The stock market has swelled this past year, with both the Dow Jones and S&P 500 shattering all-time highs. But recent volatility has some investors examining whether it’s time to recalibrate their investments and shift some funds into a steady asset class, like real estate. We touched on this topic earlier and desired to revisit it with greater clarity, depth, and breadth.

Real estate prices are also hovering around record highs, but real estate tends to hold its value over time, so people tend to think of it as a relatively “safe” investment—especially for those with a long-term, buy and hold strategy whereby someone else pays the mortgage and the investor ends up owning the property while making money along the way. 

So, as an investor, what should you do? Do you keep pumping money into your retirement account, wagering your bets on the stock market’s continued growth? Or do you invest in a potentially overheated real estate market? There’s no right answer. But there’s also no reason why you can’t do both.

Here are four ways to leverage your retirement account to buy an investment property:

1. Take out a loan against your 401k.

There are some advantages to utilizing your 401k. The obvious one is speed and convenience. In most 401(k) plans, requesting a loan is quick and easy, needing no lengthy applications or credit checks. 

Your 401k consists of pre-tax contributions, so if you were to draw money out of your 401k (without rolling it over into an IRA or another 401k), you could face precipitous withdrawal penalties and steep income tax liabilities. So rather than pulling money out of your 401k to acquire an investment property, contemplate taking out a loan against it.

The IRS permits folks to borrow up to $50,000 or 50% of the value of their 401k, whichever is lesser, to buy an investment property. This is a good option for those who cannot otherwise afford the initial down payment needed to buy a rental property. 

What’s more, any amount that you’ve borrowed from your 401k is not calculated against your debt ratio when you go to obtain financing for the property. For example: if a borrower has $40,000 vested in a 401k and takes out $15,000 against it to buy an investment property, the bank will consider that $15,000 as a secured borrowed funds instead of a liability and the surviving $25,000 will be counted as retirement funds. 

There are a few other matters merit consideration. First, the capability to borrow against your 401k plan depends on your plan administrator. Some allow people to borrow; others do not. 

Second, most plans require the borrower to pay back the loan in five years or less (with interest). Interest is ordinarily commensurate to one or two percentage points above prime, but that interest is paid back into your retirement account and not to the plan administrator (so you’re just repaying yourself). 

On a tertiary level, repayment flexibility is baked in for most 401(k) loans; you can repay the plan loan faster with no prepayment penalty. Most plans allow loan repayment to be made conveniently through payroll deductions—using after-tax dollars, and not the pre-tax ones financing your plan. Your plan statements show credits to your loan account and your unused principal balance, just like a regular bank loan statement. 

In the quaternary range, there is no cost (other than perhaps a modest loan origination or administration fee) to tap your own 401(k) money for short-term liquidity needs. You merely name the investment account(s) from which you want to borrow money, and those investments are liquidated for the span of the loan. Consequently, you lose any positive earnings that would have been produced by those investments for a short period. The upside is that you also avoid any investment losses on this money.

Finally, some plans stipulate that you must repay the entire loan within 60 days in the event of job loss. Otherwise, the outstanding balance on loan is deemed a taxable distribution and will be detailed on a 1099-R. Once again, if you’re under the age of 59 ½, you’ll also face a 10% early distribution penalty, in addition to income tax, on the distribution.

2. Withdraw the principal from your Roth IRA.

Unlike a 401k or traditional IRA, contributions to a Roth IRA are made by applying after-tax dollars. As such, you can withdraw the principal from a Roth IRA at any time and for any purpose without paying income taxes or early withdrawal penalties. So, if you’ve been maxing out your Roth IRA for the last several years, you’re sitting on a pretty penny that could be deployed to finance a rental property. Just don’t touch the earnings in your Roth IRA; doing so will trigger those punishing taxes and penalties.

