With living costs on the rise, it’s never been more important to ensure that you’re future-proofing your retirement funds. But that can be easier said than done when you’re just limiting yourself to more linear and traditional retirement savings vehicles.

According to researchers at Fidelity, the average 401(k) balance is currently sitting at $108,200 — and while the 401(k) is widely considered one of the most tax-efficient ways to save for your future retirement, it’s not necessarily the fastest-growing. 

That’s why you may want to consider utilizing a part of the cash pool in your 401(k) by investing in a more lucrative asset class like real estate.

At the start of 2023, the S&P 500 reported annualized 10-year returns of 6.9%. And if you opt to invest in rental property, you’re opening yourself up to a passive income that could end up funding a sizable chunk of your retirement.

If this sounds like an avenue you’d like to explore, the good news is that it’s possible to use your 401(k) to invest in rental property. The bad news is that it can be a little bit tricky — but we’re happy to walk you through it.

This guide will explain the requirements on using a 401(k) to invest in property and the best types of property to invest in using a 401(k). We’ll also look at the pros and cons of using a 401(k) to invest in rental property and answer some of the most frequently asked questions about investing in real estate.

Key takeaways

• The IRS won’t allow taxpayers to use funds from a standard 401(k) plan to invest in real estate.

• To workaround IRS rules, you can either take out a loan against your 401(k) or transfer funds to an IRA.

• By using retirement funds to invest in property, you can diversify your portfolio and benefit from tax-deferred growth.

Can you use a 401(k) to invest in rental property?

The short answer is: no, you can’t use a standard 401(k) to invest in real estate. The IRS has strict rules on how you can invest using retirement funds and doesn’t allow you to buy and own rental property through your 401(k).

The longer answer is a bit more complicated.

“Strictly speaking, you typically can't invest in real estate through your 401(k). That's because 401(k)s are tied to your employer and have a limited set of investments (usually mutual funds) available to their participants,” explains Alan Sell, CFP and President at Polaris Asset Management.

Don’t despair if you’re really keen on utilizing some of your retirement savings to invest in a rental property. Just like any other IRS rule, there are several workarounds to overcome the tax body’s ban on using 401(k) funds to invest in property.

Let’s take a look.

What are the Requirements to Buy a Property with a 401(k)? 

If you want to use funds from your 401(k) to purchase a rental property, you’ve generally got two options. You can either:

• Take out a loan against your 401(k)

• Roll funds into a self-directed IRA

Both methods have their own unique set of pros and cons, and so it’s worth taking a closer look here.

Taking Out a Loan Against Your 401(k)

Most standard 401(k) plans will allow you to take out a loan against your existing retirement balance. That being said, not every plan provider allows this — so be sure to check with your employer and your plan administrator before trying to proceed with this method.

If you are allowed to take out a loan, most administrators will let you borrow up to half the value of your current 401(k) balance. There’s normally a cap of $50,000 on that borrowing limit, though.

Any 401(k) loan you take out will be structured as a non-recourse loan secured using property being purchased as collateral. That means if you end up defaulting on your 401(k) loan repayments, your plan administrator can seize the property.

Fortunately, your administrator won’t be allowed to seek any extra compensation if the value of the property exceeds the outstanding loan amount.

But assuming that you’re able to pay off the loan without any problems, most 401(k) plans will require you to pay back any loans in full within five years. You’ll also be expected to pay interest on the loan — which is normally going to be the prime lending rate plus an extra 1%.

Another positive here is that the interest payments you make to your plan administrator are paid back into your 401(k). That means you’re just repaying the interest to yourself.

Just remember: if you don’t repay your 401(k) loan by the designated term, your loan will end up getting treated as an early retirement distribution from your account. That means you’ll need to pay a 10% penalty fee alongside income taxes on the amount borrowed.

Turning your 401(k) Funds Into An IRA

The other common way to use the money you’ve accumulated in your 401(k) is to roll funds from your standard plan into an IRA.

Because the IRS allows real estate investments using IRA funds, you’ll then be able to utilize the cash from your 401(k) to invest in a far greater range of asset classes — including residential or commercial properties.

You’ll need to consult your 401(k) plan administrator to make sure your plan is eligible to be transferred into an IRA. Once confirmed, you’re also going to be required to find a custodian or a qualified trustee to handle any future real estate transactions on your behalf.

“Once you've rolled your money into the account, you can use the funds to purchase a property and have it titled in the name of the IRA,” says Polaris Asset Management’s Alan Sell.

But when setting up your new account, you’ll also need to decide which type of IRA you’d like to use for investment: a self-directed IRA or a Roth IRA.

What's the Difference Between Investing Using A Traditional IRA and a Roth IRA?

“The difference between investing in an IRA and a Roth IRA is primarily related to how the accounts are taxed,” explains Alan Sell of Polaris Asset Management.

“When you contribute to an IRA or 401(k), you get a tax break in the year you contribute, and the earnings in the account are not taxed. However, when you withdraw money from the account, you'll be taxed on those withdrawals at income tax rates.”

