Client Made a 401K Withdrawal – Uninformed Realtor Causes Client to Pay $15,000 in Unnecessary Taxes


I was sitting in the sauna a few weeks back, chatting with a fella who had just liquidated his 401k because he was sick and tired of the performance and so he decided to take action and buy an income property to improve his chances on higher returns. He was looking forward to the benefits of property ownership like positive cash flow, having someone one else payoff the mortgage and California property appreciation, especially since he bought during a time when housing prices are significantly less than usual. He was quite proud of his decision but he was lamenting however his heavy tax bill coming due at the end of this year because he had cashed in his 401k. I was flabbergasted. I asked if he had heard of a self-directed IRA or if his realtor and told him about it and he said no. I went on to tell him the details of self-directing but since it was after the fact, there was no way for him to avoid the tax man. It occurs to me that many folks don’t know about this amazing vehicle for investing so I wanted to bring you up to speed, especially you realtors who aren’t in the know.

A self-directed individual retirement account is an IRA that requires the account owner to make investment decisions, directions, on behalf of their own retirement plan. This is executed through a custodian that holds the assets on behalf of the owner. Usually the custodian or trustee handles all transactions and other records pertaining to the assets, including filing required IRS reports, issuing client statements, etc. The custodian does not make investment decisions or recommendations about the assets, only the owner can do that. The custodian merely executes the directions the owner gives, although they are very helpful if you have a transaction in mind and don’t know how to do it.

The interesting part about this account is what you can buy in it: stocks, bonds, mutual funds (traditional looking investments). But more interestingly are these: real estate, mortgages, franchises, partnerships, private equity and tax liens to name the most common. There are just a few exclusions like life insurance and collectibles.

Let’s take an example of what you can do with your 401K. Let’s say you have $200,000 in your company’s mutual fund. You transfer the whole account into a self-directed IRA. Then you decide you want to buy a property for $250,000 and get a mortgage on it. Assuming you are allowed by your company to cash out some stock, you take out $50,000 from your 401K by selling some shares, apply for the mortgage, start collecting rent, depositing the rent checks back into your self-directed IRA, leaving the balance of $150,000 in the mutual fund. Any expenses you have on that house must be paid for with your self-directed funds. Similarly any profits you realize from that property must go back into your IRA until you turn 59 ½, like a traditional IRA, lest you want to pay the 10% penalty and taxes that constitute a 401K early withdrawal. Let’s continue the example: after holding the property for 10 years you decide you want to sell it. You sell and get $400,000 for the property, depositing more than $150,000 into your IRA. A nice return on your money, no?

What have you accomplished? You have a nicely diversified portfolio: company mutual funds and an investment property. This is a simplified example for illustrative purposes but there are many creative ways to use this. Another example where you can be a passive real estate investor would be to direct your IRA to purchase equity shares in a real estate company that does the investing for you.

Obviously there are custodian fees associated with the account, like any other type of brokerage account but hopefully your returns will exceed your fees, just like when you are in the stock market. There are several companies that offer custodial services and a simple Google search of self-directed IRAs will provide that. Be sure to do cost comparisons based on the number of transactions you intend to do. This is a basic introduction to self-directed IRAs and is not intended to be comprehensive so please consult a professional before making that move but it is a very exciting vehicle for wealth building so I encourage you to take a closer look.

Please add any comments to this discussion on self-directing your IRA. Peace.

Megan McGinnis
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McGinnis is a real estate investor, financial strategist and happy blogger in Southern California.

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