Newbie to BP and REI - solo 401k vs. buy and hold REI?

Question

Hello BP community!Great to join BP. I've been reading a few blogs and forums on this amazing site for about two weeks now, and am just starting out on my own learning journey in Real Estate Investing (REI). After reading many of the inspiring and cautionary posts on this site, I'm excited to learn - and do!One of the first questions I have about REI is related to using potential investment dollars to look at "buy and hold" opportunities vs. making 401k contributions. I'm self employed with a solo 401k, and am fortunately able to contribute a substantial amount of income per year (up to $55k) pre-tax. I'll likely be looking at $40k of "investment dollars" to allocate this year. My retirement accounts are not quite where I would like them to be, so hammering the 401k with contributions always sounds like a good idea.But, being an entrepreneur and someone that loves learning, and after finding BP, I'm now considering how I can include REI into my wealth and retirement planning for 2017 and beyond. One scenario that I am considering for this year is contributing $20k into the 401k, and taking ~$20k "out" of my business as personal income (note: I'll have to take a bit more than 25 out, as this will be subject to tax). I'm starting to analyze what to do with this $40k overall. The main objective of the analysis: Do I take the ~$20k and invest into a starter REI property (e.g. 2- or 3-unit for $100k) with the balance contributed to the 401k, or do I contribute all as pre-tax dollars to my 401k?There are couple of considerations that support the 401k contribution argument:Size of my retirement portfolio: As mentioned before, adding $40k in this year would be a nice catch up. This would more or less get me on track to my next major retirement account milestone, which is a total size of 2x income by the age of 35.Reductions in taxable income: Contributions to the 401k would yield a few thousands of savings in tax obligation.Time and overhead: A 401k contribution is much easier than an REI transaction. As an entrepreneur, I'm not afraid of investing time, cash, and energy into hard or difficult things. I *do* think about Return on Time Invested, though, and am wondering if this size of deal may be more hassle than its worth.The above said, on the REI side of things, a few considerations are also compelling. Namely: Diversification of my overall investment portfolio: Despite my IRA goals, an REI opportunity would help diversification. Passive income goal: An REI deal would help move me towards building opportunities for passive streams. My initial goal is to build a modest portfolio that can yield $8-10k/month in the next 15 or 20 years. REI learning goal: I think a deal of this size is a nice starter deal. It would allow me to learn a market (or markets) deeply, get my deal sourcing and analysis systems up and running, build a small support network, and see how *real* the REI opportunity can potentially be for me....the Deal!: Of course, an REI transaction depends a lot on the specific deal, and deals are fun (in addition to possibly painful, annoying, risky)! I'm going into this open-eyed and knowing that deals can go south - so am prepping to reduce risks through as much standardized analysis and systems as possible, as well as a lot of advice seeking. I'll probably post more thoughts and questions on the feasibility of the 2- to 3-unit $100k deal, but any preliminary feedback from experienced investors on such a deal profile would be highly appreciated. In general, I'd be looking for a buy and hold, so (I believe, as a newbie) appreciation potential is potentially less of a priority for me as much as rent-ability (i.e. in terms of both rent to home value ratio, and tenancy/utilization).I'll stop here. Thanks in advance for thoughts on this!RB

Brian Eastman · Answer

@Rahul B.You can, in a certain sense, have the best of both worlds.A Solo 401(k) plan is a great vehicle for new contributions and the tax savings you receive. You are effectively getting an instant return on investment equal to your combined federal/state tax rate every time you set money aside into the plan.A Solo 401(k) can be configured to be self-directed. This means that instead of being limited to investing in conventional financial products, the Solo 401(k) could invest in rental real estate. All expenses would come from the plan and all income generated would accrue to the plan. So, in that sense it is not you investing in real estate, it is you directing your 401k to invest in real estate.There is a lot of good information here on BP in the following area:https://www.biggerpockets.com/forums/51-tax-legal-...

Brian Eastman · Answer

@Rahul B.You are correct, there is no one best answer. Even with all of the information you have provided, you have only scratched the surface. And frankly, anyone on a web forum offering to provide meaningful guidance in response would be doing you a disservice. You should sit down with a licensed independent financial advisor or tax strategist - mind you not a stock salesperson or tax return preparer - someone who can help you see the big picture and then a few distinct paths towards succcess.

