Beating the tax man (or woman)

[Anthony R.]

So currently, I am 29 and for all intents and purposes, half of my income is from rentals. Also, the income from my rentals cover all expenses. This means that what I make working is mine for savings, other investments, etc. Currently I have been dumping 13% of my work income (10% from me and 3% from employer) into my 401k. 

As I am getting ready to do my 2015 taxes tomorrow, I was thinking about how I planned on writing off, most if not all, of my rental income.  Simultaneously I am still attempting to Beat the Multiple Rental Property Poison Pill and also Hold and Collect or 1031 Trade. 

Then it hit me....

Since my earned income is unencumbered, why not max my 401k and then take loans from myself. The interest paid back to myself would only benefit my retirement, I can stop giving money to those damn dirty banks, AND, most relevant to this post, I would lower my taxable income to an all time low. 

So my question is, does this sound feasible? 

1/2 of my income is rental income and between depreciation, taxes, interest, insurance, repairs etc. It's written off.

1/2 of my income is earned income. 

After I max my 401k though that would bring my taxable income down to 41% 

Add in standard deductions and I manage to get my taxable income down to 35.6% 

Does anyone else do this? Is this a pie in the sky dream? What are the potential pitfalls to this other than the obvious such as, I buy a lemon and waste a ton of my 401k money. 

(Yes I hire a rental property CPA, no I haven't discussed my delusions of grandeur with him yet) 

[Tim Johnson]

Hi @Anthony R....I like the creativity.

I believe IRS rules limit 401K loans to $50K (total), so I assume this would be a limiting factor for you.

[Anthony R.]

@Tim JohnsonGahhh that sucks. Back to the 'income hacking' drawing board again!

[Brian Eastman]

@Anthony R.

There is also a math/tax problem with this logic that most people overlook when they look at the 401k participant loan as cheap and easy money.

You put the money into the plan on a tax-deferred basis.

You borrow the money from the plan and pay the plan interest in the range of 4-5%.

So far, so good.

Your payments to the plan are made with after-tax dollars, thus eliminating the initial deferral benefit.  Ouch!

In your case, you would be better off just using money in your pocket today to invest.  There is no point putting it into the plan in the first place if your only intention is to pull it back out immediately in a loan.

For someone who has had a 401k for some time and contributed over many years, this "hidden cost" of losing the deferral basis of the 401k funds is acceptable if the use of the borrowed funds will be of real benefit such as getting them started in real estate investing.  Hard money is actually cheaper.

[Anthony R.]

Hey @Brian Eastmanthanks for the helpful info! Seems like I will have to try and find a different way to play the system haha. 

On a side note, my business is rentals but I am also a software engineer. It's funny how many of us head into real estate! I wonder if there is a correlation between programming and rental property ownership/management? 

[Larry F.]

Brian

I have a strategy I learned about some Tax mitigation. If your interested, reach out to me. I'm a Puyallup Wholesaler. 

Regards,

[Scott W.]

Originally posted by @Brian Eastman:

@Anthony R.

There is also a math/tax problem with this logic that most people overlook when they look at the 401k participant loan as cheap and easy money.

You put the money into the plan on a tax-deferred basis.

You borrow the money from the plan and pay the plan interest in the range of 4-5%.

So far, so good.

Your payments to the plan are made with after-tax dollars, thus eliminating the initial deferral benefit.  Ouch!

In your case, you would be better off just using money in your pocket today to invest.  There is no point putting it into the plan in the first place if your only intention is to pull it back out immediately in a loan.

For someone who has had a 401k for some time and contributed over many years, this "hidden cost" of losing the deferral basis of the 401k funds is acceptable if the use of the borrowed funds will be of real benefit such as getting them started in real estate investing.  Hard money is actually cheaper.

this is seldom talked about and very few people understand it. let me give you an example.

say you borrow $50000 from your 401k. it needs to be paid back in 5 years.

you pay this back, each month, AFTER taxes. let's say you are 25% federal bracket and 4% state so 29% in taxes. that's 14,500 in taxes! good luck making $ on that loan.

you could do a heloc (interest only) and pay only 3% interest.  much better deal IMO.

[Justin Holley]

@Anthony Russel You can accomplish what you are trying to do in a much more effective way using PROPERLY structured cash value life insurance.  I know everyone is now poo pooing this post, but hear me out.  First, very few insurance agents know how to structure this because they build the policies to pay them a large commissions, rather than max the benefits to you.  When done correctly this method can provide liquidity, guaranteed returns, security from creditors, disability protection, and finally a death benefit.  Policy loans against the death benefit can be very advantageous for purchases of properties outright, supply a down payment, or use as collateral so those greedy banks cant be so greedy, etc. If you are curious how I use this PM me.  Thanks

[Thomas Rutkowski]

Justin is exactly right. I'm sure all the life insurance haters are going to pop up now, but leveraging life insurance allows you to put your money to work in two places at one time. You are earning interest or dividends on your cash value AND you are putting the loan to work in real estate at the same time. I explained the solution in a recent blog post:

https://www.biggerpockets.com/blogs/7595/47651-are-you-using-a-magic-checking-account

[Curt McClements]

In 2015, the IRS limits your pre-tax contribution to a 401k to $18,000. If you're over 50, the limit is $24,000.

[Stephen Chittenden]

A couple posts have greatly exaggerated the tax effect of paying back a 401(k) loan. It is true it is paid back after tax, but the only true double taxation is on the interest paid into the plan, not the entire payment. If you borrow from a bank, you pay that money back after-tax too.

