Unconventional Investments in IRAs

As a result, people have been hungry for ideas on how to find better potential returns while still keeping the tax advantages of IRAs. And, naturally, lots of planners, advisers, brokers, accountants, attorneys and other folks have been moving to fill the gap.

Here’s how it works

The IRA was first defined by the Employee Retirement Income Security Act of 1974. The law set some strict limits on how much money you could earn and still take a tax deduction for IRA contributions. But the law didn’t place many limits on what you can invest in. In fact, the only limitations on what you can buy in an IRA are these:

• You can’t buy life insurance in an IRA
• You can’t buy art, jewelry or other collectibles.
• You can’t buy alcoholic beverages.
• You can only buy gold and other precious metals that meet certain standards for purity and standardization.

There are also some other rules against self-dealing or using your IRA for your own personal convenience or to enrich certain relatives or fiduciaries advising you on the plan. Other than that, you can own just about anything you can imagine in an IRA, including these popular asset classes:

• Real estate
• Raw land
• Farms and Ranches
• Small, closely-held businesses
• Private lending securities
• Private equity
• Tax deeds and tax liens
• Foreign investments, including real estate
• Commercial property
• Hard money lending and bridge loans
• Mortgages

Currently, only about 4 percent of all IRAs are used to invest in these kinds of assets, via a special arrangement called a “self-directed IRA.” Basically, you hire a third-party administrator to act as a trustee for you and hold your IRA assets on your behalf. Naturally, you pay them a fee to do so. You just identify what you want to invest in, and you provide your administrator with written, specific direction on what you want your IRA to buy or sell on your behalf.

Is it a good idea?

Well, that depends a lot on the individual situation. Allocating a portion of your IRA to these kinds of assets may make sense if you want to diversify your assets away from stocks, bonds and funds. Most of the assets in the categories above are not closely correlated with the major stock and bond indexes, such as the S&P 500. So they can possibly add quite a bit of diversification benefit, as part of a balanced portfolio.

They also may make sense if you have substantial professional expertise and access to a ready market in any of these arenas. If you have been investing in real estate all your life, and you are simply a much better real estate investor than you are at picking mutual funds, and you believe that leverage is your friend, it makes just as much sense to concentrate on real estate inside your IRA as it does outside your IRA.

Things to Be Aware Of

Once you get down to the brass tacks of execution, there are a lot of rules to be aware of. Running afoul of them could cause the IRS to disallow your IRA. This could result in immediate income tax liability and penalties if you don’t watch yourself.

Not every self-directed IRA planner has the same experience. There’s a lot of case law and private letter IRS rulings that affect how you must handle self-directed IRA transactions, and these are not common knowledge, even among many financial professionals. If you get some bad advice from them, it’s still you that will have to pay the price.

Liquidity is a huge issue with these kinds of accounts. Remember, you can only contribute $5,000 in new money to an IRA in any given year. Which means if you own a home in your IRA, but have little cash, and you need to buy a new roof for $30,000, you are in a tough spot. You can only add $5,000 in cash. You will have to borrow the rest.

You can borrow to fund your IRA investments – including purchasing assets, or maintaining them, as long as you don’t borrow from yourself or a related party (as defined by the IRS in Publication 590), and as long as the loan is a non-recourse loan. That means the loan must be secured entirely by the IRA itself.  In practice, you will only be able to borrow about 65 percent of the purchase price of any asset within an IRA. Your IRA will need to put up about 35 percent equity, so you can’t leverage up the same way you can when you buy residential property outside the IRA and cross collateralize.

Also, if you do borrow within your IRA, you will find that your tax-deferred growth isn’t completely tax deferred at all.  Your IRA will be assessed a special tax called an “unrelated debt income tax” or “unrelated business income tax.” This is just a tax assessed on any profits or income to the IRA attributable to non-IRA (i.e., borrowed) money.

The $5,000 window is a very tight one, unfortunately. You can, however, mitigate that by placing these assets in a self-directed SEP IRA account, with a maximum contribution of $49,000 per year or 25 percent of your compensation, (depending on your employment/self-employment status) or a self-directed 401(k) plan.)

If you use any tax-deferred vehicle, though, you also need to be mindful of required minimum distributions (RMD) later in life. You need to be able to start taking actual income out of the IRA by April 1 of the year after the year in which you turn 70½. So if you get caught with a big, indivisible and illiquid asset, such as a house, and not much cash, you could find yourself painted into an RMD corner.

If you are considering using a self-directed IRA, it’s certainly worth making an appointment and discussing it with us in more detail, in the context of your overall financial situation.

Women and Financial Planning

Ok, 95 percent of financial planning is precisely the same for women as it is for men. But the 5 percent that is different for women is pretty important! Here is an overview of the aspects of financial planning that women, especially, should keep in mind. And we’ll look at each in more depth in future articles.

