Taxes. While we don’t have a choice in paying taxes, we can, however, legally shelter some of that income from escaping our pockets. One way includes the self-directed IRA.
An IRA is an individual retirement account. If you work a job with benefits, your employer may sponsor an IRA. It was developed as a tool to help people save for retirement and many income tax incentives are offered as encouragement to save.
You do not, however, have to be employed in a full-time job or work for a big company to enjoy the benefits of an IRA. Self-employed real estate investors can also get in on the tax benefits of having an IRA. Every individual or small business owner has access to what are called self-directed IRAs. And these self-directed IRAs can be a great wealth building tool.
How?
By controlling what the IRA invests in.
Related: Top 5 Hacks To Maximize Retirement Savings
What exactly is a self-directed IRA?
The difference between an IRA offered by a large employer and a self-directed IRA is that you control what the IRA invests in. Want to invest in real estate? No problem with a self-directed IRA.
With a self-directed IRA, you direct how the funds are to be invested. A self-directed IRA account is an IRA that isn’t limited in terms of investing in stocks, bonds, and mutual funds.. The options available to you are wide open (with certain limitations). You are able to invest in many different alternative assets, such as real estate, gold and silver, mortgage notes, private placements, commodities, tax liens, hedge funds, oil, gas, mineral, lumber, etc.
In fact, your options are almost unlimited as to what you can invest in so long as it is allowed by the IRS or U.S. Department of the Treasury. It is up to you and your creativity to find the best and most profitable investments.
The pros of a self-directed IRA
Pro #1: Tax-free or tax-deferred
Although self-directed accounts are one or the other—tax-free or tax-deferred—both can be pretty good. A traditional type of IRA account is tax-deferred—which means you get an income tax break putting the money in. It grows tax-deferred, but you pay taxes after withdrawal. Thus, you do ultimately pay tax on the transactions.
With a Roth IRA account, your contributions are made with after-tax money, letting your account can grow tax-free. There are no taxes due upon withdrawal, and there’s no set age when you’re required to start taking withdrawals. Thus, you are paying tax on the seed.
Pro #2: Safe and sheltered vehicle
Self-directed IRAs are fairly safe vehicles in regard to things like creditors or judgments. Insurance contracts and IRA accounts are some of the safest buckets, where money can be set aside in a very protected environment and is usually immune to things like bankruptcy too, depending on your state. It’s also very difficult to sue an IRA account since technically it’s a trust account.
Pro #3: You control the investment
Some folks may look at this as a con since you have to be active, disciplined, and responsible for your own investments. But if you’re knowledgeable with what you’re investing in, this can be an extremely profitable wealth-building tool. You can also choose any alternative investment options that support your goals or which you think might offer better changes of success, like private equity or a REIT.
There are two true cons to a self-directed IRA, though.
The cons of a self-directed IRA
Con #1: Fees and paperwork
Expect fees and paperwork to get used to—but no true performance fees. For active investors, these fees remain somewhat nominal. Usually custodians charge fees based on the number of investments or the total value of the account. Depending on the type of asset in the account, some banks and custodians are better than others.
Con #2: Heavily regulated and complicated
The SEC heavily regulates all retirement accounts. Expect pages of rules and a lot of paperwork. Of course, you can’t do any self-dealing—meaning you as an individual would personally benefit, such as running a full-blown business from your IRA account. The last thing you want to do is have your account disqualified.
Also, your liability varies by the type of investment or asset class. Keep in mind you can also set up separate IRA accounts to limit any account’s liability. Many people don’t realize that they can have multiple IRA accounts with multiple companies.
FAQs on self-directed IRAs
How much can I contribute per year?
You can contribute up to $5,500 ($6,500 if you are over 50) per year of your earned income. Remember that rental income is passive income, so if that is all of the income you have, you cannot contribute anything.
Can anyone set one up?
Yes, as long as you meet the income requirements. Talk with your tax advisor to be sure.
How can I open a self-directed IRA?
Self-directed IRAs are opened through the use of a custodian. It’s important to do your research and shop around for companies with a solid reputation and the investments you would like to add.
Can I rollover or transfer my existing retirement account to a self-directed IRA?
