Investing Retirement Funds (using a SDIRA)

Total Disclaimer Here: Investing using Self Directed IRAs requires specialized assistance. I am not an attorney. I am not a CPA. I’m an investor. If you decide to utilize your Self Directed IRA to invest in real estate, please contact the professionals. 

Enjoying Family Time

Retirement Fun takes additional money

Enjoying Retirement Means Investing Wisely

Enjoying retirement can be easier by having a solid retirement nest egg. Above, a family enjoys some time together in a tropical location, far away from St. Louis, Alton, and Wood River. There’s nothing wrong with “stay-cations”. St. Louis has the Arch, one of the best free zoos in the country, and of course the Cardinals. Only 30 minutes from Alton, IL is Pere Marquette State Park. And it’s pretty easy to jump on the Madison County Trails from just about anywhere.

Being able to travel away to visit your family, or maybe even bringing your family with you on a tropical adventure (and paying for their costs), is a dream for many. To do that, you’ll need plenty of available cash in your retirement accounts. And that takes planning.

Investing Calculator

Investing isn’t as easy as plugging numbers into a calculator

I’m not a huge fan of investing using traditional retirement vehicles to achieve my retirement goals. I personally believe that IRAs and 401(k) plans are designed to keep you in servitude to the financial planners and your workplace. Pensions are even worse. I have a couple of retired friends whose pension payments have stayed flat for 15 years or more. When the National Steel plant in Granite City went into bankruptcy, most retirees had their pension benefits cut by 25% or more! And they lost their “guaranteed” health insurance.

My bottom line is do not count on others to provide you with retirement income.

You can read more on my logic over at Bigger Pockets, where I am an active Pro member with more than 500 posts. Check out the post where I show the fallacy of using a 401(k) to become financially independent in retirement.

My conclusion? Retirement planning is not a set-and-forget activity. You need to invest more than money – you need to invest your time and then invest your money wisely.

A Self-Directed IRA is One Possible Approach

Many investors have heard of Self Directed IRAs before (SDIRA for short). What they didn’t know is certain SDIRA plans can invest in more than just stocks, bonds, and mutual funds. That’s probably because most investment advisers can’t make money off of you investing in them so why tell you?

SDIRAs can invest in other tangible assets like Real Estate, Gold, and Commodities. In fact, there are only a few prohibited investments types in a SDIRA – namely collectibles like artwork and rare coins, S-corp stocks, gemstones and metals with some exceptions, and insurance contracts.

Yes. You can invest in Real Estate using a SDIRA. And if the investment is done correctly, you’ll have a safer and more profitable retirement.

My assumption is you are reading this post and are already convinced that real estate is a good and wise investment choice for you and your circumstances. I don’t have the space here to convince you of that. So let’s get on to talking about using SDIRAs as part of your retirement plan.

How does investing through a Self-Directed IRA investment work?

In essence, this investment works similarly to your traditional IRA. I later cover things you absolutely, positively cannot do or risk a lot of taxable consequences.

  1. Talk with your CPA or financial planner. Understand how taxes are treated within a SDIRA and if is the right approach. It’s a little bit different than you’d think (thanks again, IRS).
  2. Set up a SDIRA with a qualified company. You won’t find Schwab or Fidelity of much help here. You’ll need to find a company who specializes in these types of IRAs. And it will cost you a fee to do so.
  3. Identify a real estate investment you’d like to make. This could be purchasing a property, lending money to someone else (who is not a disqualified person), or maybe purchasing delinquent real estate taxes.
  4. Make sure to buy the asset exclusively through the IRA. Your personal name cannot be on it and you cannot have any substantial dealings with the asset. This is an investment. If you turn it into a business-like entity, you’ll blow-up your IRA. And you don’t want to do that.
  5. All expenses and incomes go through the IRA – never to you personally.
    1. In fact, I recommend that all property management is handled by a third-party property manager unrelated to you. Never swing a hammer, never answer a resident call, never replace a light bulb on the property. After all, you are retiring. Why would you want to create a new job for yourself?
    2. If you are buying or making loans, have a third-party loan servicing company handle it for you.
  6. Get a Broker’s Price Opinion on the investment every year. This is necessary so your IRA can be properly valued for tax purposes.
What’s the benefit? Seem like a lot of work

I tend to agree. Buying real estate for yourself outside of an IRA is my preference. Investing in properties already comes with a number of tax benefits. But if you are going to be a passive investor on a property (maybe even a preferred partnership arrangement), it may make sense to utilize an IRA investing vehicle. Why is this?

As a passive investor, you really won’t have a legal say in the day-to-day operations. All you are looking for is passive income and letting someone else run the thing. Keep it inside an IRA and all profits go back tax deferred or tax free. Again, talk to your professional adviser on this. The best part? IRA purchases can even take out loans to purchase!

