Outside of defined benefit plans and cash balance plans, 401ks allow for generous retirement contributions. Specifically, they allow for both employee contribution and employer contributions. Let’s examine them both:
- Employee Contributions. Sometimes referred to as employee deferrals, you are allowed up to a maximum of $19,500 annually. If you are over the age of 50, you can contribute an additional $6,500. But in order to contribute these amounts you have to have at least that much in earned income. This can be either self-employment income or W2 income if you are taxed as an S-Corporation or C-Corporation.
- Employer Contributions. In addition, there can be an employer matching component. The employer match can be up to 25% of compensation or, for self-employed individuals, an amount of 20%.
Combined employee and employer contributions are subject to annual maximums. This maximum is $57,000 if under the age of 50 and $63,500 if age 50 or older. These are generally indexed higher at least every couple years.
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Can a 401k invest in real estate?
It certainly can. A 401k is known for making traditional investments, like stocks and bonds. But it allows plan participants the ability to invest in real estate (along with other assets).
In addition, a solo plan allows for investment in almost any type of asset class without requiring the consent or approval of a custodian. The IRS only designates a few specific investment types that are prohibited.
What kind of real estate can a 401k invest in?
This is an easy question to answer – anything. But there are some tax considerations (more about that in a bit). I have seen people use funds for land, single family homes, apartment buildings and commercial properties.
More specifically, I have seen people invest in partnerships that acquire larger properties.
First of all, let’s assume that a self employed individual has a solo 401k. This is because in order to contribute to a solo 401k, a person must have earned income.
If you are an employee for a company who sponsors a 401k, they will have a trustee who will direct the investments. You will be given investment choices and likely they will not include actual real estate.
This is where we get back to being self-employed. By acting as your own trustee, you have the ability to self-direct the investments as you see fit.
Real Estate Compared to Stocks
I am always amazed how often this comes up and how the answer is spun depending on whom you are talking to. The real estate folks say that it’s real estate, while the stock market guys say stocks.
First, let’s look at the numbers.
Let’s now take a closer look at stocks.
Depending on which period you examine, stocks have returned approximately 10% annually (including reinvested dividends). Exclude inflation, and stocks have a real return of 5% to 6%.
Now you are probably thinking that things are looking pretty grim for real estate, huh? The stock market guys just stop here and say, “see – stocks have better returns than real estate.” Well let’s take a closer look.
Still examining the quantitative factors, most would agree that there are two ways to make money in stocks: stock appreciation (capital gains) and dividends (income). While with real estate you can make money four different ways: (1) home appreciation (capital gains); (2) rental cash flow (income); (3) non-cash depreciation (tax benefits); and (4) principle balance reductions from mortgage amortization (equity paydown).
In our previous example, we actually compared the two ways to make money in stocks (price appreciation and dividends) to only one way to make money in real estate (home appreciation). We have not even addressed the other ways to make money in real estate. In addition, we have not even discussed probably the most important benefit to investment real estate – leverage.
I’m not going to spend much time on leverage as most of you understand the concept. But let’s just say that not many other investments allow you to borrow up to 100% of the asset value, have someone else pay down the mortgage (tenants), and give you such great tax benefits.
If you take a look again at the hypothetical home purchase in 1968 for $45,000 and assume a 20% down payment, include potential rental income (after adjusting for expenses), and consider depreciation deductions, you would find that real estate will easily make you more money than stocks.
But numbers aside, let’s look at some of the other factors.
First of all, real estate and stocks are different forms of investments. Stocks are certainly more passive than real estate. With real estate you often have tenants (we have previously discussed this issue). Because of the active participation of real estate, you should get compensated over stocks. And of course you do.
Another big issue to address is liquidity. Stocks are obviously more liquid than real estate. Illiquidity is perceived as an advantage to stocks, and generally it is. However, the illiquidity of real estate has some benefits to the American consumer. We all know that we live in a credit card society and if the average person could freely buy and sell real estate on a daily basis he would probably be in trouble. Let’s face it – it’s unfortunate, but the average person is not really good at managing money (as our nation’s negative savings rate would imply). For the average consumer, an investment in real estate is like a piggy bank. Sure they can borrow against it, but in the long-term they will still build equity.
I recently saw the Forbes 500 – want to guess whether there were more people who made it on the list by investing in real estate or investing in stocks? I think you know the answer.