If you're on a tight investment budget, you might be assessing whether investing in real estate or a Roth individual retirement account (IRA) is better. Real estate offers tax advantages and high potential returns, while Roth IRAs deliver tax-free growth and tax-free withdrawals. Here's a look at some of the pros and cons of real estate investing and Roth IRAs, plus an introduction to self-directed IRAs (SDIRAs), which could offer the best of both worlds.
Key Takeaways
- Real estate investing offers several tax advantages and high potential returns, including potential cash flow from investing.
- Real estate investors buy, sell, manage, and improve property for profit or rental income.
- A Roth IRA offers tax-free growth and tax-free withdrawals during retirement.
- Roth IRAs are subject to contribution limits and withdrawal rules.
- Self-directed IRAs allow you to invest in alternative assets, including real estate.
What Is Real Estate Investing?
Real estate investing involves earning money from owning or selling property. This is perhaps the oldest way of building wealth.
A major draw of real estate is that these investments typically have tax advantages. For example, mortgage interest, property taxes, and certain maintenance expenses are typically tax deductible, reducing your overall tax bill. In addition to serving as a good way to diversify your portfolio, real estate can also be a hedge against inflation since property values and rental income often increase with inflation, offering some protection against rising prices.
As with any investment, there are potential drawbacks. Among the biggest is that real estate investments lack liquidity compared with other asset classes. Also, prices in real estate can be volatile. If you’re not selling the property, you have to deal with tenants from whom the best you can expect is that they care for the property so that upkeep is still required but at a minimum. Real estate investing can also require a high initial investment and, if you’re the sole owner, take up a lot of your time and give you stress beyond just the typical worries over profits and losses.
Here are some of the ways you can invest and potentially profit in the real estate market:
- Airbnb and vacation rentals: Income is generated by short-term leasing of a room or section of your home to guests, often at rates higher than traditional renting.
- House flipping: Profit is made by buying properties, often needing major repairs, at a lower price, renovating or improving them, and then selling them at a higher price, ideally exceeding the total investment from buying and renovating the property.
- “House hacking”: This is a newer term for renting out part of your home, either while you’re away on vacation or while living in the home.
- Real estate crowdfunding: Investors earn returns either through a share of the rental income from the crowdfunded property or through the appreciation of the property’s value over time.
- Real estate investment trusts (REITs): You earn profits from dividends from the trust. You own shares in the REIT’s assets, including commercial, residential, or other properties. The income can come from developing, selling, or renting the real estate.
- Real estate limited partnerships: You contribute capital and then receive income from the partnership’s real estate investments, including development, leasing, or selling properties.
- Real estate mutual funds: Any profit you make is from the appreciation of the fund’s value based on the performance of its underlying real estate assets.
- Rental property: Earnings come from collecting rent from tenants, ideally exceeding the costs of mortgages, maintenance, and property management, resulting in a profit.
Pros and Cons of Real Estate Investing
Pros
High profit potential
Tax advantages
Steady cash flow
Diversification
Cons
Illiquid
High transaction costs
High operational costs in time and money
Regulatory risks
What Is a Roth IRA?
A Roth IRA is a special type of retirement account that is funded with after-tax dollars. Unlike regular IRAs, you pay taxes on money when it goes into your account, and future withdrawals are tax-free.
Paying the taxes upfront means enjoying tax-free growth on your investments. Roth IRAs can be particularly lucrative if your marginal taxes are higher inretirement than when contributing. With these accounts, you also aren’t forced to withdraw at a certain age and can withdraw contributions without penalty at any time.
On the downside, there are limits to how much you can contribute. If your modified adjusted gross income is above a certain amount, you won’t be able to contribute at all. Moreover, unlike a traditional IRA, you can’t deduct your contributions. Investment choices might be more limited than a traditional IRA, too.
