths have a lower contribution limit than a 401k. For example, you can only contribute up to $6,000 ($7,000 if over 50) yearly into your IRA account. However, if you're married, your spouse can also have their own Roth so long as they work, and you can each contribute $6,000 per year into the accounts.
It's important to note that the money that goes into your Roth account must have already been taxed. Paying taxes ahead of time is what makes the funds tax-free later. If you dislike paying income taxes up front, a Traditional IRA might be better suited for your needs.
Distributions
Withdrawing funds from a Roth is pretty easy since there aren't fees to do so. Additionally, you can easily remove funds without any penalties for essential things like:
- Your education
- First Home purchase
- Emergencies
However, Roth IRAs do not have a loan system, so you will just be withdrawing from your retirement plan. Generally, you have 60 days to pay back the money without taxes or penalties. However, if the money is used for the list mentioned above, you can utilize that money without penalty.
Roth IRA Pros and Cons
| Pros | |
| Tax-free funds | |
| No age requirements to open | |
| Easily access your funds | |
| Less fees | |
| No mandatory distribution age |
| Cons | |
| Contributions are taxed ahead of time | |
| Income based limitations | |
| Withdrawal restrictions | |
| No tax deductions the year of contribution | |
| 5-year holding of contributions |
As you can see, opening this kind of retirement savings account has many pros and cons. However, utilizing a Roth is still a fantastic way to build a nest egg for retirement. Plus, it's a great way to start investing if you're new to the investment world.
Additionally, drawing tax-free money when you retire is excellent, especially if you are in a higher tax bracket.
A Roth IRA for Real Estate
Using a Roth IRA for real estate is pretty simple. If you're a first-time home buyer, you can purchase a property for yourself using your funds without penalty. However, if you aren't a first-time home buyer, real estate can only be purchased as an investment property. An investment property means you can't live in the home, but you can rent it out, flip it, or turn it into a vacation rental.
You can buy investment property with cash you have in your Roth IRA for real estate, or you can secure financing through a non-recourse loan. So in theory, you would withdraw the downpayment and use leverage instead of purchasing the property outright.
Key Takeaways
Both 401ks and Roth IRA accounts make excellent investment and savings opportunities. If you want to retire comfortably by the age of 60, utilizing an investment retirement account is extremely important. However, there are some differences between the two, like:
- Qualifications
- Contributions
- Distributions
- Withdrawal fees
- Ease of access to your money
Additionally, you can have a 401k and a Roth IRA if you want to take advantage of both. Having the ability to save on a tax-deferred and tax-free basis provides account holders many benefits when hitting retirement age, and should be carefully considered when opening a Roth IRA.