Longevity risk. Things are rapidly changing for the younger generation. Women are attending universities more than men are, these days, and those who have chosen careers have generally attained income parity with men their age. However, there’s a lot of catching up to do. The fact remains that women have historically earned less than men in the work force for a variety of reasons – and yet they have longer life expectancies.

This means that unless they get substantial help from husbands and other family members, women have to make their retirement savings last longer, on average, than men. Conversely, women have a higher risk of running out of savings towards the end of their lives than men do – and have a higher risk of spending many more years in assisted living facilities and nursing homes.

There are no magic bullets for this: Women have to be even more savvy savers and investors than men are, for this reason.

Women also tend to be more conservative in their investing than men. While men tend to be willing to take big risks in pursuit of big rewards, studies show that women are more inclined to seek modest returns, safety and security.

This is very wise of them – safety is important, and men tend to underestimate the risks involved in their investment decisions.  But it also means that in the aggregate, women must save a higher percentage of their savings. It just takes longer to build up a $1 million dollar nest egg saving at a 5 percent rate of return than it does at a riskier 8 percent.

The basic advice we always give, then – stay out of credit card trouble, live on less than you make, buy a reasonably priced home you can afford, maximize your tax-advantaged savings vehicles such as 401(k)s, 403(b)s and IRAs, is even more important for women.

Insurance

One place where women do get a break is on buying life insurance. Their longer life expectancies translates to lower premiums than men – all other things being equal. On the other hand, women may receive lower payouts on lifetime income annuities than men – for the exact same reason.

One technique we may consider is to steer life insurance to companies that publish separate rate tables for men and women, while routing annuity business to companies with joint tables – though for married women, we just use joint life expectancy tables for annuities and it works out just fine.

For medical insurance, a lot depends on your jurisdiction. Some states require all carriers to cover maternity benefits, while in other areas, you have to buy a separate rider for routine maternity care. Pretty much all plans will cover extraordinary medical events arising from pregnancy, such as ectopic pregnancies or other emergency conditions or conditions that present a clear medical problem or life-threatening problem for an expecting mother, requiring extraordinary treatment over and above routine maternity care and delivery.

Just be sure you understand what your plan covers. And if you are planning to have a baby, it generally makes sense to purchase a rider, if your plan doesn’t cover it.

Jurisdictions also vary concerning fertility treatments. Some states require plans to cover it, and in other states you need to shop around.

Social Security

The thing to remember about Social Security is that you have to be married at least ten years to qualify for spousal benefits. So if you’ve been a stay-at-home spouse for 8 years, and the marriage is in trouble, but you haven’t been working, you’re in a tough spot when it comes to social security. If you stay married for at least ten years, you are entitled to a portion of the Social Security benefits your husband earned while working during your marriage. Here’s the Social Security Administration page on Social Security for women, including divorcees, widows, parents, retirees, etc.

Long Term Care Insurance

This is a critical issue for women. Traditionally, women have married older men, and have been around to care for their older husbands in their declining years. But modern medicine is enabling many women to live well beyond their husbands. Modern economies are causing adult children to live far away from aging parents. The traditional family support systems for older women have eroded. Meanwhile, the cost of long term care can be devastating to a widow’s pension and retirement savings. The cost of a full-time nursing home facility can exceed $80,000 per year, and more in some areas. This is where long term care insurance important.

Medicare doesn’t provide more than a token long term care benefit. Medicaid may, but you may have to spend everything you have down to your last $2,000 or so in the world first. Some states exempt certain items.

Long term care insurance is definitely something to consider. Depending on the policy, it pays the costs of home care, adult day care, assisted living facilities, nursing homes and even hospice care. It protects you from having to sign over your family home to Medicaid authorities at the end of your life. It protects your pension income from having to go to the nursing home, and it protects your savings for you.

Some states, including Oregon, have long-term care partnership programs. You buy, say, $200,000 in lifetime long term care insurance benefits, and the state will exempt that much in assets before you are allowed to qualify for Medicaid. It’s a win-win. But long term care insurance may not make sense for the very wealthy, who can self-insure and who are unlikely to need to rely on Medicaid. It also may not make much sense for poorer women, who are likely to be Medicaid recipients regardless, and who need the money they would spend on long term care premiums just to have some retirement income.

On the other hand, it doesn’t make sense to save and save and save all your life – only to have to spend everything you saved on long term care. It’s a very individual decision, and it’s a conversation worth having with a planner.

Divorce Considerations

I hate it that some of our clients go through, or have gone through, this painful process – even when it’s best in the long run. One of the most common mistakes women make, though, is staying in the same unaffordable house for the sake of the children. If you can’t afford the house you’re in, it’s time to accept the inevitable and move on. If the house prevents you from saving your own money, if it causes you to put off saving for your childrens’ education, if it prevents you from forming an emergency fund, or you’re relying on credit cards to pay the grocery bill, then you’ve got too much house. If possible, it’s time to downsize to something you can afford while you get your start as a newly single woman.