When you buy a property using a self-directed IRA (or “traditional IRA”), it’s also worth noting any income you receive from your property is tax-deferred. That applies to both capital gains from appreciation and rental income.

By contrast, you don't get a tax break in the year that you’re contributing to a Roth IRA. But on the flip side, you won't have to pay tax on the earnings in your Roth IRA or on any withdrawals you make in retirement.

What are the Benefits of Investing in Real Estate Using a 401(k)? 

The key benefit to using funds from your 401(k) to invest in rental property is that it will strengthen your overall financial position as you inch closer to the age of retirement.

By deploying part of your retirement funds, you’re able to increase your buying power as an investor — thus accelerating portfolio growth and adding real estate to your basket of investments.

“Investing in real estate through a 401k allows for potential diversification of your retirement portfolio beyond traditional investment options,” says Boyd Rudy, Team Leader and Associate Broker at MiReloTeam Powered by KW Professionals.

“Real estate can provide the opportunity for long-term appreciation and potential income through rental payments. Additionally, investing in real estate within a tax-advantaged account like a 401k allows you to defer taxes on any profits or rental income until retirement.”

Whether you’re borrowing money against your 401(k) balance or rolling it into an IRA, that tax-deferred growth can be a big help when planning for the future.

What are the Best Types of Properties to Buy Using a 401(k)? 

When it comes to the types of rental properties you should buy using retirement funds, it’s important to note that no two investors are 100% alike. As a result, the best property investment for you might not be a smart move for the investor next door.

It’s all going to depend on your investment goals, your tolerance for risk, and your time horizon.

“A rental property with strong income prospects may be a less-risky route than a speculative raw land purchase,” says Alan Sell.

“Furthermore, if you will be retiring soon and need current income, you may want to prioritize properties with strong cash flow as opposed to opportunities for value appreciation.”

In addition, Boyd Rudy points out it’s worth looking at residential rental properties, commercial properties, or real estate investment trusts (REITs) as potential options for investment — as long as you’re getting sound advice while you’re hunting.

“It is advisable to consult with a financial advisor who specializes in retirement accounts and real estate investments to determine the most suitable properties for your specific situation,” he says.

“They can guide you through the process, help you understand the specific rules and regulations of your 401k plan, assess the risks involved, and ensure that your investment aligns with your overall financial goals and retirement strategy.”

What are the Risks of Investing in Real Estate Through a 401(k)? 

There are a few key risks you need to be aware of before investing in rental properties using your 401(k) funds, and the biggest risk is non-compliance.

There’s a lot of paperwork involved if you plan on borrowing money against your 401(k) or turning some (or all) of your retirement savings into an IRA. You’ll have documentation to complete and file, and you need to keep amazing records in case the IRS or your plan administrator ever comes knocking.

That’s when it pays to have access to a Family Operating System® like Trustworthy.

Trustworthy is a 256-bit encrypted digital safe that enables you to securely store all of your family documents — including estate documents, tax returns, property information, IDs, insurance policies, and everything in between.

You can then add your accountant or financial planner as a collaborator on your account so they can access documentation to help you fulfill any outstanding IRS obligations without any friction.

Beyond the risk of non-compliance, you’re also going to be facing the typical issues property owners and landlords face when entering the real estate market.

“Investing in real estate through a 401k also comes with risks. Real estate investments can be subject to market fluctuations, property maintenance costs, vacancy risks, and other challenges,” Boyd Rudy says.

“It is important to carefully research and analyze potential properties and consider the long-term implications before making any investment decisions.” 

That being said, it’s also important to consider how investing in real estate might affect your cash flow moving forward.

“One of the main risks of holding real estate as a retirement asset in an IRA is that for some clients, they can end up with the majority of their retirement savings tied up in just one or two real estate holdings. If those properties don't perform as hoped, it can be a major problem,” says Polaris Asset Management’s Alan Sell.

“The solution is just to make sure they're also investing in other ways as well, and not solely reliant on just one or two properties. I'd advise anyone considering investing in real estate through their IRA to consider their goals, objectives, risk tolerance, and other investment holdings. For the right person, real estate can be a fantastic asset to include in their retirement plan.”

Frequently Asked Questions

What's the Difference Between Investing in Property Using a 401(k) Versus a Roth IRA?

Contributions to a 401(k) are made on a pre-tax basis, meaning you don't pay taxes on contributions until you retire. With a Roth IRA, contributions are made with after-tax dollars.

What are Alternatives to Buying an Investment Property?

One of the best alternatives to buying an investment property is to invest in a real estate investment trust (REIT). You can buy or sell REIT shares using a range of different retirement accounts.

Can I Transfer My 401k Without Losing Money?

You can move money from a traditional 401(k) to a self-directed IRA, you’ll avoid losing money by incurring a tax liability. If you transfer cash to a Roth IRA, you’ll need to pay taxes on the transfer.