Our regular financial planning columnist has spiced things up with a Q&A.
I am looking for a way to get into the distressed real estate market. What do you know about using the money in my IRA or 401(k) money to invest in real estate?
Sincerely,
Cash Poor and IRA Rich
Dear Cash Poor,
You have good financial instincts. Real estate could be a great investment right now, and we are currently increasing exposure to this sector. But the risks and accounting red tape when making direct investments using IRA or 401(k) money should be avoided.
Cashing out a traditional individual retirement account (IRA) or 401(k) will trigger a taxable distribution and usually an additional 10 percent early-withdrawal penalty for people younger than 59½. I don’t recommend this approach because the penalty is high and the investment results unpredictable. One recent belief that I hope has been forever scorched from the American consciousness by the recent recession is the idea that real estate investments always increase in value.
Another ill-advised option would be to transfer your IRA to a self-directed custodian that allows for real estate purchases. These transactions have been gaining popularity, but I believe most investors should avoid these complex techniques. You will likely lose the power of leverage because few banks lend money to an IRA. Additionally, you can’t deduct property taxes and you can’t use depreciation. When an IRA holds the property, an individual is not allowed to cover an expense – such as buying paint or new granite countertops – out of personal funds or it will likely be deemed a prohibited transaction in the eyes of the IRS and could cause your entire IRA to be taxed.
Many 401(k) plans allow you to take a loan of 50 percent of the vested account balance up to $50,000. Borrowing from your 401(k) is penalty free, unless you don’t pay the money back. Then the usual early withdrawal penalties apply. You are charged interest on the loan because your 401(k) is the bank, and the interest gets added to your account. Most plans also require you to repay the loan within five years and definitely before you change employers. I would suggest not tapping your 401(k) plan.
Don’t get me wrong. I believe this is a good time to invest a portion of your portfolio in real estate. In fact, after being out of the real estate markets for several years, our firm is recommending a 4 percent allocation in diversified portfolios. If you don’t have the cash or financing available to purchase directly, consider investing your IRA or 401(k) money in a real estate investment trust (REIT). These investment pools are typically publicly traded and run by real estate investment professionals. You can invest directly in specific REITs or indirectly through diversified mutual funds and exchange-traded funds (ETFs).
If you are looking for an easy recommendation for an investment vehicle, try the Vanguard REIT ETF (symbol is VNQ). The expense ratio is 0.15 percent, and the effective yield is 3.5 percent. This is by far the simplest and most cost effective way to take advantage of this trend. If you do invest in real estate, remember it is a long-term investment, and like all such investments, you will have to give it time.
If you have a money question nagging at you, email: questions (at) emarotta (dot) com.
Matthew Illian is a wealth manager in the Richmond office of Marotta Wealth Management, Inc., providing fee-only financial planning and wealth management at www.emarotta.com.
Just discovered this site.
My comments are from investors point of view, ………….. I have skin in the game.
Now is absolutely the best time to invest in real estate ( unless the US goes totally Socialist communist Marxist)
The Big question is what type of investor are you and what are you goals /needs, etc.
You must understand things like; Good debt/bad debt, leverage, tax strategies and business structures, IRR ( internal rate of return), OPM (other peoples money), control is necessary /ownership is not, risk/reward ratio, and get this info from an actual investors point of view
Self directed IRA’s are easy, just know the rules, you could invest in almost anything you have knowledge about, gems, antique cars, baseball cards, art works, etc.
Food for thought, is paying off your you home mortgage a good investment strategy or is mortgaging it to the hilt to invest better? depends on you again and the type of investor you are, and how you put the money to work.
I must speak my mind, the following is a disappointing and misguided comment from the writer:
“One recent belief that I hope has been forever scorched from the American consciousness by the recent recession is the idea that real estate investments always increase in value.”
talk to other investors doing deals.
Moving your money or at least a portion of it to a truly self-directed IRA (Retirement Account) Custodian is a GREAT idea!
There are many fine custodians out there such as Equity Trust (formerly Mid-Ohio), Pensco and Entrust. You can invest in many various types of investments directly through your IRA such as stock, bonds, use it to provide venture capital for a new business, lend to an existing business, etc. As for Real Estate investments (my personal favorite investment vehicle for over 26 years); you can use your IRA to buy real estate to resell or rent, partner with others, develop, take out on option to buy and sell the option, lend money to others to buy (there are actually quite a number of people how are lending their Retirment Account money to earn an exceptional rate of return on real estate secured investments right now) and as you can imagine, the list of ways to invest goes on here too.
