Many American companies give their workers access to 401(k) plans, which let them save for retirement and get tax breaks at the same time. It takes its moniker from a subsection of the Internal Revenue Code in the United States (IRC). A 401(k) plan is a retirement savings program sponsored by your company and designed to help you prepare for your financial future after retirement.
Employers can choose from a variety of 401(k) plans, including the more common “traditional” plan, the “safe harbor” plan, the “SIMPLE” plan, the “Roth” plan, and the “Solo” 401(k) plan (not for employees). There are many different kinds of 401(k) plans, each with its own features, contribution limits, and requirements for who can join.
Traditional 401(k) plans let workers put money into their retirement accounts through payroll deductions without paying taxes. This is true as long as the worker is eligible for the plan. As a bonus, traditional 401(k) plans allow employers to contribute on behalf of all participants, provide matching contributions based on employees’ elective deferrals, or both. Contributions to traditional 401(k) plans must adhere to nondiscrimination guidelines outlined in the plans’ rules. These tests ensure that deferred wages and employer matching contributions do not favor highly paid employees.
A Roth 401(k) plan offered by an employer differs significantly from a traditional 401(k) plan. Employee contributions to a Roth IRA are made with after-tax money rather than pre-tax money, like in a traditional 401(k) plan. Still, the federal government does not tax interest, capital gains, or dividends from a Roth IRA. If you expect to be in a higher tax bracket in retirement, this type of 401(k) plan is the best option. This Roth IRA is beneficial not only to older workers with high incomes but also to younger workers with high contributions.
While similar to a traditional 401(k) plan, a “safe harbor” 401(k) plan must include provisions such as fully vested employer contributions. Employer contributions can be in the form of matching contributions, which are only made on behalf of employees who defer or can be contributions made on behalf of all eligible employees regardless of whether those employees make elective deferrals. The safe harbor 401(k) plan, unlike traditional 401(k) plans, is exempt from the arduous annual nondiscrimination tests.
The Simplified Employee Pension (SIMPLE) 401(k) Plan was made so that small business could offer their employees an easy and cheap way to save for retirement. Unlike traditional 401(k) plans, SIMPLE 401(k) plans are not required to undergo annual nondiscrimination tests. Employer contributions under a safe harbor 401(k) plan must be fully vested. Companies with fewer than 100 employees who paid out at least $5,000 in wages in the prior calendar year are eligible to set up this type of 401(k) plan for their workers. If an employee is eligible for a SIMPLE 401(k) plan, they cannot take part in any other retirement plans offered by their employer.
A Solo 401(k) is a qualified retirement account for employers with no full-time workers other than their spouses or partners. This kind of 401(k) retirement account is also called an Individual 401(k), Self Employed 401(k), Self-directed, or Solo-K. In a Solo 401(k) retirement plan, the employer is both the boss and the employee. The plan lets the employer contribute both as an employer and an employee. This lets them get the most out of their retirement savings and business deductions. The Solo 401(k) is not subject to the complicated ERISA (Employee Retirement Income Security Act of 1974) rules because it is only for the business owner(s), their spouse(s), and their partners.
The answer is yes, though not straightforward. Due to tax laws, individuals cannot invest their 401(k) funds directly in real estate. However, there are still opportunities to use your 401(k) to finance the purchase of investment property. The process will be explained below.
Investing in real estate using 401(k) could be done through any of these processes:
If the terms of your plan permit loans, you can use your 401(k) to finance a real estate purchase. The Internal Revenue Service states that you may borrow up to $50,000 or fifty percent of your balance, whichever is less, including any outstanding loan balances. Unless the loan finances your primary residence, it must be repaid within five years-with interest-to remain tax-free; 401(k) loans used to purchase a primary residence may be repaid over a longer period—up to 15 years—if your plan permits. Nonetheless, the interest is deposited into the retirement account, so you’re just giving the money back to yourself. The interest you pay contributes to your 401(k) savings but cannot be deducted from your tax return.
Not every plan provider permits 401(k) loans. Alternatively, you can use a 401(k)-hardship withdrawal to help pay for real estate-related costs. Hardship distributions, like loans, are subject to the terms of the plan’s guidelines. Hardship withdrawals from a 401(k) reduce your savings because they are not reimbursable, increase your tax liability, and trigger a 10 percent early withdrawal penalty (especially traditional Roth plans) if you are under age 59 and ½ unless you meet the criteria for an exemption. With a Roth 401(k), you can take out all your money at any time without paying taxes or penalties. However, your earnings are still taxed.
To avoid the 10% early withdrawal penalty and other restrictions on a 401(k) distribution, you can roll over up to $10,000 from your 401(k) into a Roth IRA instead. However, because Roth IRA contributions are post-tax and 401(k) contributions are pre-tax, you will owe income tax on the money you rolled over.
Land, commercial, and residential property can all be purchased with a solo 401(k), and the income from these investments can grow tax-free. Instead of having a broker oversee your retirement savings, you can take charge with a solo 401(k). Participants need to know their way around the real estate market and be willing to abide by restrictions on the kinds of deals they can make. A participant in a solo 401(k) plan is not allowed to buy or sell real estate to a member of their immediate family or the participant’s primary residence, nor is the participant allowed to alter the fair market value of any investment made with plan funds.
In conclusion, adding real estate to a portfolio’s diversification can help spread risk across a wider range of investments. You can buy real estate with money from your 401(k), either for yourself or as an investment. Using a 401(k) to invest in real estate has tax and penalty consequences that depend on the details of the transaction. Though not straightforward, 401(k) accounts can be used for real estate investing by taking out loans, hardship withdrawals, rolling over to a Roth IRA, or using a Solo 401(k) account.