Let’s 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 for such 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:
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You can purchase assets into your plan which are not prohibited. Real estate is not prohibited.
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You may not deal with yourself or members of your family (other than siblings).
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All transactions must be at 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.