There are a few prohibited transaction types and ‘partner’, but the custodian you choose should provide guidance to ensure you are doing things correctly. For more information / education about self-directed IRA’s, Google the names mentioned above. All of these companies offer an abundance of educational literature on their websites.
In the interest of full disclosure, I have 5 IRA’s with Equity Trust. I own a Real Estate firm and have been investing in real estate since 1983.
MUCH SUCCESS!!!
PS As Mr. Illian very clearly mentions in his article, this is certainly not for everyone.
PSS Please forgive my spelling errors. I’m not the best speller or typist.
Dear Jesse, these Q&As are primarily directed at investors who desire to make smart money decisions without the hassle of actively managing complex investments. These are business owners who are already focused in their own area of genius but know that it is wise not to have all of their resources tied up in their business. Or super savers who want a tax efficient and low cost way to fund their nest eggs.
In my view, the experience of the average investor is akin to being told to swim to shore after being placed in the middle of the ocean with only a life preserver. Most do not even know which direction to start swimming. Eventually the sharks start to swarm. Most of the financial planning advice is being sold. A portion of the financial planning industry is making a worthy attempt to lose it’s life insurance salesmen image and join the professional fiduciary ranks of accountants and lawyers. I encourage this transition but recognize that perverse interests will always hold a significant grip between the relationship of men and money. In giving advice, simplicity is one my principles of business and investing success. If I can not easily explain the mechanics of a concept on a napkin, it is likely not a good fit in an investment portfolio.
I hope that by explaining a short bit about my perspective might help you understand a little more about the advice given above.
What a fascinating article. I’d like to add several points to the discussion.
1. I think the question “should I invest IRA in R/E” is the wrong question. A more useful question would be: “Under what circumstances is R/E a good IRA investment?”
2. With the revised question you can build a matrix to organize all the info presented above. This should lead to a more informed decision on an individual basis.
3. Note that Mr. Illian’s firm is recommending only a 4% investment in “diversified portfolios”…I assume that means real estate. One would have to have $100,000 in the IRA account to support a $4,000 investment in real estate. Now look at your matrix and figure out if there are any solutions that allow you to participate and stay within some reasonable % (4%?, 10%).
4. Mr. LaPaglia’s comment: Now is absolutely the best time to invest in real estate ( unless the US goes totally Socialist communist Marxist)” bears further discussion. There are some who believe we have experienced a silent, bloodless coup in America and in fact are being led into an overtly socialist existence where there are limited private property rights. This has been going on through multiple administrations controlled by either party, so this is not aimed at a particular party. I believe that we have moved away from an economy based on adding value and creating capital through savings…and into an economy where artificial demand was stimulated by easy credit and pro-real estate tax policies. Prices have been inflated. I would caution a prospective investor to consider whether the underlying values of the real estate (even at the new deflated prices) are reasonable for the underlying assets and its best use. I believe it will take 4-8 years to absorb what’s in the market. It would be important for an investor to look at the effective rate of return (not what they “promise” you) in a slow absorption period.
5. I subscribe to an e-newsletter by Larry Edelman (Uncommon Wisdom) and one of his tenants is “think about your return OF prinicpal…not just return ON principal”. It’s my sense that the original questioner was asking about real estate with an eye on increasing his returns ON principal. The gist of my remarks is that I believe the strong potential exists for more meltdown. In that case, there’s almost no rate of return high enough to cover for loss of principal. Up is NOT forever…whatever IRR they quote you in their model is unrealistic if it doesn’t include periods of pullback.
6. If one don’t have enough cash in their IRA to buy real estate and one has to resort to one of these “funds” that give you “shares” of real estate…just be aware that it was the buying and selling of “slices” of real estate cash flows and the false security of insurance (that was dishonest) that led to the sub-prime mortgage melt-down. We should ask ourselves if these real estate funds to sop up some of the IRA liquidity aren’t tools with the power to redirect hard savings away from their current owners (you…Mr. IRA owner) and into the hands of the investors stuck with these DISTRESSED assets? They are distressed because no one can afford to buy or rent them right now. How does transferring these assets to your RETIREMENT portfolio become a good deal for you?
7. Mr. Illian makes the point that if he can’t explain it on the back of a napkin it probably isn’t a good investment. Print this article and the comments. Take a dinner sized papernapkin out of your kitchen drawer. Start writing…when you run out of napkin…you will have a straightforward answer.