Investing in real estate or a 401(k), there are many things to consider. What are your dreams for retirement? Do you want to invest in a fully-kitted RV and tour the States for six months of the year, or do you want to pack up your things and move to Bali? Whatever your dream is for those sunset years, investment is the best way to get there.
This poses the question, which is the best way to invest? 401(k)s and real estate are two common terms you will hear in the world of investing. Each form of investment has its unique characteristics that can provide meaningful benefits to your financial portfolio. Each also has other considerations that will impact their value to you, depending on your specific goals and circumstances.
In this article, you will learn more about the benefits and important features of 401(k)s and real estate investments to decide which may be right for you. Additionally, you will learn a technique for combining the benefits of these investment options.
The Basics of Investing Through a 401(k)
A 401(k) is an investment account that employers can offer to their employees to save for retirement. You can contribute a portion of your paycheck into your company’s 401(k) plan to be invested in various stocks, bonds, and other funds. The bonus of this kind of investment? It’s one way to put money aside for your nest egg without having to do anything at all.
The Tax Benefits of Traditional and Roth 401(k)s
The term 401(k) references a section of the U.S. tax code, which speaks to the greatest benefit of this investment option – it is tax-advantaged. And, let’s be honest, who doesn’t like a tax break?
Your contributions to a traditional 401(k) are tax-deferred. You usually pay income taxes on your paycheck in the year you receive it. However, the portion of your paycheck contributed to a traditional 401(k) is excluded from your taxable income in that year. Instead, the tax you owe on that income defers until you withdraw the money from your 401(k) in retirement. The tax deferral also applies to any dividends or gains derived from the contributions to your 401(k).
Alternatively, some employers offer Roth 401(k)s to their employees. The tax benefit of a Roth 401(k) is slightly different. You pay taxes on the initial contribution, but all distributions (including any dividends or capital gains) are considered non-taxable income.
Other Aspects of 401(k)s You Should Know
There’s more to know about 401(k)s, though. Regardless of whether they are traditional or Roth, 401(k)s have other essential features that will impact their value to you when compared with other investment options.
- Some employers will match your contributions to your 401(k) up to certain amounts as an added benefit.
- There are limits on the amount you can contribute annually to your 401(k).
- Withdrawals from your 401(k) that you make before you turn 59½ are penalized with an additional 10% tax. The 10% penalty tax is in addition to regular taxes you may owe on the withdrawal.
- Investment options within your 401(k) will be limited to the offerings of your employer’s plan.
- You will have to take required minimum distributions (RMDs) at age 72.
Here you can see that the stars of the show are the tax benefits and employer matches – and that’s why 401(k)s are an integral part of most investors’ portfolios. However, the tax penalty for early withdrawals and limited investment options are noteworthy considerations, depending on your goals and total financial picture.
When it comes to employee contribution matches, it’s important to note a few things. While some companies may choose to match 401(k) contributions, others may not. If you work for a company that does, the amount matched depends on the terms of your company’s 401(k) plan. Your employer may choose to match your contributions in a few different ways–depending on their specific policy. Generally, employers match a fixed percentage of employee contributions with a partial match or a dollar-for-dollar match. For a partial match example, an employer might offer $0.50 for every $1 the employee contributes, and a dollar-for-dollar match means an employer adds $1 for every $1 contributed by a company. Both these matches are usually capped at a percentage of an employee’s total salary.
So how much could you receive towards your 401(k) over a lifetime? Well, this all depends on how much you earn, how long you’ve worked at a company, and the percentage your employee matches. According to Investopia, “On average, individuals earn about $0.50 on the dollar, for a maximum of 6% of their salaries. That’s the equivalent of an employer writing a $1,800 check to a worker who earns $60,000 every year. Furthermore, that $1,800 will steadily grow over time.” If you work at a company for 45 years, you’re looking at a total contribution of $81,000. Don’t forget; these numbers do not consider inflation. Of course, what you can buy with $81,000 in 45 years will be substantially less than today. But, with inflation, employees can contribute more to their retirement plans, increasing the employer’s match too. Even taking inflation into consideration, the lifetime value of matching contributions is an offer too great not to take advantage of.
Considerations for Investing In Real Estate
If you’re the kind of investor that prefers a more hands-on approach or even just a more tangible investment, then investing in real estate is another way to invest your hard-earned money. Sure, real estate investments are not easy and will require some learning on your part. Still, the payoff is likely to be very profitable. Especially since it means you won’t be putting all your eggs in one basket. We all know that in the investment world, diversifying is always good. And investing in real estate provides benefits distinct from retirement-focused tools like 401(k)s.
The reason many choose real estate as their investment of choice is the opportunity for steady rental income – either from residential or commercial tenants – that can supplement your other income. Although, rental income is only one part of the overall return on investment(ROI) from real estate when you consider:
- The potential for appreciation on the property.
- The ability to leverage your real estate to finance other investments.
- Other tax benefits in the form of deductions, favorable capital gains rates, depreciation, and 1031 exchanges.
Of course, investing in real estate carries its own set of risks, like any form of investment. And although historically, it has been a very dependable way to invest money, nothing is ever a sure thing. When it comes to investing, it’s always wise to move with caution. You have the potential for troublesome tenants, unexpected maintenance costs, and changes in the real estate market that can all impact the bottom line on the return of your investment.
Using a 401(k) to Invest in Real Estate
Another idea is to combine these two strategies. Many are surprised to learn you can invest in real estate through your 401(k) when you roll your account over to a self-directed Individual Retirement Account (IRA). Most people switch their 401(k) balances to an IRA when they switch jobs or otherwise leave their employer. You can also set up an IRA in addition to your 401(k).
With a self-directed IRA, you are responsible for managing the account and choosing how to invest it. Additionally, self-directed IRAs have other complex guidelines that must also be followed to avoid tax penalties from the IRS. For example, you cannot live in the real estate purchased through a self-directed IRA, and you must use the funds in the IRA to cover any expenses related to the investment.
The distinguishing feature of using a self-directed IRA to investing in real estate is that you can combine the tax deferral benefit of your IRA with the favorable real estate investment returns of cash flow and asset appreciation.
So, there you have it. Real estate and 401(k) investments are two distinctive ways to save for retirement and make sound investments for your future. If you’re considering taking advantage of the income-producing investment that investing in real estate brings, don’t hesitate to contact us at Spartan Invest.
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