Cashing Out 401K vs Rolling Over to Roth IRA

Hello everyone,

Suppose my 401k has about 70K from a former employer. What is the best solution from the following list and why? I’m going into real estate investing full time.

  1. Roll over the 70k into a Roth IRA. Then, I can invest in real estate transactions. Of course, I don’t have access to any profit until later on in life.

  2. Cash out the 401k. This will leave me with about 49k (20% tax + 10% penalty). I’ll have immediate access to the money which would be used for my real estate business.

Any constructive comments would be greatly appreciated.

Jerry

I’ve been doing a little research and self-directed IRA with checkbook control looks pretty interesting. Does anyone have any experience with this type of IRA? Is it worth it?

If you have a sound plan to put the money to work, then either/or of these options will be fine. 2 years ago I would have said don’t touch your 401K but now… I would keep my options open.

You can roll the 401k into a traditional IRA and avoid any taxes and penalties. Research the term prohibited transaction. The IRS has very strict rules regarding what can and cannot be purchases with IRA funds. There are also limits on what you can personally do with the investments (i. e. can’t work on rehabs). Self-directed IRAs are good for truly passive investments like tax liens and private placements.

im debating taking out my 401k and purchasing an investment property.

anyone know how much of a hit you usually get hit with?

Worst case –

Ordinary income tax plus a 10% early withdrawal penalty on the amount withdrawn.

Selling at what may be the low point in the stock market and taking a 10 percent hit sounds like a very bad idea to me. That is basically what nearly everything you would read would tell you not to do. The stock market has been terrible, but that is precisely the wrong time to get out.

Gilberttribe,

You’re right. However, this may not be the low point of the market. And the market may come back slowly. I would rather be proactive and use the money now and recapture, hopefully, everything I’ve lost.

Thanks for your comments everyone. I done a lot of research and there are a few options available. I’m most interested in the combination of checkbook IRA with either a LLC, C-Corp or Trust. The financial hit of cashing out the account is too much.

Checkbook IRA with a trust would be a prohibitted transaction. You would need several disqualified individuals to use a c-corp with an IRA. IRA that invests in an LLC and you make investments through the LLC is the easiest way with the fewest hassles.

Keep in mind your expenses will be much higher than a 401k. You will have to pay to have all the IRA assets appraised at market value every year and that can get expensive if you hold real estate. My preference is to loan money through an IRA rather than invest directly.

BLL,

So, would any of the following scenarios work:

  1. Instruct the IRA custodian to buy beneficial interest in the trust by purchasing the trust certificates. Therefore, the IRA owns the trust. The money from the IRA or 401k is rolled-over to the trust. I would be manager of the IRA and trust.

Supposedly, the benefits are no state filing fees or franchise taxes. It is quicker to setup. And lower total cost of ownership versus the LLC.

  1. The c-corp is a little more complicated. You create a 401k plan for the company. The IRA or 401k money is rolled-over to this new plan. Then, you can direct the investments as the plan’s trustee.

The benefits are you can loan to yourself or others with restrictions. You can buy or start a business with restrictions. You can, of course, purchase options and flip properties. And you can license intellectual properties.

  1. Self-directed LLC.

I’m not sure at this point which options is better. But, at least there are other options.

It’s a prohibited transaction because your IRA cannot do business with you or any entity where you have a majority of ownership (directly or indirectly) or too much control over the entity’s operation. Do you have a disqualified individual who will act as trustee?

Besides the compliance costs for a 401k, this type of set up is not viewed kindly by the IRS, especially when you own most of the company. Get a private letter ruling.

There is no self-directed LLC. A self-directed IRA invests in a new LLC you create. Have a sibling be the manager to avoid prohibited transactions. However, there is no rule that says you can’t be the manager. The LLC is subject to all the prohibited transaction rules for IRAs as the LLC is considered a plan asset. This is the most cost effective option for you based on what you have said so far.