Rahul B. · Answer

@Brian EastmanThanks for your response. I definitely understand that incorporating REI into an existing Solo 401k portfolio can be beneficial, in terms of diversification and security/income, and that the use of this instrument is not directly comparable to personal REI activities (i.e. using after tax dollars).The challenge for me is that I'm actually getting stuck at this exact apples vs. oranges question. That is, if I had to make a choice between the two options, is it "better" (sorry for the loaded word) to take cash out of my business to use for REI, or would it be more beneficial to contribute cash to a Solo 401k (with or without engaging in REI)? I realize that there is likely not a one-size-fits-all answer here, so I've taken a crack at a hypothetical case with a few placeholder/hypothetical numbers. Keen to hear your thoughts!Scenario 1: Skip Solo 401k contribution and invest after-tax cash for personal REISelf-Employed Income: $100kBusiness Expenses: $20kTaxable Income: $80kTaxes owed (assume 25%): $20kCash Available for Living, Savings, Investing: $60kLiving Expenses: $25kRoth IRA: $5kContribution to Savings: $10kCash available for REI investing with after-tax dollars: $20kScenario 2: Skip REI, and invest pre-tax cash into a Solo 401k Self-Employed Income: $100kBusiness Expenses: $20kContribution to Solo 401k: $30kTaxable Income: $50kTaxes owed (assume 25%): $12.5kCash Available for Living, Savings, Investing: $37.5kLiving Expenses: $25k Roth IRA: $5kContribution to Savings: $7.5kAt first glance, Scenario 2 looks quite good. I'd save $7.5k on my tax bill, have a large contribution to a retirement account, and nearly be even on contributions to liquid savings. On closer analysis, I'm not so sure.Scenario 1 - AnalysisIf I use the 20k from scenario 1 to invest in a $70k property, after a whole lot assumptions, I estimate about $5k/year in tax deductions over the course of a 30-year mortgage. (Note: I may have done this calculation wrong, but essentially took $3.5k in expenses and about $1.5k in depreciation per year). In 15 years, assuming about $100/margin/month, no additional payments/year, and 2%/year in property appreciation, I'd have equity in the home of ~$58k. Scenario 2 - AnalysisIf I contribute $30k into a Solo 401k that grows at 5%/year (conservative), the value in 15 years would be around $42k. I wouldn't be able to access the cash until the age of 59 1/2, and also would not be able to take deductions beyond the initial $30k taken in 2017.Of course there are several additional factors to weigh: tenants, property management, market returns, etc. For the moment, would you say this basic framing of the analysis makes sense, or is there something missing? How would a Scenario 3 - which uses the Solo 401k investment for REI -look?

Brian Eastman · Answer

@Rahul B.I can see that you are looking at this in a common, but misconceived way. A Solo 401(k) is not a means for YOU to invest in real estate. Rather, it is a means to diversify your tax-sheltered retirement savings into asset classes such as real estate, with the aim of getting better results in terms of security/income for the retirement plan.Comparing investing in real estate personally vs investing in real estate with a retirement plan is apples and oranges. The tax treatment is too different. Both have advantages and disadvantages that are non-parallel to each other.In a Solo 401k, there is no tax on the income produced by a rental real estate investment. As such, there is no place to apply deductions to reduce that non-existent taxation.The real way to look at the benefits of self-directing a retirement plan is; "Can my retirement savings grow better investing in real estate as opposed to conventional financial products?"Your aim of tax-reduction can also be achieved. Income from your self-employment is contributed to the plan and reduces your overall tax burden. This is achieved not only by the dollars directly placed in the plan, but also by the fact that a larger distribution as you are considering will likely reduce your overall income to the point of putting you in a lower tax bracket on the income you are taxed on.

Rahul B. · Answer

@Brian EastmanI've done a little bit of reading on the SD IRAs and use of Solo 401k's for real estate investing. This is an interesting opportunity, thanks again for the tip.I am leaning towards using after-tax dollars for my first deal, to decrease complexity and ensure that I get started soon. That said, I'd like to ensure I'm not missing out on a possible, majorly tax advantaged strategy.I have two concerns with using a Solo 401k for REI: I read on another BP post that investing in real estate within my Solo 401k (for example) would meant that I can't claim certain tax deductions (interest, tax, insurance, costs fees, depreciation, etc.). Is this correct? If so, wouldn't this be a large disadvantage vis-a-vis the use of SD IRAs and Solo 401ks for REI?From my limited research, it sounds like if I invest in REI through an SD IRA or Solo 401k, I would not have access to the cash flows until the age of 59 1/2 without penalty. Is this understanding correct?In general I think that if I had much more independent consulting income (in the several hundred k range, for example), I'd probably be more inclined to use SD IRAs or a Solo 401k, as a means of diversifying a retirement portfolio. At the moment, I suppose my investing strategy is aligned towards a) reducing annual tax obligations, and b) generating cash flow on a monthly basis. These two objectives seem to point towards the use of after-tax dollars. Interested to hear your thoughts on this.

Rahul B. · Answer

@Brian EastmanThanks for your response. I was not aware that this would be a possibility for a Solo 401(k) plan. This would indeed blend the best of both worlds - I'll have a look right away!