A Costly, Common Retirement Account Error Exposed
As an individual retirement account (IRA) custodian, I often encounter investors who have been using their IRA or 401(k) accounts to buy and sell real estate in ways that are costing them serious capital. These sticky situations do not always lead to the so-called “implosion” of a retirement portfolio that you hear about so often, but they do cost significant amounts of money each time you make this strategic error. One of the worst and most common mistakes is the inefficient use of 401(k) funds to flip houses.
Here is what the investor has usually been doing, often for years:
Investors who buy and then wholesale or fix-and-flip houses will use 401(k) funds to make the initial purchase of the property and sometimes to fund the rehab as well. They access the funds by taking them out of their 401(k) as a distribution and paying their ordinary income tax rate at the time that they withdraw the money. Usually, that rate is between 20 and 25 percent. Once they have the money to fund the project, they flip the home and pay capital gains taxes on the profits to the tune of 30 or 35 percent.
To put some numbers with this common practice, imagine you purchase a property for $50,000 and put an additional $15,000 into it for repairs and upgrades before selling it for $155,000. That is a profit of $90,000. Capital gains taxes will come to about $30,000, nearly one-third of your entire profit, and that is before you factor in the money you paid when you took the distribution in the first place!
If the investor in the example had used a self-directed 401(k) to flip the home instead of withdrawing the money, paying taxes on the distribution, then paying capital gains taxes on the profits, they could have saved the vast majority of the money they paid in taxes and kept it as available capital for their next investment.
The good news: If you have been funding your real estate deals this way, you probably did not violate any regulations that might distribute your entire 401(k) account or cost you your portfolio in fines, fees and penalties.
The bad news: You probably could have been doing a lot more deals if you hadn’t been spending all your investment capital paying taxes. Fortunately, it’s never too late to make that change.