Pros and Cons of Roth IRAs
Pros
Tax-free growth and withdrawals
Withdraw contributions anytime with no tax or penalty
No required minimum distribution for your lifetime
Can contribute no matter your age
Cons
No upfront tax break
Unqualified withdrawals may trigger taxes and penalties
Limited investment choices (unless you have a self-directed IRA)
No ability to leverage funds
How to Invest in a Roth IRA
Opening a Roth IRA is a fairly straightforward process. First, determine if your modified adjusted gross income (MAGI) is too high. If it isn’t, you can get a Roth IRA by taking the following steps:
Choose Where To Open an Account
Most investment companies offer Roth IRAs. Important factors when deciding which firm to choose include the quality of the customer service, fees, and the variety of investments offered.
Apply
You can usually complete the entire application online. To do so, you’ll need a photo ID, your Social Security number, bank details, and information about your employer. You’ll also need to give information on any beneficiaries should you die with funds left in the account.
Select Your Investments
There are three basic approaches to choosing investments. You can either build your own portfolio, buy a target date or life-cycle fund, or consult a financial advisor to select something else.
Set Up Your Contribution Schedule
You can make an annual payment or set up monthly transfers from your bank account to your Roth IRA.
Roth IRA Income Limits
You can contribute to a Roth IRA no matter how old you are, provided you have earned income. The most you can contribute to a Roth IRA as of 2023 is $6,500. For 2024, that number will increase to $7,000. These limits are subject to a $1,000 catch-up contribution for individuals age 50 and older.
However, you can contribute to a Roth IRA based on your modified adjusted gross income (MAGI) and filing status. If your MAGI is in the Roth IRA phaseout range, you can contribute a lower amount—but you can't contribute anything at all if your MAGI exceeds the upper limit for your filing status. Here's a rundown for the 2023 and 2024 tax years.
| Filing Status | 2023 MAGI | 2024 MAGI | Contribution Limit |
|---|---|---|---|
| Married filing jointly or qualifying widow(er) | Less than $218,000 | Less than $230,000 | Full contribution allowed |
| $218,000 to $227,999 | $230,000 to $239,999 | Partial contribution allowed | |
| $228,000 and above | $240,000 and above | No contribution allowed | |
| Single, head of household, or married filing separately (and you didn't live with your spouse at any time during the year) | Less than $138,000 | Less than $146,000 | Full contribution allowed |
| $138,000 to $152,999 | $146,000 to $160,999 | Partial contribution allowed | |
| $153,000 and above | $161,000 and above | No contribution allowed | |
| Married filing separately (and you lived with your spouse at any time during the year) | Less than $10,000 | Less than $10,000 | Reduced contribution allowed |
| $10,000 and above | $10,000 and above | No contribution allowed |
If your income prevents you from contributing to a Roth IRA, real estate could be your other option—whether you become a landlord, flip houses, put money into REITs, or invest through some of the best real estate crowdfunding sites.
Self-Directed IRAs: The Best of Both Worlds?
Most major IRA custodians limit their investment choices to traditional assets like stocks, bonds, and mutual funds because they want you to invest in their financial products. However, there's a way to get around that limitation.
Self-directed IRAs are structured like standard IRAs and have the same tax advantages, contribution limits, and withdrawal rules.
Self-directed IRAs (SDIRAs) let you access nontraditional assets, including real estate. Real estate is one of the most popular SDIRA assets, and you can put money in all types of real estate and real estate-related assets:
- Apartment buildings
- Condominiums
- Commercial properties
- Foreclosures
- Improved or unimproved land
- Leases
- Mortgage notes
- Offshore properties
- Single-family and multi-unit homes
- Storage spaces
- Trust deeds
You can structure an SDIRA as either a traditional or Roth IRA, so you decide when you get the tax break. If you opt for a traditional SDIRA, your contributions may be tax deductible (depending on your income and whether you have an employer-sponsored plan), but you'll owe income tax on your withdrawals in retirement.