The ability to take out a loan against SDIRA-owned properties is HUGE! Think about why this is using a very conservative example (I want my properties to cash flow at least a 12% return.)

  • You buy a property for $200,000 cash.
  • The property earns 7.61% through cash-flow or about $15,750/yr
  • It appreciates at 2% per year.
  • After ten years you sell it for $250,000. That’s a profit of about $50,000
  • You’ve made $157,500 in cash flow over those years.
  • In total, you’ve earned $207,000 in profit. Congratulations! Not too bad!

See a Pro Forma Example here.

But let’s take out a loan on a bigger property and see what happens.

  • You buy a property worth $800,000, using a $200,000 down payment.
  • The property earns earns roughly 7.25% in cash flow (because you have to pay for the financing on $600000) or about $16,000/yr
  • It appreciates at 2% per year.
  • After ten years, you sell it for $1,000,000. That’s a profit of roughly $200,000.
    • Or did you actually make more than $200,000?
    • The renters were paying off your principle for the last ten years. In fact, they paid off $231,000 of the loan balance.
    • You have to add that $231,000 to your “profit”.
  • You made at least $120,000 in cash flow. (This was lessened because of UBIT taxes which are described below).
  • Your total 10-year profit is $551,000 (120CF + 200 Appreciation + 231 paydown) off the same $200,000 investment.

See a Pro Forma example here.

Which would you rather have? Profits of $551,000 or profits of $207,000 from the same $200,000 investment? I think the answer is rather obvious. You see, when you buy mutual funds in your IRA, you can’t leverage that money like you can when you buy real estate.

Even if you were to earn 8% in a mutual fund IRA, your $200,000 investment would only “profit” by $231,000.

UBIT Taxes: One thing to mention about using loans in IRAs. They are then subject to the Unrelated Business Income Tax. This is a complicated formula that will cause roughly 75% of the cash flow to be “taxable”. My rough estimate is this will reduce you cash flow by $4,000 per year, sliding downward as the property is paid off by your residents.

Being a lender for real estate purchases

Lending from an IRA makes even more sense to me. Let’s look at an example.

Example: An investor comes to you looking to purchase a rental property. The property is in bad shape and has been mismanaged for years. They can get a really good deal on it. Their plan is to buy it, fix it, rent it out, and then refinance it in about a year to pull all of the equity out. Looking at the specifics:

  • Fourplex in Pontoon Beach.
  • Expected rents are $595/unit or $2,380/m in rent.
  • Purchase Price: $65,000
  • Expected rehab needs: $30,000
  • All-in costs: $100,000
  • After Repair Value: $140,000
  • They ask you to loan them $75,000 to complete the deal.
  • Initial check is for $50K at close and $5K draws every two weeks.
  • Interest-only loan at 9% with 2 points added to the payoff.

(NOTE: You should always require the investor to have some of their own money in the deal when lending but may decide against it in an equity-split arrangement)

A year later, the investor tells you they are refinancing and you determine the payoff amount. When you add everything up from this loan, you realize you’ve made almost $7,500 on this deal. Not a bad return, and since it was backed up by a tangible asset like real estate, not as risky as you’d think.

Compare this investment to The Fidelity Freedom Income Fund (10 year return of 3.93%), the Fidelity Strategic Dividend & Income fund (10 year return of 6.13%) or the Fidelity US Bond Fund (10 year return of 4.40%). You’ve doubled or tripled what you could have made!

But now you have to pay taxes on it. Unless you make the loan inside of an IRA. So now, you have all $7,500 to use for your “lending” next year.

What are the Investing Dangers?

As with all investments, there is the risk of loss. You could lose everything, you might have to foreclose, or you might get stuck with a non-performing note… Of course, you have risks with mutual fund investing, too. How many people were wiped out when Madoff funds collapsed?

Also, you have to follow all of the IRS rules on this:

  1. The IRA purchases the property/investment, not you personally. In fact, you should never have held title on it.
  2. Never use your personal funds for things like escrow or to pay for inspections. Again, the IRA is a separate entity from you.
  3. Insurance is in the name of the IRA
  4. Pay all income and expenses through the IRA.
  5. The SDIRA provider will hold the title work, assignments, etc.
  6. Never do any substantial work on the property. I recommend you don’t even do things like show it to potential residents. Don’t even change a light bulb.
  7. Do not work with direct lineage. This includes children and grandchildren, moms and dads, and grandparents. If you do this, you’ll blow up the entire IRA, which could have significant penalties and tax consequences
  8. Work with a professional SDIRA provider.

Wrapping everything up, a lot of money is currently tied up in traditional IRAs. If your investment is not working for you as well as it should, using a specialized SDIRA could be your ticket to greater retirement enjoyment.

Have you ever used a SDIRA to invest in non-traditional assets? Do you have any questions or answers we haven’t covered? Let us know below!