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.

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.

Bank on Yourself – A Review

In a nutshell, the book’s author, Pamela Yellen, advocates using dividend-paying whole life insurance policies, designed with a small death benefit and funded right up to the “MEC limit” to build up cash value as quickly as possible. You then use the tax-free withdrawals and tax-free loans from the cash value in the whole life policy to supplement your retirement savings, or finance large purchases, such as college tuition and cars, using your policy (and paying yourself back – or not – the loan is secured by the death benefit, so it’s the safest loan any financial institution has going).

The idea, in part, is to become your own bank. You’re financing your large purchases yourself, using your life insurance policy, and paying interest to yourself instead of to a bank or finance company.

It’s not a new idea: I’ve seen the same concept in different forms, from Robert Castiglione’s LEAP to the Infinite Banking concept to Be Your Own Banker. Bank on Yourself seems to be the one that’s had the most success getting broad public buy in at the consumer level  in recent years, though a lot of insurance agents use the LEAP system. And, in fact, before we had today’s large and easily accessible mutual funds, and term life insurance got so cheap, there was a lot of financial planning done using precisely this approach.

So should you use the Bank On Yourself approach? Well, as with so many things in financial planning, the answer is “it depends.”

The system is not a scam, by a long shot. And for certain people, it can work extremely well. It works so well, in fact, that banks themselves frequently use the cash value in life insurance policies as tier one capital on their own books, a concept called COLI, for company-owned life insurance.

But the concept is oversold. Actually, as with so many financial products and services and concepts, it’s undersold to the people who can benefit from it and oversoldto the people who can’t.

You will benefit most from the Bank on Yourself concept if you meet most of these criteria:

1. You want or need a permanent death benefit.
2. You have substantial free cash flow to devote to contributing a lot of premium into your policy
3. That cash flow is from a reasonably stable source. There’s no reason to expect you’ll have to lapse it.
4. You can pay the insurance policy up in full, with no more premiums due, by the time you retire.
5. You have already contributed the maximum allowable to your IRA, Roth IRA or 401(k), or you don’t qualify.
6. You make too much money for your children to be considered for need-based financial aid. Assets in life insurance cash values aren’t counted as parental assets for the purpose of computing need-based financial aid under the federal system.
7. You’re going to need to start pulling money out within the next several years. Life insurance is a front-loaded product. Half your first year’s premium or more will go to paying commissions and fees. It takes years, typically, to reach the breakeven point on non-MEC whole life insurance policies.
8. You own a small business and you can use the cash value as a reserve pool of money. (Historically, farmers frequently used loans from whole life policies to borrow money to plant in the spring, and paid their policy back at the harvest.)
9. You like the tax benefits of the Roth IRA and you want to “go big” with more than $5,000 per year, or as much as you possibly can.
10. You might want to retire prior to age 59½ and want a pool of money you can tap without paying penalties or committing to a Section 72(t) arrangement.
11. Your state provides substantial asset protection to life insurance cash values.
12. You want your assets to bypass probate at your death.
13. You may have a substantial estate tax liability at your death, or the death of your spouse (whichever comes later), and your heirs will need substantial cash liquidity to pay the tax rather than liquidate assets in a hurry.
14. You can do it and still get the death benefit you need to provide adequate protection for your loved ones (very important).

Important: Bank on Yourself and similar programs are not for you if you have trouble swallowing a term life premium to protect your family. Premiums on these whole life policies, when properly funded, will run thousands of dollars every year. You need to contribute to these policies at the same level you might fund a big 401(k).

It’s probably not for you if you consider yourself very risk tolerant, and you think you would prefer a bumpy 8 percent return to a smooth 6 percent.

So this isn’t a very revolutionary idea or anything. It’s really reverting to an older concept, and it’s pretty easy to do: You just need a highly rated whole life policy from a dividend-paying mutual life insurance company (stock companies won’t work) that does not practice direct recognition. (This means you still earn interest and dividends on all your cash values, even if you have borrowed against them. For example, you have $100,000 in cash value. You borrow $25,000 to buy a car at 6 percent interest. But the insurance company still pays you interest and dividends of, say 5 percent on the entire $100,000 you started with – not just on the $75,000 remaining.) Not every company does this. Two obvious examples of companies that do – that are excellent candidates for this kind of planning, include New York Life and Northwestern Mutual.

Downsides: While NYL and NM are both solid, proven dividend payors – as are most mutual life insurance companies, they can’t get blood out of a stone. They rely on treasuries to drive their returns, and yields on treasuries are extremely low. Current policyholders are benefiting from past higher yields. New policyholders should not expect to see the same level of dividend payouts as past generations of policy owners have seen.

I should quibble with some sleight of hand on Yeller’s part, too: She uses the fact that treasuries have outperformed stocks over the last 20 years, when that has nothing to do with expectations of future returns. You cannot expect treasuries to continue their past performance over 20 years if the same 20 year treasuries started 20 years ago with yields of 8 percent and now have yields of 3 percent.

Furthermore, Yellen uses the DALBAR study, which we refer to in a recent update, to note that the average investor only saw a return of 3.49 percent annually, for the last 20 years, once you took investor behavior into account. But this is sort of a cheesy metric: The 20 year returns on stocks are much better than what the typical investor will experience – and if you’ve made it this far into the article, and you use a financial planner (like me) you probably aren’t the “typical investor.”

The bottom line: This kind of planning has its place. But it also banks on Congress continuing to grant life insurance the same benefit of tax-free buildup of life cash value and tax-free withdrawals of dividends and tax-free loans. If the rules change, this is going to be tough to unravel.

Our approach, as with everything else, is to balance and diversify. I like this concept for the right people, with a portion of the portfolio – and frequently the portion you devote to safety. Whole life cash value is very stable.

But I don’t advocate using this concept for everything you do. Hold an IRA. Get some money in equities, annuities, and your own small business. Diversify, diversify, diversify.