Taxes, how do I loathe thee? Let me count the ways.
Fortunately, real estate investors (as self-employed people) can take advantage of 401(k)s just like W-2 employees can, to invest a certain amount of money each year tax-free for retirement. And the good news does not stop there – they can even invest in real estate as their 401(k) retirement investment!
But there are plenty of details that investors should know before they jump off the diving board.
First, individual (or solo) 401(k) accounts are for self-employed people who own sole proprietorships or partnerships (such as LLCs created for real estate ownership), but have no employees (other than spouses, who are allowed). Real estate investors with employees can set up normal 401(k) accounts and benefit that way.
There are contribution limits, of course. For tax year 2013, self-employed people can contribute a total of $17,500 as their “employee” limit, but can also contribute as the employer, up to 25% of their self-employment income (to a maximum total contribution of $51,000).
Money contributed is an “above the line” tax deduction, meaning it is taken off a taxpayer’s taxable income before calculating their adjusted gross income.
Solo 401(k)s can be created in about two minutes at most major investment institutions, making it easy for real estate professionals to start one alongside their other investment brokerage accounts. In many cases, 401(k) accounts are free, and the investment bank simply charges a commission on trades.
For those who are less interested in stocks, bonds and other traditional retirement investment vehicles, they can actually contribute money to their solo 401(k) by investing in real estate. A solo 401(k) account is set up through a bank, and operates much like a checking account; the investor pays all expenses out of it, and deposits all rents and other property-related income into it. The property is titled in the name of the 401(k) plan, and the investor simply serves as a trustee (there may be some asset protection value here too, as retirement accounts often remain exempt from lawsuit collections).
Proceeds from the property are thus inherently deposited into the 401(k) account, and are not taxed until they are taken out (presumably years later, after much appreciation and rental income).
There are also Roth versions available for 401(k) accounts, wherein the investor opts to pay taxes on contributions now, but does not have to pay taxes on any withdrawals in their golden years. As always, this involves the guesswork of whether they will owe a higher portion of their income in taxes now, or in the future. One nice feature of Roth retirement accounts, however, is that all returns on the money contributed are also tax-free, when it comes time to pull them out: if the $10,000 contributed today turns into $30,000, then all $30,000 is tax-free when withdrawn, rather than just the $10,000 contributed this year (as is the case with normal retirement accounts).
Investors can create an individual 401(k) any time before the end of the calendar tax year (December 31), but once it is created they can make contributions to it up until they file their taxes (April 15, or later for those who file an extension).
It is worth mentioning that tax law becomes complicated quickly, and the ideas above should simply be a starting point for a conversation with a sharp accountant (ideally one who specializes in real estate investor clients).