Let’s talk about self-directed retirement accounts.
In a typical 401k or IRA account, investors place their money in their retirement accounts and leave the control over the investments made with their money to an account custodian. The custodian is the company or individual who is responsible to make investment decisions for the retirement account holders.
Sometimes they do a good job. Sometimes they don’t.
Often times they beat inflation just by a couple points; in fact, many manage their fees in order to make that the case. It’s possible that they return 12 percent for the year, but they control the fees as well, and they make sure to pull that down to an 8 percent return.
For traditional retirement accounts, once the account is set up and some basic questions are asked about the investor’s appetite for risk and growth, the investor has no say about where their money is invested.
There is an alternative, however, and it is called a self-directed retirement account.
With a self-directed retirement account, the investor takes the responsibility of making trades for the account. That means that the investor directs where the retirement account money is invested. The investor can choose the mutual fund or stocks if they would like, or they can direct the account to invest in a specific real estate project.
Some accounts are even checkbook controlled so the investor can write checks directly from their retirement account.
The primary advantage, therefore, of a self-directed retirement account is that the investor takes control of their retirement money and controls its growth.
Another advantage is that the investor can use retirement funds that they wouldn’t typically have access to. When we asked in the first training videos about potential money available to invest, most people only answer with money in checking and savings accounts, ignoring the retirement accounts; however, there are ways to roll your retirement account money into a self-directed retirement account and immediately start using that otherwise untouchable money.
You may already have a 401k through your current or past employer, and you may already have an IRA account. The thing that you need to check for each of those accounts is whether they are self-directed and if they allow for real estate investments. Even if it’s self-directed, some accounts limit where you can invest your own money. If your account is not self-directed or does not allow for real estate investments, then you can roll that money over to an account that is self-directed or that allows for real estate investments. Sometimes you will be charged a fee or penalty to make the transfer, but it’s usually minimal. If you’re able to roll your money into the right type of account through the same company, then you may be able to avoid those fees.
If you’re starting from scratch, then you need to decide where to set up your account and what type of account to set up. The most common is a self-directed Individual Retirement Account (SDIRA).
You can also set up a company, like an LLC and set up your SDIRA through your LLC. That’s very simple to do in most states.
We have established relationships with SDIRA and financial firms that specialize in this very strategy. They have minimal fees and were created specifically for you. If you’re interested in having a conversation with them, please let our team know and we can make the connection for you.
Types of Accounts
Another advantage of using a self-directed retirement account to invest in tax liens and deeds, rather than using a personal bank account, is that taxes can be deferred the same way the original retirement account was set up.
There are two primary IRA accounts that you can choose from; traditional IRA accounts and Roth IRA accounts.
The difference between the two accounts is the point in time where the investor is taxed. Contributions to Roth accounts are made with after-tax assets, all transactions within the IRA have no tax impact, and withdrawals are usually tax-free.
Contributions to Traditional IRA accounts are made on pre-tax assets. All transactions and earnings within the IRA have no tax impact, and withdrawals at retirement are taxed as income.
Roth accounts have become popular because you are not taxed on the growth made in the account, whereas with traditional accounts you are taxed when you pull the money out of the account but you are not taxed before putting the money in the account.
Let’s compare some numbers so you understand what that means.
For simplicity’s sake, let’s assume that the investor has an annual income of $60,000 putting the investor in the 22% tax bracket, making $1,154 each week before taxes, and $900 after taxes.
If the client were investing into a Traditional SDIRA, then they could invest before taxes are pulled, so they could invest from the $1,154 amount. Let’s assume that they want to invest $100 from every paycheck, so the new taxable income would be $1,054, and their check after taxes would be $822.
Using a simple retirement account projection calculator, assuming the investor is 30 years old, pulling the account at 67 for retirement, continuously invests $100 each week, and makes an annual return on money of 10 percent, then the account’s value at 67 years old would be $1,863,932.
The investor would also be in the top income bracket due to the large amount of money being pulled that will count as income, so the investor would pay 37 percent of $1,863,932, or $689,655, leaving the investor with $1,174,277.
If the investor was investing into a Roth SDIRA then they would invest their after-tax dollars into their retirement account, and it would grow tax free. Using the same numbers as before, the investor’s check would be $1,154 before taxes, and $900 after taxes. The investor would then invest $100 every week, so their final amount kept would be $800. The difference in money kept each week by the investor is $22, $1,144 a year, or $42,328 over the 37-year period that we are considering.
Using the same calculator and assumptions, the investor would end up with the same amount in the retirement account at retirement: $1,863,932. The difference this time is that the investor already paid taxes on the money, and the growth within a Roth IRA is not taxable, so the investor pulls the $1,863,932 from the retirement account and is not responsible to pay any taxes on that amount.
The net positive, after considering the $42k in lost income over the $37 year period is $647,327. The investor keeps $647,327 that they would have had to pay in taxes!
Pretty amazing, right?
When setting up your account with the custodian, make sure to have an open dialogue to discuss which option is the best one for your situation, but most people opt for a Roth IRA… because money.
Once you have set up your account, you will need to fund the account. The investor is limited to the amount that he or she can contribute to the account every year, unless the investor is rolling over money from another retirement account. Once the investor has funded the account and has checkbook control, the investor can make investments in the name of their LLC.
When an exit occurs on the real estate investment, the money is put directly back into the IRA account and cannot be held by the individual investor. Because the investor never takes that money into personal accounts, the investor is not taxed like normal income. If the investor holds the money, then it’s possible that money will be counted as pulled from the retirement account early and the investor will need to pay taxes or penalties on the amount held out of the account. Make sure to follow the rules and avoid fees and penalties. It’s not difficult to do.
The investor then continues that process of making investments over and over through their self-directed IRA, depositing the money directly back to the IRA, and then reinvesting over and over to maximize the return.