Thank you for your question about making a 401k withdrawal to invest it in real estate.
Here are the basic assumptions you mention:
- You are considering purchasing a condo at a bargain price.
- You plan on living in that property and sell off your current home property in a few years.
- The rent will help pay off the mortgage on your current home.
Since we do not know what the price of housing will be in a couple of years, you must weigh your investment alternatives based on the level of risk you want to take. In order to help you make the right decision start by asking yourself these questions:
- What kind of taxes and penalties will I have to pay if I make a withdrawal from my 401k account.?
- What are my financial goals?Do I have diversified investments in my retirement account? Do I have sufficient assets and income flow to cover my expenses after retirement?
- What are the risks of waiting to sell my house in a couple of years?
- Can I afford to make the payments even if the property is not rented out and can’t be sold at a price that is enough to pay back the loan?
In order to help you make a wise financial decision, read about these topics:
- 401k Withdrawal rules and penalties
- 401k Withdrawal and taxes
- Investing in Real Estate with your 401k
401k Withdrawal Rules and Penalties
Withdrawal rules vary on the different types of accounts. Your fund may or may not allow for an early withdrawal, including ones that you pay a penalty. So, always check with your retirement plan administrator to learn the 401k withdrawal rules.
A 401K has the following general rules based on your age at the time of the withdrawal.:
Under 59 ½ :
In general , if allowed to make a withdrawal, you will pay a 10% penalty and taxes. There are some hardship cases that include paying a penalty including:
- Making a first time home purchase for a primary residence.
- Paying for college tuition or other qualified education expenses
There are also some that waive the penalty. You will always be liable for any tax that occurs due to the withdrawal, including:
- Total disabled.
- Significant medical expenses, over 7.5% of your adjust Gross Annual Income.
- Court ordered payments such as alimony or child support .
If you are between: 59 ½ and 70 ½ years old :
You can make withdrawals without a penalty, but the funds will be considered income and subject to your state and federal taxes.
If you are over the age of 70 ½:
You must make withdrawals according to the IRS minimum distribution schedule. If you don’t make withdrawals, then the IRS will fine you.
Remember to check with your administrator regarding your rights to make withdrawals and the penalties you might incur.
401k Withdrawal and Taxes
Even if you are exempt from a penalty, your 401k withdrawal may still be taxable (assuming that you have a traditional 401k retirement account). The rationale behind the 401k account is that you will have less income when you retire, and therefore you will pay less overall tax on your withdrawals (which become mandatory at 70 ½).
By making a withdrawal now you will pay higher taxes in the current tax year, based on your marginal tax rate (which will be pushed up by the withdrawal) . Check with your tax professional regarding making a withdrawal from your 401k.
401k Withdrawal for a Real Estate Investment
Your investment possibilities depends on the type of retirement account you have. If your retirement account is a Roth IRA account, you might be able to use the funds to invest in real estate property.
If it is a traditional 401k account, then you can either invest in a REIT or real estate based fund, make a withdrawal (with taxes and penalties) or take out a loan. A 401k loan may be an alternative to a withdrawal, as long as you can afford to make the payments. If for some reason, you cannot afford to pay back the loan then the 401k is used to pay back the loan and that is considered a withdrawal that will be subject to taxes and possibly a penalty (depending on your age).
You mention that you wish to down size. However, you just refinanced your house and perhaps now is not the best time to sell your current house. Can you afford to make the mortgage payments? What will happen if you cannot make the payment in a few years? Will you need your retirement funds? Since you are planning to invest your retirement funds in more real estate, have your considered these questions:
- Are you investments well diversified? Are you putting to much money into real estate?
- Have you planned your future retirement needs and the projected cash flow from your pension and retirement accounts? Since each person has their own risk aversion levels, only you can decide if your portfolio meets your needs.
Summary: Making a 401k Withdrawal to Downsize and Invest in Real Estate
To help you make the best decision, your major consideration should be:
What taxes and penalties will you incur on the 401K withdrawal
Your overall financial position. Basically you are talking about moving a retirement asset into a real estate asset.
Your level of risk taking. Here are the steps to take:
- Speak to your retirement plan administrator to see your rights regarding taking a 401k withdrawal
- Speak to your tax professional regarding your potential tax liabilities.
- Speak to a professional retirement and/or investment advisor to check your overall financial situation (assets and cash flow needs). Check your portfolio diversification and make sure your investments meet your acceptable level of risk.