[Anthony R.]

@Stephen Chittenden Wouldn't the interest paid back be a write off since it's a loan for an investment property? I asked my CPA if I take a personal loan for repairs if the interest was a write off and he said yes. Wouldn't this be the same? 

On the note of "after tax" If I am using income from the property, PRE TAX income, to pay back a loan, and also the tax and interest are write offs, then how is this a bad idea again? 

On a side side note, I won't be going this route. I asked my CPA last week about it and he STRONGLY discouraged it. There's a reason I pay people smarter than me to answer questions and I'd be a fool not to take sound advice. So now this question is purely academic. 

[Stephen Chittenden]

@Anthony R.I don't believe you can deduct the interest, unless you are borrowing only from employer contributions under section 72(p)(3) of the Code. That said, I don't necessarily agree with your accountant that it is always a bad idea. It depends on your age, situation, and other factors. For example, if you think your investment options in the plan are going to decline in value over the time the loan is outstanding, the interest (even if double taxed) could be a good way to increase the money going into the plan. The real downside is opportunity cost from not having the money invested in the plan, but that's only a downside of your investments are going up. 

[Anthony R.]

@Stephen ChittendenSo even if I couldn't deduct the interest, isn't it going into my 401k? I mean, I am effectively paying interest to myself. So is the interest even a bad thing? 

[Stephen Chittenden]

@Anthony R.It can certainly be better than paying it to a bank. It is subject to tax when it comes out of the 401(k) plan, so you end up paying tax on money that was already taxed, but as I said, I don't think that that is always unjustified. 

[Olivia C.]

Take a look at Infinite Banking via the book Bank on Yourself by Yellen.  The procedure is complicated and must be done exactly right.  It might be what you are seeking. 

I don't get anything for posting this and I'm not soliciting anything.  I've just read some books on the topic and will use the technique myself for real estate construction loans.

[Hugo Castellanos]

I am of course a newbie, but... I am wondering, why do you even have a 401k?!?

coincidentially, I had this discussion with my friend last night and we ran some numbers with online 401k estimators (nobody knows what it's gonna do for real). I am 37 yo, I have no 401k (well, like 20k my employer has put in it, which I don't even count on).

If I started putting down 18k a year, by the time I retire at 65 (I am not planning on working that long!), I would have put in myself around 570k, my employer around 60k ad I would have around 1.6 mill (at 5% market increase per year), that I would have to take out year by year. At that poing, YOU DO PAY TAXES. I say this, because many of my colleagues (educated doctors) think you don't pay taxes at all and this is all free money. So if you want to live with around 6k a month of cash flow from your 401k, you would have to take out around 100k and pay 25% taxes... at 2016 rates!! I think it will be higher in the future, and also your money will for sure be less valuable. At this rate, you would eat up your 401k in around 13 yrs and a bit (as per my rookie calculations).

If you really want to do this, I would think a Roth 401k is a better option. You do pay taxes before you put it in, but then you put the money to work at market's expense and then all the interests and what you take out is tax-free. You can do some comparisons online too. However, I know you have some limitations as to enter a Roth 401k if you make over like 130k a year... there's a loophole to put 5k a year even if you make more, but I don't know much more about this or other limits.

I also calculated if you only buy 6 properties around 180k in value with 25% down (I estimated costs with closing and all to be around 60k and threw in another 20k for some repairs before renting or after) and you take loans for 15k and rent them for around 1.6k a month, taking into account expenses, I think you would have no cashflow, but at 15 years, you would generate 10.2k in rents, minus taxes, insurance and all that, I think it would be close to those 6k you would be living on at 65. Not only that, but in 28 yrs (when I am 65), I estimated the houses to be around 250k and the rents to have increase, but to be conservative, I didn't add this into the calc. So at 65 yrs, I could potentially own these same 6 houses (assuming I didn't do anything else), have a similar cashflow to what a 401k would give me, and would not eat it up in 13 yrs. On top of that I would still have over 500k from the rents from years 16 through 28 (that I most likely would invest in something else or in some more properties).

That's why I don't have a 401k! My financial advisor said: Don't put all your eggs in the same basket! And I think I am not... each property is a different basket to me... even if the housing market collapses again, that will mean more people need to rent from me! No need to sell!!

Please if anybody reads this and thinks I am completely wrong, let me know, as this is a lot of my strategy!

I hope this helps!

[Scott W.]

Thus is correct. When doing leverage and buying correctly, nothing can beat the returns of rentals.

So in terms of your 401k even with the penalty, take it out...take it all out.

[Thomas Rutkowski]

It doesn't' make sense to maximize your 401k contributions to get the tax deduction and then turn around and borrow money FROM yourself. Sure, you got a tax deduction, but you just gave the government a blank check. You don't know what tax rates will be in the future and you don't know what tax rate you will be in when you decide to take income from your 401k. 

It makes much more sense to put your money into high cash value permanent life insurance. A properly designed and funded policy has cash value from day one. And unlike a 401k loan, you don't borrow "FROM" it, you borrow "AGAINST" it. All the life insurance haters on this site can never seem to grasp the significance of the difference in those two words. It means that your cash is working and earning interest in two places at the same time. 

Just as with a "Roth", you are contributing to your retirement plan with after-tax dollars, your money will grow tax free, and because you take income via a loan, you access your money tax-free. But unlike a Roth IRA/401k, there is no limit on contributions and a life insurance death benefit rides along.