The ability to transfer IRA funds depends strongly on your situation, but here are some other common questions of when you can transfer or rollover your retirement funds:
Where can I invest a self-directed IRA?
Popular types of investments include:
- Rental real estate
- Secured loans to others for real estate (trust deed lending)
- Private small business stock or LLC interests
- Precious metals, such as gold or silver
- Cryptocurrency, such as Bitcoin
However, some types of investments cannot be included in retirement accounts. Examples include:
- Collectibles, such as fine artwork, stamps, coins, alcoholic beverages, or antiques
- Life insurance
- S corporation stock
- Any investment owned by someone in your immediate family
Related: The 5 Best Investments in My Self-Directed IRA
What restrictions are there on using a self-directed IRA?
It is particularly important for real estate investors to pay attention to the self-directed IRA restrictions. If you’re planning to invest in rental properties using this method, you must be very careful to stay legal.
1. Material benefit restrictions
You cannot benefit from any of the funds or investments in your self-directed IRA. That means you cannot live in a property owned by your IRA or, if you are a real estate agent and buy a property to put in your IRA, you cannot take a commission.
A prohibited transaction would also include anything involving a “disqualified person,” such as a spouse or child… or you.
2. Material participation restrictions
This can be a tricky one. This means, for example, that you cannot do anything to maintain that rental property in your IRA. You can’t paint, fix up, or repair anything on any property in your IRA. If you get caught, your IRA may lose its status. The law then requires you to pay both taxes that would have been owed along with penalties and interest.
Instead, you have to hire someone to do anything and everything for you and pay them with funds directly out of your IRA. This can get a bit complicated at times because there are numerous forms to be filled out and time involved in receiving the payments.
3. Custodian requirements
You must use a proper self-directed IRA custodian to open your account—not just any bank. These custodians will actually hold title to property your IRA buys for your benefit.
4. Depreciation benefit loss
According to the self-directed IRA rules, you lose the benefits of depreciation if you hold real estate in your IRA. However, you do get the potential benefits of tax-free income and the offset of any IRA contributions.
Can you get loans in your IRA?
Yes, you can, but you may have a tough time finding someone who will loan to your IRA. You may also encounter something called UBIT, or unrelated business income taxes, which may make an investment feasible. Talk to your tax advisor on this issue.
What tax pitfalls should you look out for?
The unrelated business income tax (UBIT) applies when your IRA receives unrelated business income. Alternatively, any investment income that your IRA receives is exempt from the UBIT tax.
These types of exempt investment income may include:
- Real estate rental income: Rent collected from real estate is investment income and is exempt from UBIT.
- Interest income: Interest and points made from money lending is investment income and is exempt from UBIT.
- Capital gain income: The sale, exchange, or disposition of assets is investment income and is exempt from UBIT.
- Dividend income: Dividend income from a C corp, where the company pays corporate tax, is exempt investment income.
- Royalty income: Royalty income derived from intangible property rights, such as intellectual property, oil and gas, or mineral-leasing activities is investment income and is exempt from UBIT.
So, make sure your IRA receives investment income as opposed to “business income.”
What is a checkbook-control IRA or IRA LLC?
Many self-directed retirement account owners use an IRA LLC, also known as a “checkbook-control IRA,” to hold their retirement assets so that they have fast access. This is a suitable option for owners with real estate investments.
Should you use an individual 401k instead of a self-directed IRA?
This is where things get interesting, and ultimately, personal.
An individual 401k is a great self-directed account option and can be used instead of an IRA for persons who are self-employed. However, if you aren’t self-employed, the individual 401k may not be the best option for you.
If you are self-employed and you want to maximize your contributions, the individual 401k has much higher maximum-contribution limits: $54,000 annually versus $5,500 annually for an IRA.
That’s nearly a tenfold difference.
And let’s not forget about debt: Self-employed individuals with debt should choose an individual 401k over an IRA. Individual 401ks are exempt from unrelated debt-financed income tax on leveraged real estate.
A self-directed IRA is a better option for someone who has already saved for retirement. Some funds can roll over to a self-directed IRA.
There are a lot of factors at play when rolling funds into an IRA. Fortunately, you have experts at your fingertips to help determine what type of funding and account considerations your circumstances warrant.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.