The purpose of this article is to give the reader a few ideas of what they can do with a self-directed retirement account. Before we get into the idea’s part thought, let’s first discuss a little bit about what a self-directed account is and what it can and can’t do.
A self-directed retirement account is basically an IRA, 401k or other retirement account that you are used to seeing that is invested in stocks, bonds, and mutual funds. But where the accounts that you are familiar are managed by third party custodians that invest in the traditional stocks, bonds, and mutual funds, a self directed account is managed by a custodian that will allow you the owner to select the investments you would like to make. Investments can be what ever you would like as long as the IRA does not complete a prohibited transaction, does not invest in collectibles, make excess contributions, and withdrawals are made when required by law. Further you cannot enter into a transaction with a disqualified person.
To keep things simple we will be referring to all these various self-directed accounts as a IRA.
When you create a IRA it becomes an entity of it’s own. What it does is completely separate from your own personal funds. It is managed by the third party custodian or more simply a custodian which is a company that signs all legal documents on behalf of the IRA, writes checks, and acts as the all around book keeper and record keeper of the IRA. Two of the top companies that fill this role in the country are Equity Trust Company and Entrust. To get a full education on all the different types of accounts, how to set them up, and required forms and documents, please visit their web sites: www.trustetc.com and www.theentrustgroup.com .
While the IRA is an entity unto itself and managed by the custodian, you are the owner and can direct how the custodian invests the funds. The profits and losses created from these investments will increase and decrease the IRA account balance with all taxes deferred until you start with drawing funds when you retire. Or in the case of a Roth IRA that is created with after tax money, no taxes will ever be paid as long as you do not complete a prohibited transaction, invest in things you are not supposed to, and don’t make early withdrawals.
So what can’t you do? A prohibited transaction is any improper use of your IRA account by you, your beneficiary, any disqualified person. Basically YOU cannot borrow money from your IRA, YOU can’t sell property to your IRA, YOU can’t receive unreasonable compensation for managing your IRA, YOU can’t use your IRA as a security for a loan, and YOU can’t buy properties for personal use with your IRA funds. YOU cannot get a benefit out of your IRA. Likewise, your beneficiary, the person who inherits all your stuff, cannot do any of these things either.
You cannot do any of these things with a disqualified person. Understanding exactly who a disqualified person is will allow you to make a huge profit with your IRA.
So who is disqualified? Anyone who has discretionary authority in administering your IRA: you and your beneficiary we have already discussed, and also linear members of your family, and your spouse. So your spouse, your grandparents, your parents, you, your children and grandchildren are out. Your brothers and sisters, step children not legally related to you, cousins, and friends are in. Please keep this in mind when you are putting together transactions.
What if my IRA enters into a prohibited transaction. No there is no IRA jail, you don’t get locked up, but if you may have to pay taxes on premature distribution, your IRA may loose it tax deferred status, and you may have penalties to pay. Please be sure to read up on the custodian web sites mention previously.
So what can’t my IRA invest in? You can invest in any legitimate investment, but not in collectibles. This includes art works, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages and other tangible personal properties. In some cases you can buy gold or silver, and coins, but please investigate this a little further before doing so.
You also cannot make excess contributions into your IRA. Each and every retirement account has a different set of rules and regulations on how much you can sock away into the account each year and is way beyond the scope of this article. Please get with your accountant and your custodian when you set up your account so you know exactly how much you can put into the account each year and when and how much you need to withdraw when the time comes.
To set up a self directed account, the first step would be to gather information about all the types of accounts from custodian company and then sit down with your accountant and / or financial advisor to find out which type of account best suits your needs. You may find that you want to roll over an existing account that you currently have into a self directed IRA. If you don’t have an existing account to roll over, you may want to start a new account with the basic $2000 annual contribution. Or you if you have a corporation or other type of company, you may want to open a simple IRA account that has much higher contribution limits. There are many different options and combinations of options, so please get with an expert for advice.
Let’s take a look at a typical scenario. Mr. & Mrs. Investor have worked quite a few years in corporate America and both have built up a sizable 401k account with their corporations. Both have socked away as much as they can into their accounts over the past 10 or so years and have about $50,000 each. As their real estate investing career is really taking off, they have just left their corporate jobs for good. They get a letter in the mail from the current company managing their 401k advising them that they need to roll their 401k account over from it’s current company and into another retirement account somewhere else.
