MONEY QUESTIONS by Matthew Illian, CFP^®

Q: I am looking for a way to get into the distressed real estate market. What recommendations do you have about investing  IRA or 401(k) funds in rental houses?

Sincerely,  Cash Poor and IRA Rich

Dear Cash Poor,

You have good financial instincts. Real estate could be a great investment right now, and we are currently increasing exposure to this sector. But the risks and accounting red tape when making direct investments using IRA or 401(k) money should be avoided.

One option is to simply cash our your IRA and invest these funds. Cashing out a traditional individual retirement account (IRA) or 401(k) will trigger a taxable distribution and an additional 10% early-withdrawal penalty for people younger than 59 1/2. I don’t recommend this approach because the penalty is high and the investment results unpredictable. One recent belief that I hope has been forever scorched from the American consciousness by the recent recession is the idea that real estate investments always increase in value.

Another ill-advised option would be to transfer your IRA to a self directed custodian that allows for real estate purchases. These transactions have been gaining popularity, but I believe most investors should avoid these complex techniques. You will likely lose the power of leverage because few banks lend money to an IRA. Additionally, you can’t deduct property taxes and you can’t use depreciation. When an IRA holds the property, an individual is not allowed to cover an expense–like buying paint or new granite countertops– out of personal funds or it will likely be deemed a prohibited transaction in the eyes of the IRS and could cause your entire IRA to be taxed.

Many 401(k) plans allow you to take a loan of 50% of the vested account balance up to $50,000. Borrowing from your 401(k) is penalty free, unless you don’t pay the money back. Then the usual early withdrawal penalties apply. You are charged interest on the loan because your 401(k) is the bank, and the interest gets added to your account. Most plans also require you to repay the loan within five years and definitely before you change employers. I would suggest not tapping your 401(k) plan.

Don’t get me wrong. I believe this is a good time to invest a portion of your portfolio in real estate. Our firm is now recommending a 7% allocation in diversified portfolios. If you don’t have the cash or financing available to purchase directly, consider investing your IRA or 401(k) money in a real estate investment trust (REIT). These investment pools are typically publicly traded and can be purchased directly or indirectly through diversified mutual funds and exchange-traded funds (ETFs). If you are looking for an easy recommendation for an investment vehicle, try the Vanguard REIT ETF (symbol is VNQ). The expense ratio is only 0.10%, and the effective yield is 2.3%. This is by far the simplest and most cost effective way to take advantage of this trend. If you do invest in real estate, remember it is a long-term investment, and like all such investments, you will have to give it time.

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