The kids will be ok. In fact, they’ll probably be better off, in the long run.

You also need to do a careful debt inventory, as well, prior to getting divorced. It’s no fun getting blindsided by a debt that you forgot about, but you and your husband entered into jointly.

The other thing is to make sure you keep life insurance in place in the event of a divorce. Your marriage may go away, but if you have children, your insurable interest in your spouse doesn’t go away. If you are relying on alimony or child support payments from your ex, you should also look at owning a life insurance policy on him to protect you and your children from financial hardship if something should happen to him. Likewise, if you are taking care of the children, you may want to have a life insurance policy on you to help your ex provide for the children if something happens to you.

These are just a few of the things we look at with our women clients. We enjoy working with women of all ages, both single and married and everywhere in between.

Investing DRIP by DRIP

DRIP Basics

Continuing with our ‘dividend investing’ theme, I’d like to talk a bit about DRIPs. The term “DRIP” stands for “dividend re-investment plan.”  In a recent column, we discussed the concept of stock dividends. In a nutshell, when a company has excess operating earnings, they can choose to reinvest those earnings in the company (by buying inventory, upgrading technology, paying down debt, making acquisitions, etc.), or they can return that cash to the shareholders in the form of dividends.

In their purest form, dividends are paid to shareholders by check, or the equivalent amount of cash is credited to their brokerage accounts.

Companies that offer DRIP plans, however, do something a little different: Instead of sending DRIP participants a check, they will simply credit them with as many shares, or fractions of shares, as their regularly scheduled dividend will buy. DRIP participants generally don’t purchase shares from a broker. Instead, they buy shares directly from the company’s department of investor relations, or from a transfer agent.

Advantages

You can usually start a DRIP plan with a company for a very small amount of money – sometimes as little as a single share. DRIPs can be good for smaller investors, because their dividends may not otherwise be big enough to do anything with: Not enough money to buy more shares with, efficiently, and not enough to make it worthwhile to keep around in a money market fund.

For this reason, DRIP programs can be good for those with smaller accounts, who still want to hold individual securities. They allow a way for very small investors to dollar cost average small amounts of money into company shares, often without having to pay onerous brokerage commissions, which can be very inefficient for very small transactions.

They can also be very good gifts – for example, a grandparent can “gift” a very young child a few shares in, say, Campbell’s Soup. Campbell’s will continue to issue dividends, of course, but the cash will be credited to the child in the form of additional shares or fractions of shares. The parent and grandparent can teach the child the basics of investing through ownership of a company that the child can understand.

If you want to scale up, it is quite possible to build a portfolio consisting of dozens, or even hundreds of companies that sponsor DRIP programs – building up a sizeable investment portfolio, but with generally lower commissions, fees and expenses you would associate with mutual funds and brokerage accounts.

This is a laborious process, though, in practice – so it’s best suited for true DRIP aficionados.

You also have the advantage of a lot more tax planning flexibility than you would get in a single mutual fund. For example, you can manage your exposure to capital gains taxes by selling money losers along with winners, to the extent practicable. Capital losses cancel out gains, thus lowering your capital gains tax bill – a practice known as “tax loss harvesting.”

Disadvantages of DRIPs

Any dividends you receive are taxable – normally as qualified dividend income, if the companies are qualified U.S. companies. This is true, even if you don’t personally receive a check. The company will issue you a Form 1099-DIV, and you must declare this as qualified dividend income on your taxes.

If, instead, you elected a company that didn’t generate dividends at all, but instead reinvested all of its earnings back into the company, you would be able to defer those taxes until such time as the company did issue a dividend (Meanwhile, Uncle Sam still gets a cut if you sell shares at a profit, in the form of a capital gains tax, except in retirement accounts).

As a practical matter, DRIPs don’t function well in IRAs, because you need a formal custodian to hold assets within IRAs. There are ways to do it by opening up a self-directed IRA account with a third-party administrator, but that probably only makes sense as part of a larger self-directed IRA strategy. More on those in a future column!

Those on limited budgets who use DRIPS are also taking on quite a bit of individual security risk. Companies can and do go out of business from time to time, and shareholders can potentially by wiped out. If you don’t want to bet the whole caboodle on one company, there are also mutual funds that accept relatively low minimums, if you commit to a monthly amount in a retirement plan. This will instantly diversify your holdings among dozens, hundreds and even thousands of companies, in some cases – and they will also reinvest your dividends for you in the form of fund shares.

This could be a better solution, depending on your budget, risk tolerance, and overall situation. If you want to know more about either DRIP plans, or options for low-minimum mutual fund investing, please give our office a call. We would love to work with you.