How to Use 401k to Buy Real Estate

A 401(k) plan is a retirement savings vehicle sponsored by an employer, allowing employees to contribute a portion of their pre-tax salary to an investment account. These contributions grow tax-deferred, meaning taxes are not paid until funds are withdrawn in retirement. Many individuals consider leveraging these accumulated retirement funds for significant investments, such as real estate, a tangible asset with potential for appreciation and income. While directly purchasing real estate with a standard 401(k) is generally not permitted, specific regulated methods exist to utilize these retirement assets for property acquisition. This article explores structured approaches to access 401(k) funds for real estate, outlining requirements and processes.

Borrowing from Your 401k

Accessing funds from a 401(k) through a loan is a common method to use retirement savings before retirement age, often for real estate. Eligibility for a 401(k) loan requires plan allowance, as not all plans offer this feature. Participants must be actively employed with the sponsoring company and have a vested balance.

The Internal Revenue Service (IRS) sets limits on the amount that can be borrowed from a 401(k). The maximum loan amount is 50% of the participant’s vested account balance, up to $50,000. For instance, if an individual has a vested balance of $80,000, they could borrow up to $40,000; if they have $120,000, the loan would be capped at $50,000.

Repayment terms are regulated. Most loans must be repaid within five years, through payroll deductions. However, if the loan is used to purchase a primary residence, the repayment period can extend up to 15 years. Interest rates are set by the plan administrator, often slightly above the prime rate. Interest is paid back into the participant’s 401(k) account, earning interest for themselves rather than a commercial lender.

A 401(k) loan is tax-free and penalty-free if repaid according to the loan agreement. However, if the loan is not repaid on time, the outstanding balance can be treated as a taxable distribution. The amount becomes subject to ordinary income tax, and if the participant is under 59½, an additional 10% early withdrawal penalty may apply. This underscores the importance of a clear repayment plan.

To initiate a 401(k) loan, identify the plan administrator or custodian (e.g., Fidelity, Vanguard, Empower Retirement). These entities manage the plan and provide information on loan availability and requirements. The participant requests application forms detailing loan terms and conditions.

Complete application forms with accurate personal and loan-specific information, including desired loan amount and purpose, especially for an extended repayment period for a primary residence. Submit completed forms to the plan administrator for review and approval. Upon approval, funds are disbursed via direct deposit or check, usually within days to weeks, depending on processing times.

Rollover to a Self-Directed Account

To gain more control over investment choices, including real estate, move 401(k) funds into a self-directed retirement account. Self-Directed IRAs (SDIRA) and Solo 401(k)s allow for a broader range of investment options beyond publicly traded stocks, bonds, and mutual funds, including alternative assets like real estate. These accounts operate under specific IRS rules governing permissible investments and transactions.

An SDIRA can be a Traditional or Roth IRA, managed by a specialized custodian facilitating alternative investments. A Solo 401(k) (Individual 401(k) or Uni-K) is for self-employed individuals or small business owners with no full-time employees other than themselves or their spouse. Eligibility hinges on self-employment income, making it viable for those who own their business or freelance. Both accounts offer tax-deferred growth, similar to a traditional 401(k), but with expanded investment flexibility.

Transferring funds from a traditional 401(k) to a self-directed account is a rollover. There are two primary types of rollovers: direct and indirect. A direct rollover transfers funds directly from the existing 401(k) plan administrator to the new self-directed account custodian without the participant taking possession. This method is preferred as it avoids tax withholding and penalties.

An indirect rollover distributes funds to the participant, who has 60 days to deposit them into a new retirement account. If not redeposited within 60 days, the distribution becomes taxable and may incur a 10% early withdrawal penalty if the participant is under 59½. The distributing 401(k) plan is required to withhold 20% for federal income taxes, which the participant must make up from other sources to roll over the full amount.

To initiate a rollover, gather key information about your current 401(k) plan, including account number, plan administrator’s contact details, and total vested balance. Simultaneously, select a self-directed account custodian and open the new SDIRA or Solo 401(k). Custodians specializing in self-directed accounts provide guidance on supported assets and fee structures.

Once the new account is established, obtain rollover forms from both your existing 401(k) provider and the new self-directed account custodian. Forms from the current 401(k) provider authorize fund transfer, while forms from the new custodian provide receiving instructions. Accurately complete all informational fields on these forms, ensuring account numbers, transfer amounts, and beneficiary information are correct. After submitting completed forms to both parties, monitor the fund transfer, which can take weeks depending on institutions involved. Confirmation of successful fund receipt in the new self-directed account marks rollover completion, making funds available for broader investment choices.

Investing in Real Estate with Self-Directed Funds

Once funds are rolled over into an SDIRA or Solo 401(k), the account holder can invest in real estate, governed by specific IRS regulations to maintain the retirement account’s tax-advantaged status. Permitted real estate investments include residential properties, commercial properties, raw land, and certain non-publicly traded REITs. However, the IRS imposes strict rules to prevent self-dealing and transactions with disqualified persons.

Prohibited transactions include direct or indirect use of retirement account assets by the account holder, spouse, lineal descendants (children, grandchildren), or controlled entities. For example, an SDIRA cannot purchase property the account holder or a disqualified person intends to live in or use personally, such as a vacation home. All transactions must solely benefit the retirement account, not the individual. The property cannot be used as collateral for a personal loan, and the account holder cannot perform repairs or maintenance themselves.

Unrelated Business Taxable Income (UBTI), or Unrelated Debt-Financed Income (UDFI), can apply to real estate investments within self-directed accounts. If the retirement account uses debt financing (e.g., a mortgage) to purchase property, a portion of the income generated can be subject to UBTI. The IRS views income from debt-financed property as potentially competing with taxable businesses. The tax rate for UBTI can be as high as the corporate tax rate, which can significantly reduce the investment’s net return.

Purchasing real estate with self-directed funds involves the SDIRA or Solo 401(k) custodian facilitating the investment. The account holder identifies the property, and the custodian handles financial aspects of the transaction. Funds from the retirement account cover down payment, closing costs, and ongoing expenses like property taxes, insurance premiums, and maintenance. If a mortgage is used, the loan must be a non-recourse loan, meaning the lender can only claim the property itself as collateral and has no recourse against the account holder’s personal assets.

Property must be titled in the retirement account’s name, not the individual’s. For example, the deed might read “Custodian Name FBO [Your Name] IRA.” This ensures the property is legally recognized as a retirement trust asset. All income generated by the property, such as rental income, must flow directly into the retirement account. Similarly, all property expenses must be paid directly from the retirement account. This strict separation of funds maintains the account’s tax-advantaged status and avoids prohibited transactions.

The custodian ensures compliance with IRS rules throughout the investment’s lifecycle. They are responsible for holding the assets, processing transactions, and reporting to the IRS. While the custodian handles administrative and compliance, the account holder makes investment decisions and manages the property, often by hiring third-party property managers to avoid self-dealing. Adhering to these rules prevents the investment from being classified as a prohibited transaction, which could result in the entire account’s distribution and incur taxes and penalties.