To clarify: you’ve probably heard people talk about using their Roth IRA to obtain their first home. The IRS enables people to withdraw up to $10,000 in principal and earnings penalty-free from their Roth IRA for said purchase. This only applies to the purchase of a first home, however, and cannot be used for an investment property. 

Other withdrawals that avoid penalties are: qualified higher education expenses, medical expenses, and insurance premiums, substantially equal payments, withdrawals for death, or total/permanent disability.

3. Purchase real estate directly through a self-directed IRA.

A self-directed IRA is an individual retirement account that allows you to pick from a mixture of investment options as permitted by the IRA custodian. You aren’t restricted to traditional investments, such as stocks, bonds, or mutual funds. With a self-directed IRA, you can fund all sorts of alternative investments, like private mortgages, oil, and gas limited partnerships, intellectual property, and (you guessed it!)—real estate.

Using a self-directed IRA to invest in real estate is involved, but it’s possible.

In short, here’s what you need to know:

· You must keep an arm’s length distance from the property. That implies that you cannot live in or actively run the property.

· The property must be used singularly as an investment—not as a second home, vacation home, home for your children, or office for your business.

· You cannot purchase the property from a “disqualified” person, which includes your spouse, parents, grandparents, great-grandparents, service providers of your IRA, or any entity that will retain 50% or more ownership of the property. 

· Technically, the title of the property will be held by the custodian of the IRA for your benefit, and you cannot be the custodian.

· You must hire a third party to handle all operations.

· Any and all revenue generated by the property, including rental income and sales proceeds, must flow back to the IRA to preserve the tax-deferred status of the income. In other words, you cannot pocket any of the profit the property generates. 

· Since your IRA doesn’t pay taxes, you won’t get to experience the traditional tax advantages associated with holding rental property—such as the mortgage interest deduction or depreciation.

Some people consider it a precarious investment strategy to use your self-directed IRA to buy a rental property. For instance, unforeseen repairs or maintenance expenses must be paid for by the IRA. If you do not have enough money in the IRA to cover these expenses, and if your income exceeds the threshold for making additional contributions to your IRA, you may face penalties. Investors are forewarned to proceed with caution.  

Still, want to go this route but don’t have a self-directed IRA? You can rollover funds from a traditional IRA or 401k into a self-directed IRA without paying any income tax or early withdrawal penalties.

4. Use your retirement account to buy stock in a real estate investment trust. 

A fourth, and perhaps more middle-ground, the approach is to use your retirement account to invest in a real estate investment trust (REIT). A REIT is similar to a mutual fund except that it is restricted to invest in real estate, mortgages, and other real-estate-related assets. REITs come in all diverse shapes and sizes. Some invest in a broad portfolio of real estate across asset classes and geographies, while others are centered around a particular market niche (like retail, multifamily, or office).

There are advantages to investing in REITs. First, it’s a more liquid investment. You can buy and sell shares of REITs just as you’d trade traditional stocks or mutual funds. Real estate, when owned outright, is an illiquid investment.

Second, REITs allow you to be a passive real estate investor. You don’t need to take on the day-to-day responsibilities of a landlord.

Finally, by law, REITs are required to pay up to 90% of their profits to shareholders in the form of dividends. As a consequence, those who invest in REITs can usually count on almost immediate returns, and as a result, they are an outstanding passive income stream.

There are drawbacks, of course. Any earnings from the REIT will be taxed and treated as income; you won’t have the same tax benefits that you would if you owned the real estate outright. Besides, REITs often carry hefty management fees compared to investing in conventional mutual funds. Investors should compare REITs carefully before deciding which to invest in.

The Bottom Line

The determination to tap your retirement account to invest in rental property is not a decision that should be made in a vacuum. It’s a commitment that should be made concerning your overall investment portfolio. It’s important to be diversified. If you aren’t expanded already, investing in real estate is one way to get there.

As always, we recommend sitting down with your accountant or retirement advisor to discuss in greater detail. Those advisors will be able to help you evaluate your options about your broader retirement goals. The above in no way constitutes investment advice.