HOW TO GET MORE FROM YOUR IRA
Boosting Returns and Reducing Risk With a 401(k)
The IRA is a powerful tool. Millions of people are using them to invest for their retirement. They can reduce taxable income now and let your investments grow tax deferred, allowing you to wait and pay taxes later.
But there is something most IRA holders don’t know.
Using leverage can produce gains higher than most people are getting in their IRAs. Some are using real estate to do this by buying rental properties or investing in syndications. The question is not “Whether or not I should buy real estate in my IRA?”, it’s “How can I get the best return on my investment, regardless of whether it is inside or outside of my IRA?”
When taken over longer periods of time, leveraged real estate frequently produces returns greater than those obtained in the stock market. In any given year, the stock market might be up 35 percent, or it might be down 35 percent. But over the long haul, such as the last century for example, the S&P 500 has produced an average return of about 10 percent. Some people are satisfied with that. Others choose to use leveraged real estate for obtaining higher returns.
One downside of using leverage in an IRA is taxes. But there is a solution.
You can use a self-directed 401(k), or Solo 401k.
First let’s look at pros and cons of 401(k)s and IRAs. Then we’ll take a look at how to qualify for a Solo 401(k).
There are several advantages to using a Solo 401(k).
ONE. Assets in a 401(k) can be leveraged without tax liability.
Did you know that IRAs with leveraged assets may be subject to UBIT?
You might be asking, “What is UBIT?”
UBIT is Unrelated Business Income Tax. An IRA that is used to conduct a trade or business is subject to paying UBIT. Wholesaling within an IRA can easily fall into this category. A form of UBIT is Unrelated Debt Financed Income, or UDFI. UDFI generally works like this. If a property is purchased using borrowed funds, taxes would be due on the amount of income generated by the leveraged portion of the investment. So if a property is held in an IRA and leveraged 50 percent, then 50 percent of the gains during the tax year would be subject to UBIT.
Of course, we prefer to avoid UBIT/UDFI taxes, so we seek an alternative way to put our retirement funds to work. This is one reason a Solo 401(k) is superior to an IRA.
TWO. Solo 401(k)s have less risk when it comes to Prohibited Transactions.
Certain transactions are prohibited within retirement accounts. Such as you cannot buy or sell to yourself. Transactions must be arms length and not between disqualified parties. Transactions with your ancestors and descendants are prohibited. So are transactions with your spouse. You cannot invest in collectibles or artwork. The IRS provides a list of the prohibited items in IRS Publication 590.
Most people would not intentionally make a prohibited transaction. But what if you do make a transaction in your IRA that is prohibited? What are the consequences?
One “standard rule” is the IRS imposes a 15-percent penalty tax on the amount of the transaction. This is assessed against the disqualified person. If that person is the owner of the IRA then the entire IRA can be deemed distributed and you must pay taxes on the entire distribution, possibly sending you into a higher tax bracket. If you are under 59-1/2 then you are also assessed an early withdrawal penalty.
What if the IRA was valued at $500,000? What would that do to the value of your IRA? How would it change your financial plans?
What happens if you do a prohibited transaction within a 401(k)?
Liability is limited to the value of the prohibited transaction. Only that transaction is considered distributed from the IRA. You are still subject to the early withdrawal penalty if you are not eligible to take distributions.
Can you see the potential difference if a $100,000 investment was made from a 401(k) valued at $500,000?
THREE. You can borrow from your own 401(k).
You can borrow up to the maximum of the account value, or $50,000.00, whichever is less. And you have up to five years to pay back the loan.
FOUR. CONTRIBUTION LIMITS ARE HIGHER ON 401(k)s.
In 2022 the contribution limit on all of your IRAs is $6,000, or $7,000 if you are age 50 or older. For 401(k)s the limit is $20,500. That will increase to $22,500 in 2023.
HOW CAN I GET A SOLO 401(K)?
You might be wondering how you could have a Solo 401(k) instead of an IRA.
You need to have business income and the business must not have any employees except you and your spouse. If your business is larger, then you may want to look into other forms of 401(k)s that can be self directed that allows all of your employees to participate.
This can be from any kind of business where you pay yourself W-2 income. It could be real estate, such as wholesaling or property management, but not necessarily real estate. It could be a home-based business such as selling stuff online or dog-walking. The point is to qualify with a business that lets you have a self-directed 401(k) account such as a Solo 401(k). Then you are able to transfer funds from a Traditional IRA or old 401(k) to the Solo 401(k).
ICING ON THE CAKE
If all of this sounds good, there is one more step that can make the Solo 401 even better.
If your plan permits it, you can convert Traditional 401(k) funds to Roth 401(k) funds. Taxes must be paid on the amount being converted. This would allow you to make tax-free gains from your leveraged investments. All future withdrawals will be tax-free provided you meet the age requirement or other exceptions for making distributions.
For more information about Roth conversions see another blog, To Roth Or Not To Roth.
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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.