Being astute real estate investors who have educated themselves on self directed IRA’s, they roll each of their 401k accounts over into a self directed IRA and now can direct how their money is invested. All profits made from their investments will go back into their retirement accounts and not into their own pockets, but they know they are passing on a few good real estate deals every year for lack of funds and while they don’t really need the income from these passed up deals today, if they utilized their 401k accounts to buy into a few of these deals, they sure could used the income in 20 or 30 years.
Mr. & Mrs. Investor also have formed a corporation to invest in their real estate to protect their assets from lawsuits and from taxes and their tax advisor tells they should also start a simple IRA plan within their company for each of them. Then they can contribute up to $7,000 each out of the salaries they receive from this company that reduces the income they report to the IRS by $7,000. Their company can then match up to 3% of their annual compensation.
So for example if they paid themselves a salary of $10,000 each from the company, they can take $7,000 of that each to contribute to their simple IRA and reduce their reported income by $7,000. Their company can then contributed up to 3% of their $10,000 salary or $300. So at the end of the first year, they will each have an account with $7,300 in it. At the end of year two they could each have $14,600 in their accounts, just from contributions and with no profits from investing the amounts.
Now Mr. Investor’s son, Investor Junior. He is working right along side mom and dad, he is doing well in real estate also and so has never really had a corporate job. He has a wife and kids and needs almost every dollar he makes from his investing to support his family, so he takes a different route and he starts a Roth IRA for himself and his wife. They each contribute only $3,000 to their IRAs and at the end of year one have 2 Roth IRA’s worth $3,000 each and at the end of year 2 worth $6,000 each if they make no investing profits. But they do have an advantage in that their Roth IRA’s were created with after tax dollars, so any profits they make are tax free with no taxed to be paid when they start taking distributions at age 59 ½. Please take note here for future examples that Investor Junior is related to Mr. Investor, but as he is from a previous marriage, he is only Mrs. Investor’s step-son and not actually related. We will look at this more in a minute.
Ok, now we know what a self directed IRA is and some basics of setting them up and getting initial funds into them. Now on to the fun stuff, let’s look at a few examples of how a self-directed account can be used!
After rolling over their 401k accounts Mr. Investor comes across a little house in his town that is in a nice rental neighborhood with an after repaired value of $80,000. It should rent for about $800 a month with maybe a little more if he gets a lease to own tenant to take it over. It needs about $10,000 in repairs: landscaping, painting, new carpet, and some minor handy man items. He can buy it for $40,000. He has enough income from other investments to live on for a while, so he decides to buy this house with his IRA account that he created by rolling over his 401k that has a current balance of $50,000.
He fills out all the proper forms and purchases this house in the name of his rolled over IRA. And immediately finds a lease to own buyer that pays his IRA $4,000 down as a non-refundable option fee. The buyer agrees to do the landscaping, painting, and handy man repairs if the IRA will pay $3,000 to replace the carpets. They are going to pay him $800 a month with $100 of that going toward their down payment when they get financed and cash him out. And about 6 months later his tenants are able to get their credit in line, get a loan and pay off their lease option. When they pay him off he will have earned $80,000 in proceeds from the sale, down payment and monthly credit toward down payment, plus $700 (the $800 lease payment less $100 rent credit) for 6 months for another $4,200, and has spent $40,000 to purchase and $3,000 on carpets. So his new balance in his roll over IRA after 6 months is $91,200 ($50,000 – $40,000 purchase – $3,000 for carpet + $4,000 option fee + $600 down payment credit from rents for 6 months + $4,200 in rent + $75,400 proceeds from sale). He almost doubled his account with one transaction.
Mr. Investor is very proud of this first deal and is discussing it with his advisors and thinking about trying to find two more similar deals. He is cautioned by his advisors that just like buying real estate in his personal name, buying real estate directly in his IRA name can be risky too. What happens if he has grown the account to $300,000 and he has one of his tenant get hurt in one of the houses owned by the IRA and they go to court and win a law suit, he could stand to loose the entire retirement account. So like Mr. Investor, before you purchase rental properties in the name of your IRA, you might also want to talk about the risks with your advisors and your custodian. But again this can get outside the scope of this article.
