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How can I use real estate and rental properties to fund early retirement?

Real estate investment is a popular way to support retirement. For many, buying a home may be the biggest investment they ever make. Indeed, not having to make any more mortgage or rent payments can be the deciding factor in choosing when to retire or whether retirement is even possible. Real estate, however, can support an early retirement thanks to the rental income it can generate.

The advantages of using real estate and rental property to fund early retirement.

If you own property that you can rent to others, or want to purchase a rental property to help support your retirement plans, the following advantages may help you retire early:

  • Decision-making control over your investment. One difference between relying on real estate and using a retirement account like a 401(k) is that with real property you have more authority over how to make the most of its earning potential. You are not at the whim of the stock market. You get to make the important decisions like what property to purchase, where to set rent amounts and when or whether to raise them, whether to invest in improvements to the property, and the kinds of tenants you rent to.
  • Control over how much and when you can invest toward early retirement. Retirement accounts can limit how much you can contribute to them in a year. For the year 2024, for example, the most you can contribute to an employer’s 401(k) account is $23,000. Although your employer might contribute matching funds to your account, the combined amount that you can put into your 401(k) account is still capped.
  • Control over when to benefit from your investment. Unlike a retirement account, which requires you to go through special procedures to access funds early, rental real estate is not subject to any government restrictions on when you can use it as a retirement income source. From the moment you start renting your property, you can start earning passive rental income.
  • You can use loans to purchase an income generating property. Retirement accounts rely on taking pre-tax money from your income and setting it aside to grow over a period of time. This limits your potential investment funds to what you earn from your job. To purchase real estate, you can get financing to acquire an income generating asset.
  • Real estate tends to appreciate. Although sometimes real estate prices can go down, generally real estate increases in value over time. If you combine this appreciation with leveraged funds, you can see impressive increases in the value of your land investments. For example, if you buy property worth $200,000, contributing $40,000 of your own money as 20% of the price and borrowing the rest from a lender, and the property appreciates at a 3% annual rate it will increase in value to $206,000 in one year. If you invested that $40,000 at the same rate of return with no leveraged funds, your investment would likely increase by only $1,200.
  • Real estate can be a hedge against inflation. This can be especially helpful if you are buying rental property with a mortgage in a high inflation environment because your monthly mortgage payments do not increase with the rate of inflation. On top of that, because inflation tends to drive up prices across the board, including for real estate, you may even see your property value go up at the same time.

The disadvantages of using real estate and rental property to fund early retirement.

As compelling as the advantages of using real estate to retire early are, there are some caveats:

  • Maintaining the rental property is critical. To maintain the value of your investment property, you only have two choices: perform upkeep and repairs yourself, or pay someone else. This commitment of time or money to maintenance is something to factor into your profit calculations and overall retirement plan. Even if you hire a property manager, or property management company, there may be still be some oversight required on your part.
  • It can be hard to find, and keep, good tenants. Although your rental property may increase in value over time through appreciation, it’s going to be important to find tenants who pay their rent consistently and on time, and who do not damage your property. It pays to carefully vet potential tenants before they move in, and to have an effective Lease Agreement that protects your investment property. Doing so not only improves your chances of finding a quality tenant, it also reduces the risk of paying out legal fees to evict or end a tenant’s lease.
  • Real estate values decline sometimes. Although annual appreciation in value is the general rule for real property, it is not an absolute rule. There are times when the real estate market experiences a sharp downturn. This can temporarily lead to reduced home values or rental prices, making it harder to increase rent and possibly threatening your ability to sell the property. 
  • Property taxes. When you own property, typically, state and local laws require you to pay property taxes, in addition to other taxes you may be required to pay as a landlord. In addition to a mortgage, insurance, and upkeep costs, property taxes can be a significant annual cost to consider.

How can I use retirement accounts to fund early retirement?

Another way to finance early retirement is to use your 401(k) retirement account. How you do this depends on your age, situation, and the withdrawal method you use.

Because 401(k) accounts are subject to federal government regulation, the federal government gets to decide how soon you can take funds from your account without paying a 10% federal tax penalty in addition to the income tax you may owe. Presently, the federal retirement age is 59.5 years. How the IRS calculates the penalty depends in part on whether your 401(k) account is a traditional or a Roth 401(k):

  • For a traditional account, the IRS calculates the 10% penalty on the entire account balance.
  • For a Roth account, the penalty is calculated only on the investment growth of the account and does not count your contributions to it.

The advantages of using a 401(k) account to fund early retirement.

