Growing A 401k vs. Liquidating To Invest In Real Estate

Should you liquidate your 401k to start investing in real estate? This question has frequented the BiggerPockets forums over the past few years, eliciting mixed answers.

Most financial advisors and older folks will tell you that it’s better to contribute to your 401k and let it grow tax-deferred. Meanwhile, the younger folks in pursuit of early financial freedom are skeptical of this advice—and rightfully so.

The thought the young folks have is that if you are in your 20s and in pursuit of financial freedom, it is likely you will be financially free well before you hit the age of 60. Therefore, the amount in your 401k will not really matter. It will just be an added bonus as you hit your “golden years.”

As a Millennial, my initial thoughts aligned with these young folks. However, I do highly regard the advice of my elders, so before fully advocating for this, I figured it would make sense to do an analysis to see if the numbers make sense and to explore some other options.

In the first part of this article, I show you the analysis I performed comparing what your annual returns would need to be as a 25-year-old taking out your 401k to start investing in real estate.

You will see that at first glance, it may seem to make sense to liquidate the 401k, but be sure to keep reading, as there are better options. As a disclosure, I am neither a financial advisor nor a CPA. I am just obsessed with the notion of financial freedom and love exploring ways to expedite the journey.

Let’s dive in to the analysis.

Assumptions

Age: 25 years old
401k Balance at Year 0: $15,000
401k Return: 7% assumes 401k is held in stocks, bonds, mutual funds, etc.
Income Tax Rate: 30%
Capital Gains Tax Rate: 15%
Withdrawal Penalty: 10%
Annual Contribution to 401k: $3,000 pre-tax
Annual Contribution to Other Liquidated 401k Investments: $2,100 because you save 30% less after the assumed 30% tax
Tax Savings from Reducing Income by Contributing to 401k: Invested and earning 7% annually

The Analysis

At 25 years old, you are probably taking your first steps in your journey towards financial freedom. Age 60 seems very far away, so you are likely tempted to take that out now and use it to expedite your journey towards financial freedom—especially after seeing the two tables below:

*Calculated by (Investment Balance x Tax Rate) + (W2 Savings – Taxes Paid on Gains)

*Calculated by (Investment Balance – Annual Contributions) x Capital Gains Tax

**Calculated by (Taxable Return Exclusive of Contributions + Contributions)

Given the assumptions mentioned above, the 25-year-old will have to earn 8.5% annually on his/her liquidated 401k to achieve the same type of returns as they would on their current 401k.

Is this achievable? Absolutely, especially with the wealth of knowledge here on BiggerPockets and the four wealth generators of real estate.

Hold on a second, though! It’s not black and white. Liquidate it or leave it. There are other things to consider including in your reserves, as well as other creative ways you can reap the high returns of real estate, tax-deferred.

First off, the reserves.

In order to qualify for any conventional-type loan that is sold to Fannie or Freddie, you need to have a certain amount of months of reserves (or liquidity). Lenders consider your 401k as part of your reserves, so losing ~40% of it through liquidation will be a huge hit. Not only that, but using what you have left for a down payment will be a double kill.

There is a high probability that this will either prevent you from taking out a conventional loan or at the least increase the cost significantly.

But don’t worry. There are better options.

The Best of Both Worlds

In the analysis above, we assume your 401k is handled by a financial advisor and is diversified amongst a plethora of mutual funds, index funds, bonds, stocks, etc. that garner a return of 7%. The analysis suggests that despite the tax-deferred earnings, there is a high probability that you can attain a better annual return on a liquidated 401k (8.5%+) by investing it yourself.

Fortunately, there is a way for you to invest in these same high-yielding assets (i.e., real estate) with your 401k without taking the penalty. Rather than having your 401k held with a financial advisor and being diversified amongst asset classes that return ~7% annually, you can move it to a self-directed IRA or a solo 401k to manage yourself.

With these self-directed accounts, you can invest in almost anything. Even real estate.

Notice how I said almost anything. The one limiting factor is that you cannot get a conventional recourse loan with your 401k. That means that the low-down payment, owner-occupied loans are not available.

In other words, you CANNOT house hack with your 401k or self directed IRA. This is for investment property only so most lenders will require at least 15% down and sufficient cash flow.

But Crraaaiiiigg, I WANNA HOUSE HACK.

House Hacking with Your 401k

Good news! You can! Despite what I said above, you can still use your 401k to house hack. Just not directly.

How?

You can give yourself a loan from your 401k for the lesser of $50,000 or 50% of your 401k’s balance. This can help with your down payment on a house hack.

You will be paying your solo 401k interest of approximately 4.0%. This is certainly not the best use of your 401k money, but if you do not care much about the balance of your 401k and are looking to invest in real estate to achieve early financial freedom, this may make sense.

So, rather than going ahead and liquidating the 401k, use it to your advantage. The net proceeds you would get when taking it out and when taking a loan against it are almost equivalent. Still, by taking a loan against it, you are not getting penalized and your 401k is still growing tax-free.

Warning! Before making the loan request, be sure to talk to your lender. Taking a loan out against your 401k does reduce the amount of your reserves and therefore may impact your ability to get financing.

So, What Should You Do?

First off, I need to disclose again that I am neither an accredited financial advisor nor a CPA. I just love this stuff. While I am sure there are many ways to creatively use your retirement funds, I am sharing with you what I have learned and what seems to me are the most plausible scenarios.

The most optimal way to use your 401k is to either move it into a self-directed IRA/solo 401k or to take a loan out against the funds to help you invest in real estate. Which of those scenarios to choose is entirely up to you and dependent on your goals.

If your goals are to accumulate maximum net worth, then the self-directed account makes the most sense. Invest the solo 401k/self-directed IRA in real estate (or other higher yielding assets) tax-deferred. This way, you can experience both the phenomenal long-term returns of real estate as well as tax-deferred growth.

If your goals are to attain early financial freedom and you don’t care much about the returns of the 401k, it makes more sense to take the loan out against your 401k, use the proceeds from the loan to assist with your down payment, and pay your retirement account a relatively low interest rate of ~4%. Depending on the balance of your 401k, this will free up to $50,000 for you, which will be more than enough to get started on a house hack.

What’s your strategy of choice when it comes to the 401k—and why?

I’d love to hear from you in the comments!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.