Self-Directed IRA and 401K Plans
Your IRA and 401K can be self-directed plans. A self-directed IRA or 401K is not that much different from a traditional IRA or 401K in terms of growing your retirement savings other than a self-directed IRA allows you to invest in a wider variety of instruments such as real estate, tax lien certificates, mortgages, notes, franchises, and more. With a self-directed IRA, you are also able to invest in real estate tax free which is why this is considered one of the best self-directed IRA real estate investments. Buying real estate through your IRA means you can get higher returns and lower risk than you get from stocks, mutual funds or bonds.
Self-directed IRAs and 401Ks are not created equal. Self-directed can mean little control up to 100% control and your investment choices can be slim or they can be extensive. It’s all about control and choices. Most people are not aware of these differences. They can mean the difference between a shrinking retirement account and one that is increasing in value or between being able to retire and having to work during retirement years. Many people like to invest in real estate to create wealth and for financial security, but are unaware that they can invest their IRA and 401K retirement savings in real estate and have total control and flexibility while enjoying tremendous tax advantages. The key is in how you structure your IRA or 401K. If done correctly, you can have 100% control, checkbook access to your funds and be in a position to act quickly on a wide variety of investments opportunities, including real estate.
How many Americans would invest their retirement funds in real estate if they understood the benefits and how to do it? The answer is a lot of them! What if they could get bank financing for real estate purchases and borrow cash from their retirement funds with no penalties and taxes! It would seem like it is too good to be true!
Self-Directed IRA Real Estate Rules
Once you have converted your IRA or 401k to a Self-Directed Plan, there are certain IRA real estate investments the government allows you to invest in. One of those is residential real estate - which includes single family homes, duplexes and apartments. If you have ever thought about owning IRA real estate investment properties, doing so through your retirement account is perfect, especially if you do not have time to manage or take care of the property yourself. It is not hard to invest in rental properties, however there are a few things you are prohibited from doing.
The following are Self-Directed IRA Rules:
• All investments must be arms-length, meaning the buyer and seller are acting in their
own self-interest and there is no influence from other parties
• You cannot buy or sell property from a disqualified individual. Disqualified individuals
include you, your spouse, your parents, your kids and/or their spouses, grandchildren,
grandparents, investment advisors, fiduciaries and entities where the disqualified
individual owns 50% or more interest
• You cannot receive immediate benefit from a property owned by your IRA. No vacation
homes, personal residences or office spaces because these would benefit in some way
• You cannot lend yourself money to perform rehab work or cosmetic work on the home
purchased by your IRA. You cannot perform any maintenance on the home or even
furnish the home. It is all done via a property management company, which is nice
because then you do not have to deal with tenants. All income or rental profits
generated from your investment must go back to your self-directed IRA and all
expenses like improvements, property taxes and bills directly related to the investment
property must be paid from your IRA account
Just remember, the main purpose of your IRA or 401k savings plan is to benefit you in the future. It is not intended for personal use today. Your goal is to get the highest rate of return as possible. Just a 1% increase over 10 years or more is a substantial amount of money. Unfortunately, retirement plans have not been performing very well over the past few years.
Types of Retirement Plans Eligible for Self-Directed IRA/ 401(K) Accounts
IRA’s offer two big advantages or incentives to encourage people to save for their retirement; First, regular contributions to an IRA or real estate IRA may be tax deductible on an IRA holder’s tax return. Second, earnings on a traditional IRA are not taxed until the IRA holder or beneficiary takes the money out (unless it is a Roth IRA). It is these regular deposits, accrued earnings (Rental Income) and the passage of time that combines to produce large account balances. Also, with a Traditional Individual Retirement Account, you can choose your investments.
• Traditional IRA / 401K
• SEP IRA
• Roth IRA / 401K
• Simple IRA
The Self-Directed IRA: With a Self-Directed Ira you will get true freedom and control of your retirement account. A Self-Directed individual retirement account allows you to invest in a variety of things including real estate. There are two different types of Self-Directed IRA’s, Traditional Self-Directed IRA and Self-Directed IRA LLCs. Both offer very similar tax treatments with the one major difference being an IRA LLC does not require the consent of a custodian to make account withdrawals for investment purposes.
