How to Use a 401k to Invest in Real Estate

A 401(k) plan serves as a foundational retirement savings vehicle for many individuals. While traditionally guiding investments into publicly traded assets, specialized avenues within the 401(k) framework allow for broader choices, including direct real estate acquisitions. This approach offers diversification beyond conventional market offerings. Understanding the specific types that permit such alternative investments can enhance a retirement portfolio.

Understanding the Self-Directed 401k Vehicle

A “Self-Directed 401(k),” also known as a “Solo 401(k)” or “One-Participant 401(k),” is a retirement plan for self-employed individuals or small business owners without full-time employees other than themselves or their spouse. This 401(k) grants the account holder dual roles: plan participant and trustee. As trustee, the individual gains control over investment decisions, enabling investments in alternative assets like real estate, which are unavailable in traditional employer-sponsored 401(k)s.

A Solo 401(k) differs from standard 401(k) plans. Traditional plans limit investment options to a pre-selected menu, whereas a Self-Directed 401(k) allows the trustee to direct plan assets into a wider array of investments. The account holder assumes fiduciary responsibility, ensuring investments comply with IRS regulations and benefit the plan.

Eligibility for a Solo 401(k) requires self-employment activity and no full-time employees. This includes sole proprietorships, independent contractors, and business owners whose only employee is their spouse. Individuals with a full-time job elsewhere can establish a Solo 401(k) if they also have self-employment income from a side business. The business must be actively engaged in a for-profit enterprise to qualify.

Acting as both employee and employer allows for substantial contribution limits, exceeding those of other self-employed retirement options like a SEP IRA. While a SEP IRA allows only employer contributions, a Solo 401(k) permits both employee and employer contributions. This dual contribution capacity can lead to accelerated retirement savings.

Establishing Your Self-Directed 401k Plan

Establishing a Self-Directed 401(k) plan begins with confirming eligibility. The primary requirement is self-employment income and no full-time employees other than yourself or your spouse. This ensures the plan qualifies as an “owner-only” arrangement, simplifying its administration and compliance.

Once eligibility is confirmed, selecting a plan provider or facilitator is a step. These providers draft the necessary legal documents that define the rules and structure of the 401(k) plan. They ensure the plan documents comply with IRS regulations, maintaining the plan’s tax-advantaged status.

A distinct Employer Identification Number (EIN) is required for the 401(k) trust, separate from any EIN used for the business. This EIN identifies the retirement trust to the IRS for tax reporting. An EIN can be obtained online through the IRS website by completing Form SS-4, selecting “pension plan” or “trust” as the entity type.

The EIN application requires specific information, including the trust’s legal name (e.g., “Your Name 401(k) Trust”), the trustee’s name (the plan participant), and the mailing address. Online applications often provide an EIN immediately; faxing or mailing Form SS-4 can take several business days to a few weeks.

After obtaining the EIN, the next step involves drafting and adopting the formal plan documents. These include a basic plan document and an adoption agreement, which outline the plan’s provisions, such as eligibility criteria, contribution types, and distribution rules. These documents are typically prepared by the chosen plan provider and must be signed to formally establish the plan.

The final step involves opening a dedicated bank account for the 401(k) trust. This account must be held in the name of the 401(k) trust, using its newly acquired EIN, to segregate plan assets from personal or business funds. Banks require the trust’s EIN and copies of the established plan documents to open this account, ensuring proper financial separation for compliance.

Funding and Investing Through Your Plan

After establishing the Self-Directed 401(k) plan, the next phase involves funding the account and directing its investments, particularly into real estate. Funds can be moved into the plan through direct contributions or rollovers from other qualified retirement accounts. Direct contributions include both employee elective deferrals and employer profit-sharing contributions.

For 2025, an individual under age 50 can contribute up to $23,500 as an employee elective deferral, or 100% of compensation, whichever is less. Those aged 50 and older can make an additional catch-up contribution of $7,500, increasing their employee deferral limit to $31,000. Employer profit-sharing contributions can be made up to 25% of compensation, with a combined total contribution limit of $70,000 for those under 50 in 2025. This total can increase to $77,500 for those aged 50 and older, or even higher for specific age brackets, depending on catch-up provisions.

Rollovers from existing retirement accounts, such as traditional IRAs or old employer 401(k)s, represent another common method for funding the Self-Directed 401(k). This process involves transferring funds directly from one retirement custodian to the new Self-Directed 401(k) custodian, maintaining the tax-deferred status of the assets. It is a straightforward way to consolidate retirement savings and gain access to self-directed investment options.

The Self-Directed 401(k) allows for a wide array of real estate investments. Permitted types include residential and commercial rental properties, raw land, real estate notes, and tax liens or deeds. Any investment must be made solely for the benefit of the 401(k) plan and its future beneficiaries, not for the personal benefit of the plan participant or other disqualified persons.

Investing through a Self-Directed 401(k) involves understanding and avoiding “prohibited transactions” and “disqualified persons.” Prohibited transactions are defined under ERISA and IRS rules to prevent self-dealing or misuse of plan assets. Examples include using plan assets for personal benefit, lending money between the plan and a disqualified person, or purchasing property from or selling property to a disqualified person.

“Disqualified persons” include the plan participant, their spouse, lineal ascendants (parents, grandparents), lineal descendants (children, grandchildren), and their spouses, as well as entities controlled 50% or more by these individuals. Engaging in a prohibited transaction can lead to severe consequences, including immediate disqualification of the plan, resulting in all plan assets becoming taxable and potentially subject to penalties. All income and expenses related to real estate investments held by the plan must flow through the 401(k) account.

Maintaining Compliance and Reporting

Maintaining compliance is a continuous responsibility for anyone managing a Self-Directed 401(k) plan, extending beyond its establishment and initial funding. Meticulous record-keeping is fundamental, requiring comprehensive documentation of all plan transactions, income generated, and expenses incurred. These records are necessary for tax reporting and to demonstrate adherence to IRS regulations.

One annual reporting requirement is filing Form 5500-EZ with the IRS. This informational return becomes mandatory once total assets within the Solo 401(k) plan exceed $250,000 at the end of the plan year. The form details the plan’s financial condition, investments, and operations, providing the IRS with an overview of the plan’s activities. The filing deadline for Form 5500-EZ is July 31st of the year following the plan year.

Unrelated Business Taxable Income (UBIT), also known as Unrelated Business Income Tax (UBTI), is another consideration. While income from real estate rentals is considered passive and tax-exempt within a 401(k), UBIT can apply in specific situations. This primarily occurs when a plan generates income from an active trade or business, or from debt-financed real estate acquisitions.

Unlike Self-Directed IRAs, Solo 401(k)s have an exemption from UBIT on income derived from debt-financed real estate. However, UBIT can still be triggered if the real estate activity constitutes an active trade or business, such as flipping properties frequently, or if the income comes from an operating business held within the plan through a pass-through entity. If UBIT applies, the income is taxed at trust rates.

Plan documents require periodic amendments to remain compliant with ongoing changes in tax laws and regulations. This ensures the plan continues to operate within the current legal framework. Understanding the rules for taking distributions from the 401(k) in retirement is important for long-term planning. This includes adhering to required minimum distributions (RMDs), starting at age 73, and being aware of potential penalties for early withdrawals before age 59½, unless an exception applies.