Investing in Real Estate for Retirement With a Solo 401(k)

401(k), Investing, Investing Strategy
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By Dmitriy Fomichenko

Learn more about Dmitriy on NerdWallet’s Ask an Advisor

Most people turn to stocks, bonds and mutual funds when they want to invest for retirement. These assets can be good sources of passive income — but some retirement savers prefer to mix in alternative investments, such as real estate, as well.

Solo 401(k) plans allow certain investors to do just that. The self-directed plans are designed for owners of small businesses without any full-time employees other than the owner and the owner’s spouse. They offer great flexibility in their investment options; plan owners can choose to act as the plan trustees and invest their funds in the assets of their choice.

Take my client Susan, for instance. Susan is a university professor, but she also does independent consulting work that qualifies her for a Solo 401(k). She invested her retirement savings in rental properties in her neighborhood in Jackson, Mississippi. Thanks to her knowledge of the area, she was able to capture many great real estate deals.

Investing within a Solo 401(k)

Once her Solo 401(k) plan was set up, Susan started to invest immediately, taking advantage of the low home prices in her neighborhood. She purchased an investment property for $30,000 and turned it into a rental home, which she now rents for $850 per month. Next, she bought a $16,000 home with cash from her Solo 401(k). She spent $4,000 to fix up the house and is now renting it for $700 per month.

These properties were purchased as direct investments through her Solo 401(k). That means that the houses are strictly investment properties that are rented out to her tenants and are owned by her retirement plan. Susan must deposit all rental income she receives back into the plan, and use it to pay all of her rental expenses.

Plan owners can’t use Solo 401(k) investments for personal gain — outside of retirement saving — or to benefit any disqualified person, such as their spouse, parents or children.

Using a Solo 401(k) loan to purchase a primary residence

Thanks to the flexibility of self-directed Solo 401(k)s, Susan can also borrow money from her plan. She used a Solo 401(k) loan to purchase the home where she now lives.

Using the participant loan option, Solo 401(k) plan owners can borrow as much as 50% of their balances, up to $50,000, whichever is less. The loan is tax- and penalty-free and can be used for any purpose.

Plan loans must be paid back on a regular schedule over five years. Their interest rates are the prime lending rate plus 1%. If, like Susan, an owner uses the loan to buy a primary residence, he or she can pay it back over a 15-year period.

Because she borrowed from her Solo 401(k), Susan needn’t worry about losing the loan privilege. If she’d borrowed from a company-sponsored 401(k) and lost her job, she’d have to pay back the entire balance at once.

Follow the rules

Self-directed retirement plans, such as Solo 401(k)s, give investors more flexibility than company-sponsored 401(k)s and IRAs — but there are still rules.

Again, account owners aren’t allowed to receive any personal benefits from their investments. For instance, any properties Susan purchases in her 401(k) must be rentals. She’s prohibited from using any of these properties as her primary residence.

Rules also prohibit plan owners from providing any services to the plan. Susan can’t personally perform any work on the property, even a task as simple as changing a light bulb. All work must be done by an unrelated third party.

But as long as Solo 401(k) plan owners follow the rules, real estate investments can offer healthy returns. With the right knowledge and experience, investors might get even better returns for their retirement funds than they’d receive with stocks or bonds.


Image via iStock.