A significant difference between using your retirement account for early retirement versus rental real estate is the relative simplicity of the retirement account option. Unlike with real estate, you are free of the complications around buying investment property, managing that property, finding good tenants, and fluctuations in the real estate market. Your income is truly passive. This also means that you spend less time managing your retirement investments and more time enjoying your retirement.

The primary advantages of using your 401(k) to retire early include:

  • Compared to investing in real estate, using your 401(k) to fund your retirement, early or otherwise, is comparatively simple.
  • If you avoid early withdrawal penalties, then the IRS taxes your 401(k) retirement income as regular income. You can exercise some control over minimizing or even avoiding that income tax as part of your overall income tax strategy.
  • Your funds in a 401(k) account are safe from creditors, while your real estate holdings might not be.

The disadvantages of using a 401(k) account instead of investment property to fund early retirement.

The main disadvantage of relying on your 401(k) account to support your early retirement is that unless your account has a large balance it probably will not be able to compete with real estate as a source of income. 

In addition, if you do not qualify under one of the exceptions, or have not reached retirement age, then amounts you withdraw from your retirement account are likely to expose you to the IRS 10% early withdrawal penalty. In some situations, your taxable income from your 401(k) may be subject to a higher income tax rate than you would pay in real estate capital gains taxes.

Other potential downsides of using a 401(k) to retire early include:

  • Restricted growth opportunity. The federal government limits how much you can contribute to your 401(k) every year. Your employer may or may not match some of your contributions. If you have more money to invest into your retirement, an additional investment method will be required.
  • Depletion of your retirement asset. The earlier you begin withdrawing from your retirement account, the less you can take advantage of its growth potential over time. Retirement savings accounts often grow the most in the last 10 years due to compounding interest.
  • Limited return opportunities. In addition to potentially offering less income than real estate, 401(k) income does not provide the same flexibility to earn income in different ways that real estate offers, such as by cashing out through a sale of the property. 

How can I avoid early withdrawal penalties?

If you plan to withdraw from your 401(k) account before you reach age 59.5, the IRS gives you two options to avoid the 10% penalty: the Rule of 55 and Rule 72(t).

The Rule of 55

As its name suggests, the Rule of 55 can enable you to begin withdrawing from your 401(k) as early as age 55. For public safety employees, like police officers or firefighters, the eligibility age drops to 50.

Under this rule, if you leave work in the calendar year in which you turn 55 or afterward, then you can begin making withdrawals, but only from your current 401(k) account. If you have other, older 401(k)s from past employment that you have not rolled over into your current account, then those accounts remain subject to the standard 59.5 age qualification requirement. 

Another feature of account withdrawals under the Rule of 55 is that you do not have to retire to benefit from it. You can keep working, or return to work, and continue to make the withdrawals from your 401(k).

Rule 72(t)

The main advantage of using Rule 72(t) for early retirement purposes without paying the 10% early withdrawal penalty is that no age restrictions apply. For people considering retirement before they become eligible under the Rule of 55, for example, this rule is another way to access 401(k) funds and only pay the current income tax on them.

The possible downsides of choosing the Rule 72(t) option are that it puts more affirmative responsibilities on you. For example, you are required to take your withdrawals through Substantially Equal Periodic Payment (SEPP). What this means is that your withdrawals are subject to conditions:

  • You are required to show the IRS that you have an early retirement income plan.
  • You are required to use a withdrawal schedule that lasts for five years, or until you reach age 59.5, whichever happens later. If you experience a life event like a disability, this schedule is subject to change.
  • You are required to take at least five SEPPs during your withdrawal schedule period.

The amount of your SEPPs depends on which of three methods you use to calculate them: the required distribution method, fixed amortization method, or the fixed annuitization method. To learn more about options for your 401(k), a financial advisor can help you understand what is right for you.

Which option makes the most sense for me?

There is no one-size-fits-all plan when figuring out how to fund your early retirement. Real estate investment and 401(k) plans are not mutually exclusive options, and some people use both to generate income during their retirement. Other options also exist, including IRAs or drawing on your Social Security benefits. You can request an estimate of your Social Security benefits by sending a Social Security Benefits Letter.

Planning your financial future can be complex and involves many considerations. If you have more questions about retiring early, or getting ready to retire, reach out to a Rocket Lawyer network attorney for affordable legal advice. If you need tax help, Rocket Lawyer can now match you with a tax pro for affordable and convenient tax filing services. Don't do your taxes™ – Let us do them for you.

This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.

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