Investor Junior has his account with a paltry $3,000 in his account. He figures he can’t do much with his account, but has talked to his advisors and found that since he is Mrs. Investor’s step son and for purposes of the self directed IRA not related to her, that he might be able to borrow money from Mrs. Investor to do a deal. Any interest payments he pays to Mrs. Investors IRA for the loan of the money will go back into her IRA, but any profits he makes will be his to keep.
He then goes out and finds a killer deal but he has to act fast. There is a bank owned property listed for $30,000 that has an after repaired value of $80,000. There are quite a few buyers interested in the property. He made an offer that was full price and he told them he could close in 5 days. As all the other offers even though they all offered a little more than $30,000 all wanted 30 days to get their loans put together and Junior can close in 5 days, he gets the deal.
Investor Junior then goes to Mrs. Investor and strikes a deal with her. She can lend him the $30,000 to purchase the property plus another $15,000 for him to pay for the repairs out of her rolled over IRA. He will pay her the same fees he would have paid a hard money lender: 5 points and 15% interest and he will pay it all at once when he pays her off in about 6 months.
So they draw up the proper paper work and she pays the $30,000 for purchase and loans him $15,000. In the next two months he rehabs the house, gets a tenant in it and then at the end of month 4 he sells it to an out of state investor for $80,000 and pays off his loan from Mrs. Investor’s IRA.
Let’s look at their profits. Mrs. Investor’s IRA gets $45,000 back, plus 5 points or $2,250, plus 4 months of interest at 15% or $2,250 an now her balance is $54,500. Investor Junior spent $64,500 ($30,000 purchase, $15,000 rehab, $2,250 in points, and $2,250 in interest) and earned a profit of $15,500.
The next month Investor Junior’s wife and Mrs. Investor go out to look at a house. Mom is coaching her daughter-in-law as she did not grow up in real estate as Junior did. This is the deal they worked out. They found a house that was worth $130,000 that was in really bad shape, needing about $30,000 in repairs. The owner had died and the heirs were very motivated to get it sold and agreed they could let it go for $50,000 if they could sign a contract today. Mrs. Junior signed a contract to buy it from the seller’s with her IRA that if you remember only has $3,000 in it. She had her IRA wire a $1,000 earnest money deposit to the title company the next day, got the keys from the seller’s who were leaving town and made sure she had the right to assign the contract and she had 45 days to close on the contract. Plus she had a safety net with her mother in law. If she could not find another investor to assign her contract to, Mrs. Investor was going to buy it with her IRA for $50,000.
After getting all the contracts signed up, the next day Mrs. Junior got busy. She put a sign in the yard and got on the local investor chat room and posted the following post:
675 Mulberry Street.
3 bedrooms, 1 ½ bath, 1 car garage, full basement
After repair value $130,000
Needs $30,000 in repairs – nothing structural
Need cash buyer for $60,000
House will be open today at 5:30 pm, will take a cash buyer contract today!
Please call Mrs. Junior at 816-555-1212
She had 10 calls by noon, held the house open and had 5 investors show who she knew to be very active and one agreed to take over her contract at a price of $65,000. Remember there were 5 buyers there at 5:30 so they did get into a little bit of a bidding war. Everyone went to closing on their assigned day and Mrs. Junior ended up with a check for $15,000 going back to her IRA as her assignment fee. Now her account balance stands at $17,000 ($3,000 initial balance – $1000 EMD + $15,000 in assignment fee).
Now all these examples are fictitious and the deals are simplified and do not include holding costs and a few other fees, but you can see how utilizing a self directed account whether you start with a large balance or a small one can grow your retirement funds very quickly. You do need to keep in mind that all profits earned by the IRA, need to stay in the IRA and not go back into your personal or business accounts and to get advice from experts where you needed. It also helps if you have a non-related friend that you might borrow money from or lend money to or buy and sell houses between your IRA accounts.
There are quite a few more complicated scenarios, so do your homework on self directed IRAs as well as private lending. You may find that you can make a good return on your investment by being the bank for other investors letting them do all the hard work of hunting down houses, making repairs, dealing with tenants and the like and you just sit back and have your IRA collect the interest payments each month.