Skylar Clarine is a fact-checker and expert in personal finance with a range of experience including veterinary technology and film studies.
If you’re on a tight investing budget, you may wonder if investing in real estate or a Roth IRA is better. After all, real estate offers valuable tax perks and high potential returns, while Roth IRAs provide 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 can offer the best of both worlds.
Real estate investing refers to buying, selling, managing, and improving real property for profit. From steady cash flows and high potential returns to tax advantages and diversification, real estate can be a sound—and lucrative—investment strategy. There are numerous ways to tap the real estate market, including:
A Roth IRA is a tax-advantaged way to save for retirement. While you can’t deduct your contributions (like you can with a traditional IRA), money in the account grows tax-free, and qualified distributions during retirement are also tax-free. These tax perks make a Roth IRA an excellent place to hold investments that would otherwise trigger substantial taxes.
You can contribute to a Roth IRA no matter how young or old you are, provided you have earned income. The most you can contribute to a Roth IRA (or any IRA for that matter) for each of the 2021 and 2022 tax years is:
However, there is one income-related reason you might not be able to contribute to a Roth IRA: You make too much money. Your ability to contribute to a Roth IRA is based on your modified adjusted gross income (MAGI) and filing status.
If your MAGI is in the Roth IRA phase-out range, you can contribute a reduced 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 2021 and 2022 tax years:
Of course, if your income precludes you from contributing to a Roth IRA, then real estate would be the better choice for your investing dollars—whether you become a landlord, flip houses, buy REITs, or something else.
High profit potential
Tax advantages
Steady cash flow
Ability to leverage funds
Illiquid
High transaction costs
High operational costs
Regulatory risks
Tax-free growth and withdrawals
Withdraw contributions any time with no tax or penalty
No RMDs for account owner's lifetime
Can contribute no matter your age
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
Most "big box" 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 much like standard IRAs and have the same tax advantages, contribution limits, and withdrawal rules.
Self-directed IRAs let you access non-traditional assets—including real estate. Real estate is one of the most popular SDIRA assets, and you can invest in all types of real estate (and real estate-related assets), including:
You can structure an SDIRA as either a traditional or Roth IRA—meaning you can 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. That means 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.
Invest in alternative assets
Tax advantages
Higher potential return than standard IRAs
Asset protection
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 their conventional IRA cousins.
A self-directed IRA 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. Some of the more common SDIRA investments include real estate, precious metals, private equity, private lending, and LLCs.
IRA contribution limits are the same across all types of IRAs, including traditional IRAs, Roth IRAs, and self-directed plans. For each of the 2021 and 2022 tax years, you can contribute up to $6,000, or a maximum of $7,000 if you're age 50 or older.
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 like-kind, meaning "they're of 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 to 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.
Several deductions can offset your rental income and lower your taxes if you own 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 (QBI).
Of course, it's not a bad idea to invest in real estate and a Roth IRA if you have the resources to do so. Real estate offers much higher earnings potential, but it's hard to beat a Roth's tax-free withdrawals—not to mention the years (or decades) of tax-free compounding. When in doubt, speak with your financial planner or advisor, who can help you determine an investment strategy that works best for you and your situation.
Internal Revenue Service. "Roth IRAs."
Internal Revenue Service. "Traditional and Roth IRAs."
Internal Revenue Service. "Retirement Topics – IRA Contribution Limits."
Internal Revenue Service. "Amount of Roth IRA Contributions That You Can Make for 2022."
Internal Revenue Service. "Amount of Roth IRA Contributions That You Can Make For 2021."
Internal Revenue Service. "Retirement Plans FAQs on Designated Roth Accounts: What Is a Qualified Distribution From a Designated Roth Account?"
Internal Revenue Service. "IRA FAQs: Investments."
Internal Revenue Service. "Like-Kind Exchanges – Real Estate Tax Tips."
Internal Revenue Service. "Topic No. 414 Rental Income and Expenses."
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