Conversely, you don't get an upfront tax break with a Roth IRA, but qualified withdrawals in retirement are tax-free, even on earnings. Thus, if you hold real estate in your SDIRA, you will not owe taxes on the earnings, provided you wait until you're at least 59½ and it's been at least five years since you first contributed to a Roth account.
Pros and Cons of SDIRAs
Pros
Can invest in alternative assets
Tax advantages
Higher potential return than standard IRAs
Asset protection
Cons
Assets may be illiquid
Hidden fees
Paperwork and compliance
Gains may be subject to unrelated business income tax
Overall, SDIRAs can provide greater flexibility, better diversification, and higher potential returns than conventional IRA accounts.
401(k) vs. Real Estate Investing
If you're trying to decide whether to invest through a Roth IRA or by buying real estate, you may also consider using a 401(k).
401(k)s are specialized retirement accounts that are very similar to IRAs. Like IRAs, they come in both traditional and Roth forms, though traditional 401(k)s are more common. Here are some aspects that set 401(k)s apart from Roth IRAs:
- You get a 401(k) as a benefit from your employer. You can't open one on your own.
- Contribution limits are much higher: $22,500 for 2023 and $23,000 for 2024, with a catch-up contribution of $6,500 for 2023 and $7,000 for 2024.
- You may have less control over your investment options because your employer provides a list of mutual funds to invest in.
- Your employer may offer matching contributions which can accelerate your savings.
If you have access to a 401(k), it's usually a good move to contribute enough to maximize your employer's matching contributions. Doing so is like getting an automatic return on your investment. For example, if you make $50,000 per year and your employer offers 100% matching on the first 5% of your salary, you'll get $2,500 in matching contributions from your employer by contributing $2,500 yourself.
If you've maxed out your matching funds, don't receive matching contributions, or don't have access to a 401(k) through an employer, then it can be a good time to consider a Roth IRA or real estate investing.
What Can You Buy With a Self-Directed IRA?
A SDIRA can hold virtually any type of investment except life insurance and collectibles, including artwork, rugs, antiques, metals, gems, stamps, most coins, alcoholic beverages, and certain other tangible personal property. Common SDIRA investments include real estate, precious metals, private equity, private lending, and limited liability companies.
What Is a 1031 Exchange?
Many real estate investors use 1031 exchanges to reduce and defer taxes. A 1031 exchange lets you swap one investment property for another, deferring capital gains and depreciation recapture taxes in the process. The two properties must be of “like-kind,” that is, “the same nature or character, even if they differ in grade or quality,” according to the IRS. Real estate is generally like-kind, whether it’s improved or unimproved, and the two properties don’t need to be identical. For example, a commercial property could be like-kind with vacant land. However, property in the U.S. must be exchanged for other real property in the U.S.—you can’t exchange U.S. property for foreign property or vice versa.
What Deductions Can I Claim for a Rental Property?
You can generally deduct qualified rental expenses (e.g., mortgage interest, property taxes, interest, and utilities), operating expenses, repair costs, and depreciation. You may also be able to deduct an additional 20% of your qualified business income.
The Bottom Line
Real estate investing and Roth IRAs both offer benefits, and you don’t necessarily have to choose one over the other. It’s possible to have a Roth IRA with various investments and invest specifically in property. Investing across different asset classes is a good way to protect your investment capital against volatility.
If you have lots of upfront cash and have identified some great real estate opportunities, you might want to pursue them. Otherwise, you might find you can generate just as good and even better returns through a Roth IRA. With a Roth, you can invest in all types of ventures, including REITs, and don’t need much money to get started. However, it’s essential to know that you will likely pay a significant penalty if you withdraw earnings before turning 59 1/2 and have had the account for less than five years.
Real estate offers much higher earnings potential, but it's hard to beat a Roth's tax-free withdrawals—not to mention the years of tax-free compounding. When in doubt, speak with your financial planner or advisor, who can help you determine the best investment strategy for you and your situation.
