Softening the Tax Blow of Early 401(k) Withdrawal for REI?

Question

This is more of an Accounting question but the REI aspect of it does warrant discussion IMHO. I have a sizeable 401(k) that I would like to take a distribution on so that I can use it as after tax dollars in order to invest in more real estate and enjoy the benefits today instead of waiting until I am in my 60's. The downside to this is obviously the large hit I will take in terms of income taxes (25% to start) and excise penalty (10%). How can I minimize this?

One thought I had was to take a partial distribution now, use it to purchase a rental property and then reduce my tax burden through accelerated depreciation. Then, beginning next year, take a distribution on the remainder and, again, use accelerated depreciation to soften the tax blow. The goal is to significantly reduce my tax burden on high-income years from the 401(k) early withdrawals. How does this work in the real world? Also, how would I be affected with Depreciation re-capture when I go to sell the property? I think I can avoid this with a 1031 exchange, right?

Alan Rohrer · Answer

Account Closed

I would consider a few options:

1) If you want to invest in real estate with an end goal of retirement income, keeping it in a Self Directed IRA or 401k is a plausible option.

2) If you want to use the money now, there is a strategy called the Roll Over Business Startup (ROBS)- the steps are complicated, which is why you would have an expert handle it for you. Essentially, it allows you to use retirement money to purchase/create a business, and take money (profits) out of it NOW to avoid the additional penalty.

Also keep in mind that the distributions would be hit at your highest tax rate... so if your distribution is "sizeable", your tax on it could be more than 25% (plus the 10% penalty of course).

In the end, keep in mind that because of compounding interest, taking a tax hit now has a much bigger impact on your portfolio than taking a tax hit later. Many would recommend using one of the strategies above way before they would recommend taking a tax/penalty hit.

Michael Faulk · Answer

Account Closed... Couldn't you transfer your 401k to a Self-Directed IRA or something similar? Then use your self-directed IRA to acquire properties?

George Huber · Answer

One issue with taking a loan on your 401k is that you are paying the loan back with after tax dollars.  Then you will have to pay taxes again when you withdraw money when you retire.  Some thoughts are that you are taxed twice on the money.

Ron Burmeister · Answer

Account Closed You asked:

However - and please correct me if I am wrong - any gains realized [In a Robs Company]   should be paid back to the 401(k) plan. Is here a way to extract the  cash out of the company and take the distribution, pay the income taxes  BUT avoid the 10% excise tax?

In a ROBS setup you can pay yourself a salary.  Any gains will be taxed within the corporation.  The only time money goes back to the 401k is when you have a stock buy back or distribution.

There are differences to what you can and cannot do within a ROBS structure as opposed to a Self Directed IRA.  ROBS does not work well for long term holds and a Self Directed IRA does not work well for flips.

There is no tax or penalty moving the money from your existing 401K to the ROBS 401K provided you do a custodian to custodian transfer. If you are currently employed with the employer that has your 401k then your employer will have to let you transfer the funds out of their account.  Most employers will not allow this.

P.S. Not an Attorney or Accountant. Not offering legal or tax advice.

Alan Rohrer · Answer

Account Closed said. The rules are VERY specific and the consequences too big if you get it wrong. Be sure you work with someone who specializes in this type of work.

But what George said above is my understanding as well. Good luck!

George Blower · Answer

Account Closed

You will definitely want to speak to providers that offer the business financing 401(k) (ROBS 401k) as the rules are very specific.

For example, the business that is funded with the retirement funds has to offer goods or services.

If the plan is to use the retirement funds to finance  a real estate, the real estate operating company requirements have to be satisfying. Lastly, when a 401(k) invests in your own corporation, it not considerable loan but rather an equity investment. Therefore, there is nothing to payback; however, because the 401(k) is a shareholder 401(k), it can receive dividends. Again this is just a high level explanation.

Basit Siddiqi · Answer

Account ClosedThere are some hardship exceptions to taking money out of your 401K. However, what you are describing doesn't sound like it qualifies for an exception.

Account Closed · Answer

@Alan Rohrer Thanks for the advice. I have read about the ROBS strategy and my understanding, at a high-level overview, is you establish a C-Corp, a complimentary 401(k) plan, and your funds over to the new 401(k) plan where you use the funds for your company. However - and please correct me if I am wrong - any gains realized should be paid back to the 401(k) plan. Is here a way to extract the cash out of the company and take the distribution, pay the income taxes BUT avoid the 10% excise tax?

Jonathan R McLaughlin · Answer

you could delay the tax hit by converting part of the 401k to a conventional IRA then withdrawing. Same tax hit but I believe they don't withhold the taxes up front like they do in a 401k, so you have more time.

Softening the Tax Blow of Early 401(k) Withdrawal for REI?

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