IRA or 401k?
The “Roth 401k” is an amazing retirement account. Also known by the terms Uni(k), Solo(k), 401(k) w/ Roth sub-account, and a couple others they are all talking about the same thing. A 401(k) plan that allows the participant to designate funds as either Traditional contributions, or as Roth contributions. These plans are very popular amongst the self-employed for good reason. With no income limits, high earners can now contribute to a Roth account… and the structure allows them to very easily put $40,000 a year in Roth funds away as a couple… approximately $60,000 of their first $80,000 in income could go into the plan (between the Roth contributions and the Traditional account match their company would make). That is one heck of a way to set aside money.
The Roth 401k also has totally different, and usually softer, penalties for accidental transactions in the account. IRA law is very unforgiving. An error gets made, the account is distributed and subject to some unkind taxation. The 401k is different, as it wouldn’t be good if some large employer made an error and all their employees had massive tax bills as a result. That same, more reasonable code applies to both large and very small 401k plans. Giving single person plans the same enhanced safety.
The Roth 401k, and this is really big for real estate investors, is not subject to UDFI Taxation. “Unrelated Debt Financed Income” tax is part of the UBIT (Unrelated Business Income Tax) code that both IRAs and 401k plans are subject to. This section of code has a very reasonable and somewhat interesting history we can talk about if you like. However, most of you are here to find out how to make more money and keep it. Thus we proceed.
401k plans are not subject to the section related to income from debt, so all the people who are looking to buy a property and get a loan for it could easily save tens of thousands of dollars by using a 401k plan from us instead of an IRA. That is because the UBIT tax table is quite high. Think upper level trust rates. …We don’t like to lose 40% of our debt-financed earnings to taxes… and we’ve never met anyone who did.
As an example; you put $100,000 down on a property, and have a loan for another $100,000. After five years you sell the property for a profit of $100,000. Keeping this VERY simple, 50% of the purchase was financed. So 50% of the profit is subject to the (approx.) 40% tax. That means $50,000 is subject to the tax and that tax totals roughly $20,000. You thus only keep $80,000 of your $100,000 gain… IF it was done in an IRA. If it had been sold in a 401k plan instead, you would keep the full $100,000.
The 401k allows you to take a loan against it without penalty.
And you get to pay yourself (your account that is) the interest. If you need funds from an IRA, it’ll cost most people the income tax on that money, plus a 10% penalty. If you need the funds from your 401k, you just borrow them and pay them back over time, with the interest going to yourself. This difference has more than paid for some people to open accounts with us even on loans as small as $5,000 that would have come from the IRA otherwise.
You may take out funds for up to a 5 year term, and for either 50% of the account value or $50,000; whichever is smaller.
So what about the IRA? It has it’s place. It’s simpler and less paperwork for one. If you aren’t going to be leveraging any property, don’t desire the higher contribution limits, or the lack of income restrictions, don’t desire the ability to get access to some of the funds without penalty, and don’t value the reduced penalties for errors in the plan then the 401k is on equal ground, so take the simpler, lower investment option. We are not trying to sound down on the IRA here. It is just more clear to describe the IRA by what it lacks in comparison. If you don’t need those things, then the IRA will be the same for you, and it costs less. If you are wondering, the super majority of plans we do are 401k plans. The changes in the law have really made it that much more useful for most people. The IRA is usually on better footing to be an option if you are (or are very near) retirement age. That reduces the likelihood of contributions, and removes the penalty differential on withdrawn funds.