Self-Directed IRA LLC “checkbook control” structure offers one the ability to use his or her retirement funds to make real estate investments on their own without requiring the consent of any custodian. A special purpose limited liability company (“LLC”) is established that is owned by the IRA account and managed by the IRA account holder which is YOU. There are advantages and disadvantages to both plans with the biggest difference being the involvement of the custodian, and the costs associated with such responsibility. The traditional Self-Directed IRA will require approval of a custodian and fee’s associated with the management of the account. The Self Directed IRA LLC does not require the consent or management of a custodian thereby no fees for that activity.
The Solo 401K Plan: Most people mistakenly believe that their 401k must be invested in bank CD’s, the stock market or mutual funds. Few investors realize that the IRS has always permitted real estate to be held inside 401k retirement accounts. 401k Plans are defined in the Internal Revenue Code (Section 401) as Retirement Savings Trusts. As the name implies, a Solo 401k plan is designed for self-employed individuals or the Sole owner-employee of a corporation. The Solo 401k plan is perfect for independent contractors, such as consultants, home businesses and real estate agents. The owner’s spouse may also contribute to the plan as long as he or she is an employee of the business.
The Solo 401k Plan contains most of the characteristics of the Self Directed IRA LLC, including having the ability to make almost any type of investments, including real estate, but without the need to establish an LLC or pay custodian fees. The Solo 401k Plan is the most tax-advantageous retirement plan available because of its very high annual contribution limits. Like Self-Directed IRA LLC, to initially fund the Solo 401k you may rollover funds from traditional IRAs, SEP Plans, previous employer 401k Plans and many more. This is accomplished by setting up a Trust account for the Solo 401k and transferring the funds from the current Custodian to the trust bank account. The account can be opened at any local bank or credit union.
The IRA vs. the Personal 401K
Surprisingly, the 401K is not limited only to large corporations. Since 2001, a personal 401K has been available to individuals (sole proprietors, LLC's and small corporations) where there are no employees other than a spouse. In almost all categories, the features of the 401K top that of the IRA. One of the best benefits of the 401K is that it does not require the participant to hire a bank, custodian, or trust company to serve as trustee. This flexibility allows the participant to serve in the role as trustee. This means that all assets of the 401K trust are under the sole authority of the trustee of the plan. Any transaction that the 401K trust enters into is entered into by the trustee. This simplification eliminates the cost and delays of IRA custodians and/or LLC formation.
• Minimum Contribution: Neither plan has a minimum annual contribution. This allows
you to reduce or eliminate contributions in an off year and pour it on (in your 401K) – in
a good income year.
• Roth Feature: The Roth 401K can be structured to allow both pretax as well as Roth
contributions within the same plan. Remember, Roth distributions are tax-free!
• Taxation on Real Estate Profits: Unlike the IRA, leveraged real estate profits in your
401K are not subject to current taxation. Although it may not be practical, it is possible
to eliminate the taxation in an IRA by using a 1031 exchange.
• Asset Protection: Unlike the traditional IRA, your 401K can protect you from predatory
creditors and lawsuits.
• Cash Availability: Unlike the IRA, you can borrow (up to $50,000) from your 401K and
pay interest to yourself!
• Participant Qualification: Unlike the Roth IRA, the 401K has no personal income ceiling
to limit participation.
By purchasing real estate in your retirement plan, you are not changing what your retirement funds do (building tax-free or tax-deferred value for use at some future date) - you are simply changing the type of investment in your retirement account (from stocks, bonds and mutual funds to real estate) in order to reap the benefits of appreciation and rental income under the umbrella of the IRA/401(K) tax benefits.
