RETIREMENT ACCOUNT SECRETS YOUR BROKER WON’T TELL YOU
Several years ago I was having lunch with some friends and we were discussing what we had each done over the weekend. I mentioned that I had spent the weekend learning how to use my IRA to invest in real estate. One person reacted with, “You can do that? How come nobody ever told me about this?”
Yes, you can use a retirement account to invest in real estate. You can also use it to purchase other assets that produce income.
But your broker won’t tell you. Neither will most financial advisors. Or an employer.
And certainly not the banks, who proudly proclaim they will pay you a whopping 0.5 percent interest on CDs held in an IRA.
It’s not really their fault. They are just trying to make a living. With your money.
Why does it matter?
Because you have the ability to take control of the funds and invest in what you know best.
Nobody cares as much about your money as you do. Or your retirement and your financial freedom.
Financial literacy is not taught in schools. Or in most college curriculums. You can graduate from high school, college, and earn an MBA without taking a single class in personal finance. That’s about eighteen years of formal education without any hint of a financial plan for retirement, not to mention a household budget.
There are some things that you have to find out for yourself. Fortunately there are people willing to help. And each has their own biases and self-interests.
As investors, we tend to be biased toward what has worked for us in the past. Would you agree?
So how do we gain additional knowledge to improve on our past investing results? Where do we turn? Maybe to people who are already successful in the areas we are considering?
THE POWER OF RETIREMENT ACCOUNTS
Retirement accounts can be very powerful. In 2021 there was estimated to be about $13.9 Trillion in individual retirement accounts. That is Trillion with a capital “T”.
Retirement accounts such as 401(k)s are pushed by employers. Pensions are rapidly going the way of the 8-track player. Employers don’t want the risk of pensions and are happy to shift the burden of responsibility to their employees.
Employer matches into these accounts encourage participation and investing early. Investing early and often can lead to significant wealth when given enough time.
The tax code also encourages saving for retirement by providing a tax deduction when funds go into certain Qualified Retirement Plans. Taxes are typically deferred until the money is withdrawn after age 59 ½.
Roth accounts provide a way to grow your investments tax-free. These are some of my favorite retirement accounts.
If you invested $5,000 per year, and it earned 10-percent a year tax-free, how much do you think you would have in 31 years?
Go ahead, take a guess.
If you guessed $1 Million then you are close enough. $1,000,689.
LIMITATIONS OF RETIREMENT ACCOUNTS
While retirement accounts are encouraged by employers, tax code and brokers, there are some limitations that an investor needs to be aware of.
ONE. Limited Choices.
Many, if not most, retirement accounts are started and remain at a custodian which was determined by an employer. Many are also started at brokerage houses such as Vanguard and Charles Schwabb.
Typical investment choices are limited to stock market and bond funds where market swings can wreak havoc on a retirement nest egg.
If your portfolio value drops by 25 percent one year, what return do you need to get the next year to get back to even? If you figured 33 percent then you are correct.
That averages out to a 4-percent return per year. (-25 +33) / 2 = 4. But your total return was 0 percent. Do you see where the math seems strange?
What happens if the stock market drops 25-percent after you retire? Where do you draw income? It can take years to recover from a large market drop. Most people do not want to sell in a down market. And it takes even longer to get your spending power back if you are hit with high inflation.
The IRS does not say what you can invest in. Instead, IRS Publication 590 lists what you CANNOT invest in. The list is relatively short.
With so many choices, why do most retirement plans only offer a few?
A better question might be how can you get more choices?
You don’t have to be restricted to the choices in these plans. You have the option to invest in many opportunities with a few restrictions. You just have to use a custodian that allows true self-direction.
Self-Directed IRAs and other self-directed retirement accounts give you many more options. This allows you to invest in what you know. This could be precious metals or crypto currency. Or real estate.
Where can you invest that will provide a stream of income without selling in a bear market? And increase the income stream during periods of high inflation?
TWO. Taxes
Another downside of certain retirement accounts is how taxes are handled.
Traditional retirement accounts such as 401(k)s and IRAs are taxed at ordinary income tax rates when the funds are withdrawn. If the investment was held outside of a retirement account the earnings could benefit from long-term capital gains tax rates. The lowest of these rates is 0 and the highest is currently 20-percent. It is consistently lower than the ordinary income tax rates and short-term capital gains tax rates. So while the earnings are tax-deferred until withdrawn, the tax rate is likely to be higher.
