Real Estate Investing vs. Roth IRA

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. 

Key Takeaways

  • Real estate investing offers numerous tax advantages and high potential returns.
  • Real estate investors buy, sell, manage, and improve real property for profit.
  • A Roth IRA offers tax-free growth and tax-free withdrawals during retirement.
  • Self-directed IRAs allow you to invest in alternative assets, including real estate.

What Is Real Estate Investing?

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:

What Is a Roth IRA?

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. 

Roth IRA Income Limits

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:

  • $6,000, if you’re under age 50
  • $7,000, if you’re age 50 or older

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:

 Filing Status 2021 MAGI 2022 MAGI Contribution Limit
Married filing jointly or qualifying widow(er)  Less than $198,000  Less than $204,000  $6,000 ($7,000 if age 50+)
  $198,000 to $207,999 $204,000 to $213,999 A reduced amount
   $208,000 and above  $214,000 and above  Zero
Single, head of household, or married filing separately (and you didn’t live with your spouse at any time during the year)  Less than $125,000  Less than $129,000  $6,000 ($7,000 if age 50+)
  $125,000 to $139,999  $129,000 to $143,999  Begin to phase out
   $140,000 and above  $144,000 and above  Ineligible for direct Roth IRA
Married filing separately (and you lived with your spouse at any time during the year)  Less than $10,000  Less than $10,000  A reduced amount
$10,000 and above $10,000 and above Zero

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.

Pros and Cons of Real Estate Investing

Cons

  • Illiquid

  • High transaction costs

  • High operational costs

  • Regulatory risks

Pros and Cons of Roth IRAs

Pros

  • 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

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

Self-Directed IRAs: The Best of Both Worlds?

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:

  • 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—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. 

Overall, SDIRAs can provide greater flexibility, better diversification, and higher potential returns than their conventional IRA cousins. 

What Can You Buy With a Self-Directed IRA?

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. 

What Are the Contribution Limits for Roth IRAs?

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.

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 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.  

What Deductions Can I Claim for a Rental Property?

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).

The Bottom Line

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.