Rolling over a 401k into a Roth IRA is a taxable event. If you roll over the entire $70K, you will pay ordinary income taxes on the rollover amount. You are converting a pre-tax account to a post-tax account. You can’t do that without paying income tax on the conversion amount. If you are in the 25% tax bracket, then expect a $17500 tax hit.

SAY WHAT?!? :shocked

What you talking about Dave T?

Hmm… I didn’t think about that.

So, I can still roll the 401k over to the Roth IRA with a balance of 70k - $17500 = $52,500.
And the setup fee for the Roth IRA/LLC is approximately $2,500.

-or-

I can cash it out with a balance of $49,000 after tax & penalties.

The difference between the two options is $52,500 - $2,500 -$49,000 = $1,000.
However, any profit I make with the cash out option will be taxed as ordinary income.

But, with the IRA/LLC option, any profit that is made goes into the LLC bank account. Then, I can take the money out of the IRA, through the LLC, and receive only a 10% penalty.

Let me see…

Taxed as ordinary income (Cash-out option, 20+%) versus 10% penalty (IRA option).

Having trouble…

20+% versus 10% (for a savings of at least 10%)

Over time, 10+% savings adds up.

Am I overlooking something?

Jerry

Jerry,

I don’t think you have everything sorted out correctly.

There is no 20% tax bracket. The tax bracket you are in is the rate at which the next dollar of your ordinary income is taxed. For the purpose of this discussion, let’s say you are in the 25% tax bracket.

Here are your options as I see them.

Option 1 – Cash out the 401K.

The cash out is taxed as ordinary income. In the 25% tax bracket, your $70K 401K withdrawal will be taxed as ordinary income and the tax hit will be $17500. In addition, you will be subject to a 10% early withdrawal penalty for an additional $7000. After taxes and penalties, you will have $45500 left to invest however you wish.

The income from your investments from this point forward will be taxed at the tax rate that applies to the character of the income. Ordinary income will be taxed at your tax bracket rate. Capital gains will be taxed at the capital gains tax rate that applies to your tax bracket.

Option 2, rollover to a Roth IRA.

A direct rollover is not possible. You can only rollover from a 401K to a Traditional IRA. If you have your plan administrator do the rollover so that you take no money out of the 401K, then the rollover is tax free. Once you have a Traditional IRA, then you can convert to a Roth provided you are under the income cap for the conversion.

This IRA conversion is also done as a rollover, but in this case you are converting pre-tax funds to post-tax funds and will be hit with the tax that you would have paid on the conversion funds if they had been deposited into a Roth IRA from the beginning. Since Roth contributions are made with money you have already paid taxes on, the conversion amount will be taxed at your ordinary income tax bracket rate. Your tax hit on the full $70K will be $17500. Where the money comes from to pay the tax may also subject you to an early withdrawal penalty if the taxes were withheld from the Traditional IRA.

Opton 3 – Rollover to a Traditional IRA.

If your 401K plan administrator does the rollover for you, the full amount of your 401K is rolled over tax free. If you have your traditional IRA established as a self-directed IRA, then your real estate investing can be done inside your IRA without a tax consequence until you make withdrawals from the IRA.

Early withdrawals from your self-directed IRA are also taxed as ordinary income plus a 10% early withdrawal penalty.

Now, with your IRA/LLC strategy, I suppose you are planning to use the IRA funds to loan money to your LLC for whatever investment the LLC will undertake. The profit from the LLC investment will be used to reimburse the IRA and the remainder stays in the LLC. Meanwhile, the LLC pays the IRA interest on the loan until the loan is repaid. In the end, the net income earned by the LLC is taxed at whatever tax rate applies to the character of the income. If the income is long term capital gain, the tax rate is 15% through 2010. If the income is rental income or short term capital gains, then the tax rate is the same as your ordinary income tax bracket rate. If your LLC is engaged in an active income business, then self-employment income taxes may also come into play in addition to ordinary income taxes.