One of the false beliefs about retirement is that your spending will decrease and you will be in a lower tax bracket. After all, you won’t have to keep contributing to your nest egg. Without earned income you won’t have to pay Social Security taxes. And if you pay off your house there will not be a house payment.
The reality is that spending can increase during your retirement. Especially if you have prepared well. With more time available, there are more opportunities to do the things you planned for in retirement. Such as travel. And health care has many unknowns ranging from the cost of insurance to medications and unexpected illnesses that can drain a nest egg.
If you invested well it is quite possible that your income in retirement will be greater than during your working years. That can put you in a higher tax bracket where you will pay even more to get your money out of a traditional retirement account.
What will happen when you have to start taking Required Minimum Distributions, or RMDs?
One option that I like to use for avoiding the higher taxes of Traditional retirement accounts is a Roth account. With Roth IRAs and Roth 401(k)s the taxes are paid on the funds before they go into the account. So the account grows tax-free.
You can read more about choosing between the two in another blog, “To Roth Or Not To Roth.”
REAL ESTATE STRATEGIES AND RETIREMENT ACCOUNTS
Several real estate strategies can be used with retirement accounts. Some are more management intensive than others. Some are great for building equity, others for cash flow, and some provide both equity and cash flow.
ONE. You can own the property in a Self-Directed IRA Account. This is similar to owning a property outside of an IRA with some caveats. First, all income and expenses go through the IRA custodian to and from your account. Second, you should not do any work on the property yourself or it could be considered a contribution or prohibited transaction. For simplicity, I prefer to have a management company handle properties in my retirement accounts. Third, if you take out a loan on the property it must be a non-recourse loan, meaning you cannot use your personal credit to obtain the loan. Fourth, if you have a loan on the property, then any income is subject to Unrelated Debt Financed Income, or UDFI, tax. This is based on the amount of leverage on the property.
The advantages of owning the property include generating cash flow from rental income and the ability to increase equity through appreciation. As the property increases in value the rental income also tends to increase.
TWO. You can use SDIRA funds to be a private lender for an investor to purchase a property. The investor may be rehabbing and flipping the property. In this case the lender is repaid when the renovated property is sold. Sometimes an investor buys a property, rehabs it, rents it to a tenant, then refinances it with favorable long-term financing. This is called a BRRRR strategy, Buy, Rehab, Rehab, Rent and Repeat.
There are certain advantages to using a retirement account to be the bank for another investor. First, a lender can receive regular interest payments or possibly choose to take all the interest when the loan is paid off. The latter option can sometimes net more interest to the private lender. Second, a lender does not deal with tenants and toilets. Those responsibilities fall on the landlord or property manager.
THREE. An SDIRA can own a percentage of a syndication as a passive investor. This can provide the benefits of owning real estate without the hassles of property management. The general partners are responsible for managing the asset while equity investors have limited liability with regards to their share.
Similar to owning the entire property in an SDIRA, if the property is leveraged then the IRA can be subject to UDFI tax.
FOUR. The SDIRA can be a lender partner in a syndication. Some partnerships are set up that allow for a class of investors that are lenders. They get their returns paid before equity partners get paid. Similar to how other lenders get paid. And they also avoid the UDFI tax liability.
When it comes to using a retirement account to buy real estate some people argue that the property should be bought outside of a retirement plan because you give up so many benefits like depreciation when it is held in an IRA. But that is addressing the wrong question. What really matters is how to get the best return on funds that are already in a retirement account.
CONCLUSION
Retirement accounts have been a popular tool used to prepare for the future. They are encouraged by employers and many brokers. The responsibility of preparing for retirement has been placed on individuals. It is up to each person to prepare for their own financial future by gaining the education needed to invest wisely. Every teacher and investor has their own biases, so be aware of these biases when getting your education and making investment decisions. My personal bias is toward real estate as I have found it capable of providing cash flow through any market while increasing equity and generating higher total returns than other common alternatives.
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Mike is a retired aerospace engineer with a passion for real estate investing and teaching financial literacy. He lives with his wife in Daytona Beach, Florida.