Some people begin flipping properties for side money. Other people get pushed into it because of a job loss or other life-changing circumstance. In some cases, the temptation to raid a 401(k) or other retirement account is very strong. After all, for many workers, their 401(k) is the largest asset they have. It?s a ready source of capital ? sort of. And when jobs are few and far between ? and where wages are depressed to begin with ? sometimes you have to do what you have to do.
First, let?s look at the rules.
Your 401(k) is a tax-deferred retirement savings vehicle. The same goes for balances in SIMPLE IRAs, SEP IRAs and traditional IRAs. Generally, if you didn?t pay income taxes on money going in, you?ll have to pay income taxes on money coming out. That?s true regardless of your age, and it?s true for federal and state taxes alike.
Furthermore, you must generally pay an additional 10 percent excise tax on any money you withdraw before age 59?, or before age 55, if you are withdrawing from a 401(k) plan and have left your company.
But the 10 percent penalty is a nasty deal ? and this is why: When you take an early withdrawal from a retirement account (and it doesn?t qualify as a hardship under IRS rules that apply to IRAs), the IRS calculates the tax based on the total amount withdrawn ? not on the amount left over. So if you withdraw, say, $100,000 to start up a flipping/real estate business, you will have to pay income taxes. So follow the bouncing ball:
Let?s say your state charges a 5 percent income tax. You have $95,000 left.
But the federal government charges tax on that. If you have other income, your exemptions are usually blown, so you pay full boat: Say, 28 percent on what?s left. Bang. You are left with just $68,000 you can invest.
Then the IRS takes another cut: $10,000. That?s 10 percent of the full amount you withdrew from the retirement plan. You are now left with just $58,000.
The income tax, by itself, is not a huge deal. A lot of planners say it is, but you will have to pay income taxes anyway, sooner or later, and taxes may be higher when you retire than they are now. Furthermore, if you use the money properly, you are using it for deductible expenses. So your adjusted gross income goes down by whatever you invest in your practice. Which makes the income tax a wash ? but only in the short run, and only if you can invest the full $100,000 you took out!
In the long run, you also have to take current, year-by-year tax liabilities into account. For example:
If you left the money in a retirement account, it grows with the income tax deferred and no capital gains issues whatsoever (though you have the option of taking a capital loss if you liquidate the account entirely while it?s underwater).
In the real estate business, though, you generally have to pay taxes on any net rental income now. And if you?re a flipper, you have to pay capital gains taxes. That?s short-term capital gains tax, on any flips that take less than a year to execute ? which is most of them. That means you?ll have to pay taxes every year, now, on any money you make.
If you get classified as a dealer ? which will happen if you flip enough properties ? you will generally have to pay income taxes, rather than capital gains taxes, on your profits. You generally won?t get the benefit of depreciation deductions either. The IRS just treats the houses as inventory, like widgets on a store shelf.
Roth IRAs
Roth IRAs are a little different. There?s no federal income tax on withdrawals from a Roth IRA ? up to the amount you have contributed ? since you?ve already paid it on money you contributed to the account. You are only taxed on the gains. Just be sure you have left the money in the account for at least five years, for the most favorable tax treatment.
But the 10 percent penalty still applies, and the IRS will charge it even if you throw everything you took out into tax-deductible investment expenses.
Furthermore, you have a tremendous opportunity cost when you pull money out of a Roth IRA and put it into real estate ? or anything else. Balances in a Roth IRA grow tax-free. Everything you have in real estate, other than in self-directed retirement accounts, is taxable.
Asset Protection Considerations
Understand this, too: Your 401(k) enjoys practically unlimited creditor protection under federal law. The law doesn?t even consider your balance to be your own money. Your company?s 401(k) custodian holds it in trust for you. That means you can get sued, but creditors can?t touch it. They might be able to get a charging order against distributions, if they are incredibly patient. But they can?t touch the balance. Even the IRS can?t crack a 401(k) until you start taking money out, at which point they can get a charging order from a court, garnishing the income you take from the account. That fact makes for some favorable settlement terms for you, in the event of a lawsuit.
Similarly, federal law also grants creditor protection of up to $1 million to IRA balances?in the event of a bankruptcy filing, though the IRS can and does occasionally levy IRAs. (Unlike 401(k)s, IRAs are your money, not held in trust for you.)
People sue landlords all the time. If you tap your 401(k) or other retirement account to buy houses, you are exchanging an asset with terrific creditor protection for an asset that actually generates liability. Be very careful about doing this.
For these reasons, I generally do not recommend raiding 401(k) or other retirement accounts to get started in real estate investing. If it is for you, you will be able to find other sources of financing, sooner or later. Keep saving money.
Meanwhile, the assets in your retirement account can be an invaluable diversifier against the volatility of real estate, and once you?re over the age limits, a source of liquidity when you need it.
Alternatives
If you are still on the job with your 401(k) plan sponsor, you may consider taking out a 401(k) loan ? if your workplace plan rules allow it. Many do not, since they are time-consuming to explain to workers and to administer.
If your plan allows it, you can borrow up to half of your 401(k) balance, tax-free ? provided you pay yourself back, with interest, within five years. (Loans to buy a personal residence can be extended for longer.) The max 401(k) loan is $50,000. You?ll have to pay it back by payroll deduction each pay period, whether your real estate deals have generated spendable income or not, so be prepared for this.
Be careful about doing this, though: If you get fired from your job, you may have only 60 days to pay yourself back. Otherwise the IRS treats the loan like a distribution, and you get whacked with income taxes and penalties. If you?re in real estate, chances are you?ve got the money tied up in something pretty illiquid. If you can?t sell a property in time, you?ll get caught in a liquidity crunch. If you can?t raise the money to pay off the loan somehow, you will get clobbered.
For more information on 401(k) rules, see IRS Publication 575 ? Pension and Annuity Income. For IRAs, see Publication 525.
Self-Directed Accounts
I?ve self-directed accounts?in earlier columns. If you are totally gung-ho to do real estate, and you have terrific expertise, these can work well for you. You can manage your flipping practice within your retirement account, without having to pay taxes and penalties. Just be aware of the rules and regulations on prohibited investors, and also of the strict limitations on liquidity.
Cash Value Life Insurance Policies
If you are very patient, and you can diligently squirrel money away, you can create another source of tax-free liquidity by using the cash value of a permanent life insurance policy. These can take a number of years to build up in value, but the value grows tax-free, and you can access it via a policy loan tax-free, in most cases, to invest in real estate or anything else you like. There are no age limits, no credit checks, no questions asked, and it?s in your bank account in a few days after a quick phone call. They don?t work well for everybody ? but when they do work, they work very well, when properly designed.
We?ll be taking a closer look at this concept ? and how to make it work ? in a future Flippin? Insider. Stay tuned!
Source: http://www.realestate.com/advice/should-you-raid-your-401k-to-start-flipping-91997/
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