This week, Gail explains the many dangers of using your IRA or 401 (k) money to invest in real estate, and urges you to read your retirement plan's Summary Plan Description -- well before you leave your company.

Dear Gail --

I'm changing jobs and have $150,000 in the 401(k) with my former employer, which I am rolling over into an IRA because I'm only 52 years old. I'm nervous about the stock market and if interest rates start going up -- which at some point they'll have to -- then bonds aren't a great investment right now. So I'm thinking about investing my rollover in rental property. Any problems with this?

Doug

Dear Doug;

What you're contemplating is a minefield of potential problems that could end up costing you dearly. The "Prohibited Transaction Rules" in the tax code specifically lists what you can and cannot do with your IRA. Violate these in any way and your IRA immediately loses its protected tax status.

In other words, the IRS will view it as if you took all of your money out of the IRA and you'll owe income taxes and possibly an additional 10% early withdrawal penalty on the entire amount.

While investing in real estate in and of itself is not prohibited, it does present a lot of problems. If there's not enough money in your IRA to purchase the property outright, then your IRA would have to take out a mortgage -- not you.

I doubt you will find any lender willing to make a loan to an IRA without your personal guaranty. And your guaranty of the loan to the IRA would be prohibited. Also, you should note that pledging your IRA as collateral for any type of loan is also prohibited.

These aren't the only restrictions on IRA investments. You also cannot invest your IRA in "collectibles" such as works of art, gems, antiques and precious metals. The exception to the prohibition to precious metals is certain gold or silver coins issued by the United States, certain platinum coins, and coins issued by a state. (If you're interested in the exact details, check out Internal Revenue Code Section 408(m). )

In addition, IRA assets cannot be used to buy life insurance. An annuity, which is a combination of life insurance and investment accounts, is allowed.

However, your biggest problem is not legal but practical -- finding an IRA sponsor that will allow you to hold real estate inside your account. Mutual fund companies, insurance companies and brokerage firms are geared to act as IRA trustees for financial instruments such as stocks, bonds, mutual funds, annuities and the like.

If you do find an entity willing to act as trustee for rental property it could cost you a pretty penny. Here's why: as the owner of the IRA, you are not allowed to personally interact with the assets it holds. Only the trustee can, for instance, collect the rent, which will have to be made out to your IRA and not to you. Naturally, they will charge for this and every other service they perform on your behalf.

This is so important I'm going to repeat myself: You cannot get involved in the management or maintenance of the property. A spokesperson for the Internal Revenue Service told me, "The IRA owner can have no hands-on dealings with the rental property." The trustee has to handle everything. You are not "the landlord," the trustee is. You are just an outside third party. The "no hand-on dealings" means you cannot even fix a leaking faucet or cut the grass!

Have you thought about how repairs and property taxes would be paid? Since you are under 59 1/2, you cannot withdraw money from your IRA to pay for these without triggering the early withdrawal penalty. And you're not allowed to use money outside the IRA to pay for these things.

In the words of the IRS, the money to cover "taxes and maintenance expenses would have to come from the money generated from the property." So long as the trustee -- not you -- is withdrawing the money, IRA assets can be used to pay for expenses that might be incurred in connection with the property. But what if it's a really big expense, say, a new roof, and there isn't enough money in the IRA to cover this?

It comes down to this, my friend: while investing your IRA in rental property sounds like a really cool idea and technically is not prohibited, you've got to be sure you know what you're doing. Moreover, make sure your

trustee understands the pitfalls. There's a reason most people don't do this.

One more point, regardless what you decide to invest your rollover in: be sure your employer send your 401(k) money directly to the trustee of your IRA in what's called a trustee-to-trustee transfer. If the check's made out to you, by law, your employer must withhold 20% of the total.

Think long and hard about this,

Gail

 

Gail --

I agree that the accountant and plan administrator need a refresher course on early withdrawals from IRAs and 401(k)s. Many people do not realize that if they have attained the age of 55 at time of separation from employment, they can access the money in the plan without a 10% penalty.

However, all plan participants get a Summary Plan Description and also get a notice of participants rights a few months after separation. I got it and it explains everything. Most folks don't read. I urge folks to read this and if they cannot understand what it says, then find someone who can.

Rich

 

Dear Rich --

I couldn't agree with you more. The notice you are referring to -- called the "Special Tax Notice" or 402(f) notice -- is required by law to be given to anyone who is about to receive a distribution from a 401(k) plan. It is a wealth of information on the complex tax rules that apply.

Also, the Summary Plan Description you mention is a document you should get your hands on well before you leave your company. This document is supposed to be written in plain English and not only spells out what you can do with your retirement account when you leave the company, it tells you what your rights are while you are an employee.

Every retirement plan participant is entitled to a copy of the Summary Plan Description by law. If you've got a problem getting a copy, contact the nearest office of the Department of Labor.

Gail

 

My wife and I want to know what is associated with borrowing money from our 401(k) for a down payment for our first home. We are a young couple looking to buy our first home and would like to know the benefits and risks that go with this.

Patrick

Dear Patrick --

First of all, your 401(k) plan must allow you to take a loan. If it doesn't, this is not an option. Get your hands on a copy of the Summary Plan Description (see above). It will tell you whether loans are available and outline the terms.

Federal guidelines require that plan loan offers be made in writing and must be available to all participants on a non-discriminatory basis. in addition, the loan has to charge a "reasonable" rate of interest and must be repaid within a "reasonable" period of time. In general, this is five years, but a longer repayment period could be allowed if the money is being used to purchase a personal residence. Each plan will set its own terms for this.

You will have to make loan payments at least quarterly, but your particular plan could require a more frequent re-payment schedule. If you fall behind, your loan can be deemed a "withdrawal", with all the taxes and penalties associated with this. To avoid this, most company plans require that payments be automatically deducted from your paycheck.

The total amount of all loans you're allowed to take against your retirement plan is $50,000 or not more than half of the accrued benefit in your account, whichever is less. If it chooses to do so, a plan can make an exception and allow you to borrow up to $10,000 even if this is more than half, but will usually require that you post additional security for the loan.

If you ever think of changing jobs, or are faced with a layoff, be prepared to re-pay the balance on the loan before you leave your company. If you don't, this will be considered a "withdrawal" subject to taxes and penalties.

(Warning: I'm getting out my soapbox for this.)

I HATE the idea of taking a loan against your retirement plan! When you do so, your 401(k) investments are liquidated in an amount equal to the loan. If the market takes off, you miss out. I'm aware of the argument that you're "re-paying yourself with interest," but that will never make up for a big jump in your investments.

It would be better to reduce or even stop your 401(k) contributions for awhile so you can afford to repay a larger loan (or a loan from a family member). And, don't forget: this would be deductible, unlike a loan against your 401(k).

I know how tempting plan loans are, but do yourself a favor and only tap your 401(k) as a last resort.

Gail


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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.