Usually, we think of Individual Retirement Accounts (IRAs) as a vehicle for pretty standard publicly traded financial assets – stocks, bonds, mutual funds, and occasionally CDs and annuities. But in recent years, people have become increasingly frustrated by the low returns available in conventional financial assets.
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
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.