What is the Difference Between a 401(k) and an IRA?

Mike: Welcome back to the flipnerd.com REI Classroom, where experts from across the real estate investing industry teach you quick lessons to take your business to the next level. And now, let’s meet today’s expert host.
Clay: Hello and welcome to the REI Classroom. My name is Clay Malcolm with New Direction IRA. And today we’re going to be talking about the comparison between 401(k) plans and IRAs. A lot of people think that they’re the exact same account type but they’re actually not. So we’ll be talking about that today.
Mike: This REI Classroom real estate lesson is sponsored by theinvestormachine.com, FlipNerd’s private investor coaching program and your blueprint to investing success.
Clay: When considering the difference between the 401(k) and an IRA I think it’s an easy way to conceptualize to think of a 401(k) as more customizable and a little bit more complex to run, whereas an IRA is a little bit more of a standardized version of a 401(k). And I’ll explain what I mean by that, but first I want to just mention that either one of these account types can invest in alternative assets such as real estate.
In the case of a 401(k) plan, the plan document has to allow for alternative assets and in the case of IRAs it has to be the IRA provider that knows how to do the administration and bookkeeping for those alternative assets. So either way, you have to choose your provider or choose the setup that works but the account types themselves can both invest in real estate and other alternative assets. And there are some similarities in terms of the way, I think the way this is why people conceptualize them as the same plan, first of all, their tax advantage plans for your retirement, distribution rules are very similar, disqualified persons and prohibited transactions rules are similar. And so there’s a really easy way to kind of lump them into the same bend.
However, they are kind of different and IRAs, of course, and have some employer type plans. So traditionally, and Roth, of course, are individual accounts, right? The individual is the person who runs them. But an employer is required for both the SEP IRA and a SIMPLE IRA as they are also for 401(k). So these are all employer plans and as I say, the IRA version of them is a little bit more standardized. So what I mean by that is the rules for how you make contributions and distributions with things like that, those are all standardized whereas on a 401(k) plan the plan document is really the rulebook. And it can change a little bit about both the features of the plan as well as some of the ways that you can participate with it.
When I’m talking to real estate investors one of the reasons why I think 401(k) plans and specifically for us at New Direction we really only handle solo or individual 401(k) plans, but the things that they are interested in are the special features which, of course, IRAs typically don’t have. So let me talk about those real quickly.
So number one is in your 401(k) plan as long as the plan document allows for it your employee contribution stream to that plan can be in the Roth format. So that’s an interesting feature. Second, if you, again, the plan document allows for it, the plan participant can actually take a loan which becomes the loan money is their personal money for the time that it’s out. Now, the individual has to pay the plan back with interests, so you’re actually paying yourself back with interest but you can take a loan that becomes your personal money for that period of time of up to $50,000 or 50% of the plan assets whichever is less.
If your investment strategy is geared around investing in real estate with that leverage, 401(k) plans do not have to consider UBIT that’s derived from unrelated debt financed income. So if you have your 401(k) plan owned houses or apartment buildings that are debt leverage they would not have to figure in the impact of UBIT whereas if you have that same investment in an IRA you have to think about that. So that’s the feature that a lot of people are interested in. 401(k) plans can be an investor and an S-corp which IRAs cannot. So there are some features like that that are really a little bit different and they all are tied into the fact that the plan document allows for those things.
The other thing that’s a big one I think is that in a 401(k) plan the employer who adapts the plan also names the trustee, and, of course, in a solo 401(k) the employer and the trustee normally they’ll name themselves a trustee, and the participant they’re all one person. And because the trustee of the plan is something that is analogous to the IRA provider the trustee of the 401(k) plan is the signer for that plan, whereas the IRA provider is the signer for the IRA plan, right?
So if it’s the same person, you’re the employer, you’re the participant, and you’re the trustee, you automatically have what’s considered commonly as checkbook control. So you’re the one signing the documents and that kind of things. So there is a convenience factor there as well. So when you talk about 401(k) plans and IRAs, because there is a rollover possibility where there’s no tax and no penalty and things like that and because the tax advantages in a lot of cases are the same as the SEP or SIMPLE IRA I think there’s an element of those things all being lumped together.
So one of the things that I always encouraged somebody to do is think about the exact account type that they’re considering and think about it as a tool in conjunction with the type of investing that they want to do especially if it’s real estate and especially if it’s that leverage real estate in this particular case. So each tool is going to have a slightly different advantages and disadvantages. You know, if you’re the trustee of a 401(k) plan, you have to make sure that it runs properly, you have to file a tax documents once you get above a quarter million dollars in plan assets. So there are things to think about. In a lot of cases the 401(k) plan is a little bit more complex to run. So if you don’t want to put in that time maybe the IRA is the better plan. So it really is one of those things where it’s worthwhile to take a minute and think about the tool that you want to use and the one that works best for the type of investing that you want to do.
If you have any questions about this please feel free to visit newdirectionira.com. We have plenty of information about this kind of thing on that on our website. And I will be back in the REI Classroom later and thanks a lot for joining us today.
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