Since the IRA made a loan (you did not make a withdrawal), no early withdrawal penalty applies. Let your IRA custodian guide you so you avoid prohibited transactions and unrelated business income tax issues.

Option 4 – take a loan from your 401K.

If your plan permits a loan, you can borrow from your 401K. You will pay interest on the loan and it must be fully repaid within five years to avoid early withdrawal penalties on any unpaid amount. There is a limit on the amount that can be borrowed. You also risk incurring an early withdrawal penalty if you lose your job and can’t repay the loan.

Thanks Dave T., BLL and everyone else,

I think I finally see the light. I hope.

After taking the majority of the day off to clear my mind of this subject, I’ve come to the following conclusions:

  1. The IRA/LLC strategy may be worth it, after all. First, I now know that the 401k funds will be taxed at my ordinary income tax (thanks Dave), if I convert over to a Roth IRA. I would have until next year to accumulate enough funds to pay the taxes. As a result, I won’t have to pay the 10% penalty like I would if I used the funds from the IRA to pay the taxes. Also, with the IRA/LLC strategy, the IRA owns the LLC. Therefore, any profit realized by the LLC is not taxable since the Roth IRA owns the LLC. However, my understanding is there is a 5 year waiting period before profits can be taken out tax free and I would have to be either 59 1/2, disabled or deceased (that would be scary).

  2. The cash out option is still viable. But the tax on any profits maybe higher than the IRA/LLC option. So, over the long run, I would have less money. But, from the IRA/LLC strategy, I would have to wait until I’m 59 1/2 years old to see any profit and not be taxed and penalized. DECISIONS, DECISIONS.

BTW, an additional benefit of the IRA/LLC strategy is a beneficiary would receive the funds tax free, as long as the account has been opened for at least 5 years.

Thanks,

Jerry

The 10% penalty is an early withdrawal penalty assessed on the amount taken out of the 401k. This penalty is in ADDITION to the ordinary income taxes that will be assessed. Wihdraw $70K and your early withdrawal penalty will be $7K (10%) plus the ordinary income taxes due on the $70K.

If you do a withdrawal, whether from your 401k or from your IRA, the administrator or plan custodian may withhold 20% for income taxes so you may not have an opportunity to accumulate funds to pay the taxes out of pocket.

Just a few comments about the IRA with LLC option.

The 401k money is rolled over into a traditional IRA without any taxes or penalties due. The IRA is then directed to invest in an LLC as a non-managing member. The LLC manager, which can be the IRA owner, but not a recommended practice, invests the funds per the operating agreement. There are no taxes on the LLC income since it is owned by the IRA.
Money is not taken out of the LLC. The LLC distributes funds to the IRA and the IRA owner then takes it out of the IRA.

I have seen plans where 2 IRAs, one traditional and one Roth, invest in the same LLC with an agreement that allows most of the income to flow to the Roth IRA, where it is taken out of the IRA without taxes or penalties when the IRA owner reaches retirement age. I don’t trust this set up because there is income that is never taxed and I fell the IRS will view the set up as abusive. Rolling over the 401k balance would be a taxable event

You may also check out http://www.rothirarules.net/ They have some good information on roth ira, investment options, roth IRA taxation, etc.

Good Luck.

Thanks everyone,

Melissa, the website provided a lot of good information.

I guess it all comes down to DISCIPLINE and my current goals. If my goal was to work for someone, do the best job I can and retire, then the IRA/401k is definitely the best option. However, if I don’t mind taken a risk and have a solid plan that will allow me to hopefully earn a lot more than I would working for someone else, then maybe the cash out option is a better solution. Don’t get me wrong, I understand that I will have less buying power if I don’t use a traditional IRA. Or even the Roth IRA, with its no tax on profits, is a viable option. BUT, I have at least 20 years before I’m able to receive any of the funds.

Wheres My Money

After giving it some thought, I figure why should I throw away money because of taxes and penalties. So, after coming to my senses, i think BLL has a good point. :deal

Creativity and knowledge are going to make this country strong, again.

Jerry