What All Hard-Working Taxpayers Should Know
Using self-directed IRA or 401K funds to purchase income-generating real estate is a profitable strategy an ever-growing number of savvy investors are experiencing, especially given the current market conditions. With an IRAcheckbook or 401Kcheckbook Plan, you can buy rental property as an investment – just as you would buy stock market securities. This means our clients can use their retirement funds to buy real estate without incurring early distribution taxes or penalties, and they can realize the rental payments as tax-deferred income within their IRA or 401K - and in the case of Roth IRA funds, tax-free growth. That’s right! Rent does not show up on the tax return. There is also no Schedule E because the rent is seen as a return on investment to the IRA or 401K - not income. The same is true with capital gains. Profits upon sale are seen as a return on investment to the IRA or 401K and there is no Schedule E involved. All that is required is a one-time report of value for the self-directed IRA at year-end. In the case of a self-directed 401K, there is no requirement for a year-end report if the value is less than $250,000. The power of this is evident!
Choosing the Right Self-Directed IRA Investment Property
Because the Self-Directed IRA Real Estate Rules are strict when investing, it is very important to choose the right IRA real estate investment property that is "self-sustaining" or cash flowing each month because you cannot subsidize it. In certain parts of the US like Kansas City MO, Atlanta GA, Memphis TN, and others, it is not uncommon to find properties for $60K - $80K that rent for as much as $1,000+ a month. Those are the type of real estate investments that will produce 8% - 18% returns or more every year for the rest of your life. For those of you who like to venture into the lower-end markets throughout the Midwest like St. Louis MO, Cleveland OH and Detroit MI it is common to find properties for $40K - $50K that rent for as much as $750+ a month which produce 20%+ returns a year and that is not including capital appreciation down the road. This is certainly much better than most people can get in the stock market.
Examples of Purchases: If you decide to purchase a retirement home and you are years away from retiring, use your IRA or 401K to purchase the property and rent it out in the meantime. The income you receive in rent is tax deferred until you start to take withdrawals, so you can put it away until you do retire. When you’re ready, you simply direct your IRA or 401k to turn it over to you as a distribution at the current market value.
If you decide to purchase a residential rental property for $100,000 and the rents are $1,000 per month, use your IRA or 401K Plan to purchase the property. Once owned, deposit the rents into your IRA or 401K account and that’s it - no fancy accounting, no Schedule E, just a one-time annual report for the IRA and no requirement for the 401K if the value is under $250K. The rents are viewed as a return on investment to the IRA/401K so they don’t show up as taxable income on the tax return. Let’s say you find a better deal for a rental, so you sell. Again, there is no capital gain for the IRA or 401K; all profit is viewed as a return on investment under the umbrella of the IRA/401K provisions. You can purchase multiple properties this way and the same is true. Everything is viewed as assets of the IRA or 401K! Capital gains are treated as a return on investment as well. Again, no Schedule E. In fact, rents and/or gains are not reported on the tax return.
Examples of Return on Investment: For Instance, a $100K property that appreciates at the long-term average of 6% a year doubles in value after 12 years. If you put $25K down to buy it and borrowed the rest at 7%, your $75K mortgage has amortized to about $60K in that time. So your equity has mushroomed from $25K to $140K ($200K market value minus $60K outstanding mortgage). That is a little better than a 15% compounded average annual return – without a great deal of leverage and getting appreciation in the range of the long-term historical average.
But, if you buy a little better, you will do substantially better. If you buy under market and in an area that is rapidly appreciating, you might end up averaging 8% compound returns per year. This would make the property worth double your purchase price in nine years. At that time, your $75K mortgage would have amortized to approximately $66K. Now your $25K down payment turns into $134K in equity in nine years. That’s nearly a 21% compounded average annual return. Far better than the long-term average of the stock market. And – that does not even include steadily increasing net rents, which could push your compounded average annual returns up another few percent.
Using your Retirement Funds in Conjunction with a Loan: Using a non-recourse loan in conjunction with your IRA or 401K Plan can create a powerful wealth-building tool. It is very important when you set up a self-directed IRA or 401K with a non-recourse loan that you work with an experienced and reputable facilitator, real estate lender and tax professional. With the right counsel and professional direction, you can open the door to many more investment opportunities for your IRA or 401K. Real estate investments you once thought were “out of reach” can now be part of your portfolio!