What's Better for Creative Real Estate Investors — an IRA or 401k?

investing for retirement

More and more creative real estate investors are switching to the individual 401k and loving their new plan.

The Self-Directed IRA has been the standard vehicle for alternative investments in retirement accounts.

As many creative real estate investors know, mutual funds aren’t the only investing options for your nest egg. You can buy real estate, tax liens, notes, and even become your own private money lender.

Most people set up a Self-Directed IRA with an IRA custodian, then have learned to jump through the hoops that go along with it. But did you know that there is a better way?
You’re about to discover what most real estate investors will never know about investing in real estate in a retirement account. Introducing…

The Solo 401k

The Solo 401k, also known as an individual 401k or i401k, can be a great alternative to a Self-Directed IRA for creative real estate professionals. Here are some of the benefits:

  • The Checkbook: With an individual 401k, you are creating a 401k plan for your own business. You can elect yourself as the administrator. The administrator (you) is the one that write the checks. Having the checkbook is much more efficient than going through the custodian intermediary. For example, if you find a fantastic deal and want to get it under contract with earnest money on the spot, you can do that with the solo 401k. With the self-directed IRA, you have to wait for your custodian to cut the check, which could cause you to lose the deal.
  • No UBTI: With both the self-directed IRA and the solo 401k, you can use borrowed money to help with the purchase of real estate as long as the loan is non-recourse. However, with the solo401K, you will avoid the Unrelated Business Taxable Income (UBTI) issue that is triggered with a self-directed IRA.
  • Higher Contributions: The total contributions to a solo 401k can be larger per year than a self-directed IRA. Plus, there are no income limits for Roth contributions.
  • Mistake Forgiveness: If you do a prohibited transaction, you have a chance to adjust your mistake in an i401k. With a self-directed IRA, a prohibited transaction usually ends up in a liquidation of the plan. And a liquidation has significant penalties and tax consequences.
  • Long-Term Cost Savings: The fees to set up an i401k may be more, but the costs to maintain it are much less than having to pay a custodian each year. IRA custodians charge as a percentage of the amount in your account, so the more successful and larger your self-directed IRA becomes, the more you have to pay. With the solo 401k, the nominal ongoing fees to maintain it typically just deal with keeping your plan up to date with the right paperwork.
  • Be Your Own Bank: The feature that attracts a lot of people to the individual 401k is that the ability to borrow up to $50,000 from it. And you can spend that borrowed money on whatever you want. Just be sure to you pay yourself back.

You may be thinking, “How come I’ve never heard of this?” Four reasons.
First, it only come into existence in 2001, and a lot of people don’t know about the solo 401k. Second, financial planners and advisers typically stick with what they know and many aren’t educated on the i401k. Third, IRA custodians can earn more fees from self-directed IRA accounts since individual 401ks require less interaction. Finally, the solo 401k is only an option for people who have their own business. And that’s important to know–the requirements.

Individual 401K Requirements

Meeting the requirements for an individual 401k was tailor made for creative real estate investors:

  • Operate a Business: You must operate a business, since this is a 401k plan for your company. You don’t need to incorporate or file documents with the Secretary of State to have a business. It can be as simple as a sole proprietorship or partnership, but you at least have to have a small business, and that’s exactly what most creative real estate investors have.
  • Some Earned Income: Your income in this business must have at least some earned income (or the intent, if you just started it), even if the majority is passive income from rental property. Most creative investors can generate some earned income from a wholesale, an assignment, or a flip.
  • No Full-Time Employees: Although you can have 1099 independent contractors as well as part-timers, you can’t have any full-time employees outside of a spouse. Most creative investors fit this bill, as well.

 i401K Drawbacks

Yes, there are a few drawbacks to be aware of, too.

  • Competent Counsel: Very few advisers or IRA custodian companies really have experience and a deep understanding of how to correctly set up and educate creative investors on the nuances of real estate investing in a solo 401k.
  • Opening a Bank Account: Your favorite bank where you hold all of your other accounts may not be able to open an i401k bank account. Some bankers will look at you with cross eyes when you try to open one. But if you are a creative investor, you are probably used to people being puzzled by your out-of-the-box thinking.
  • Obtaining Title Insurance: Getting title insurance issued on solo 401K purchases can sometimes be a challenge. Title insurance underwriters don’t always know how to handle them.
  • Self Discipline: Perhaps the biggest drawback to the i401k is also its biggest strength, giving you the purse strings and having no person in the middle to hold you accountable. Outside of borrowing from it, you can’t use your retirement money for personal use, even though you might have the checkbook in your possession. In fact, commingling personal with retirement funds on any investment is not allowed. So if you have no self discipline, perhaps you are better off letting a third party custodian protect you from yourself.

The best way to overcome these drawbacks is to work with someone who has significant experience in setting up and administering these plans for creative real estate investors. They should be able to set it up right with the proper paperwork, help you open the bank account, provide materials, so you can educate title insurance underwriters on solo 401ks and assist you along the way, so that you avoid any mistakes.
Much like any aspect of creative real estate investing, you have to work with the right people.

Solo 401K Investing

Investing in your real estate business using retirement money can be a great opportunity for you. The individual 401k might be a better option for creative real estate investors, but everyone’s situation is different.
For example, some self-directed IRA people don’t want to change and to acquire checkbook access, they set up an LLC in conjunction with their IRA. This technique works, but the costs of the set up and the annual fee for an LLC can be costly, and you still miss out on all the other great benefits of a solo 401k.
More and more creative real estate investors are switching to the individual 401k and loving their new plan. Thanks for reading, and if you have any questions, feel free to comment below.