In recent years, more and more people are considering using 401k loans to fund their real estate investments. With housing prices going up and 401k account balances swelling, this seems like a clever way to put your retirement savings to work. However, there are quite a few risks and downsides with taking out a 401k loan to buy investment property that need to be considered. This article will provide a comprehensive analysis on the feasibility of using 401k loans to purchase real estate from returns, risks, tax implications and other perspectives.
The returns of funding real estate purchase with 401k loan may not justify the risks
The appeal of using 401k funds to acquire rental property or flip houses is the ability to rapidly come up with a 20-30% down payment which banks usually require for investment mortgages. However, the problem is that 401k loans charge relatively high interest rates to the borrowers. If your rental property or flip doesn’t generate sufficient cash flow to cover both the 401k loan payment and investment mortgage payment, you may end up liquidating other assets or go into further debt. Additionally, if the real estate investment underperforms and you cannot pay back the 401k loan, the outstanding balance will be treated as a distribution, subject to ordinary income tax and 10% penalty if you are under age 59 1/2.
401k investment property purchase can be complex with strict rules
The 401k loan rules for real estate purchase are much more complex compared to taking out a personal loan from a bank or using your own savings. You must set up the loan repayment as automatic payroll deductions, capped at 5 years max duration. The amount you can borrow is limited to lesser of $50,000 or 50% of your vested 401k balance. If you leave your job, the loan may become due immediately with a short window to pay it back. Furthermore, you cannot borrow from current employer’s 401k to invest in real estate.
Consider other lower-risk options to invest 401k
Given the lackluster returns and high risks, funding real estate purchase with 401k loan may not be advisable for most retirement savers. You can simply invest part of your 401k contributions into Real Estate Investment Trusts (REITs) to gain exposures to housing market. Also evaluate using a personal real estate investment loan first before tapping into your retirement savings. Additionally, a HELOC or cash-out mortgage refinance if you already own property can provide funding at better rates and terms compared to 401k borrowing.
In summary, utilizing 401k loans to acquire investment property can be quite risky and complex. The mediocre returns usually do not compensate for the tax penalties and impacts to your retirement planning if things go sideways. Consider all other options before using 401k funds to purchase real estate.