How a Self-Directed IRA Can Jumpstart Your Investing Career
Published August 9, 2017
Don’t think you have the money to invest in real estate? Your IRA could be the answer.
Most people assume they don’t have the funds to invest in real estate, but anyone with an IRA can use their retirement savings to jumpstart their investing career by converting to a self-directed option. While self-directed IRAs do require more time and commitment than conventional retirement accounts, they allow you to build wealth in a way no other option does.
To invest in real estate, you need to have enough money for at least a 20 percent down payment on a property, if not enough to buy it with cash outright. Few people have that much in the bank, waiting to be invested, but if you have an individual retirement account (IRA), you may be able to use those funds to get started, depending on what type of IRA you have.
A conventional IRA allows you to set aside $5,500 ($6,500 if you are over 50) tax free every year for your retirement. The money is invested typically in stocks and bonds, and you are taxed when you withdraw your money. Roth IRAs differ in that you are taxed before you contribute and can withdraw money tax free during retirement.
With these options, your investments are limited. However, a self-directed individual retirement account (SDIRA) allows you to invest in almost anything, including businesses, promissory notes, precious metals, and real estate. The only investments that are off limits are life insurance policies and collectibles.
The basics of SDIRA investing
If you have a conventional or Roth IRA, it’s simple to convert to a self-directed option. Contact the financial institution that holds your account to discuss what needs to be done.
Once you have a SDIRA, you can start investing in real estate. The process isn’t any different at this point than if you had cash in hand: you research investment opportunities and find the property you want to buy. When you do, don’t act. You personally can’t put money down on the property because the SDIRA is the investor. If you do, you disqualify the transaction.
To purchase the property, you need to go to the SDIRA’s custodian, usually the financial institution, and request funds from your account. The custodian writes the check, and you complete the transaction. Although it is cumbersome, the custodian can help you avoid violating IRS regulations.
However, when you have a custodian involved, investing in real estate, which is usually time sensitive, can be difficult. You may miss opportunities because the custodian doesn’t act fast enough (or makes a mistake with the amount of the check, for example), and you won’t be able to buy at auction where you have to pay immediately.
The checkbook IRA
A checkbook IRA can be a good option for some real estate investors who need more flexibility. With this option, also called an IRA LLC, you set up a limited liability company (LLC) within the IRA. You manage the LLC; the custodian manages the IRA. As manager of the LLC, you are in charge of making purchases (real estate investments) within the LLC. Not only does this eliminate the risk of missing a real estate opportunity because you cannot act immediately, but it also reduces custodian fees.
Jason Craig, president of The Entrust Group explains that, “most custodians charge on a per asset basis, so if you own two pieces of real estate in a conventional SDIRA, you will be charged for two assets. However, if you own one LLC, even if it holds five properties, you are charged for only the one asset, the LLC.”
The checkbook IRA does have drawbacks, though. Since you don’t have a custodian in charge of the actual investments, you have to be sure that you are following all of the regulations. Plus, there’s a lot of recordkeeping involved. If you want to be able to manage your own funds within a conventional account without the hassles, hybrid products exist such as the myDirection Card from The Entrust Group. The prepaid Visa card can be used to purchase assets, goods, and services for your IRA without having to go to the custodian first.
The Solo 401(k)
You have a third major option when it comes to self-directing your retirement investments: the Solo 401(k). To qualify, you must either be self-employed or have a small business that has no employees, with a few exceptions such as your spouse.
The Solo 401(k) is set up as a trust, and you would make the investments. Since there is no custodian, you save money in custodian and transaction fees. However, you have to be willing to spend the time to educate yourself on IRS regulations and perform the related recordkeeping. If you are, the Solo 401(k) offers amazing benefits.
First, you can contribute up to $58,000 per year to a Solo 401(k). If your spouse is an employee, you can double that amount for a total of $116,000 per year. The Solo 401(k) also gives you the option to withdraw cash from your account as an unsecured loan of up to $50,000 without penalties as long as you pay it back within five years. (If you take out a secured loan, you have 30 years to pay it back.)
Maximizing your SDIRA's potential
SDIRAs can be used to build substantial wealth, according to Matt Allen, director of IRA lending for North American Savings Bank, but few people use them to their full potential by borrowing money to purchase assets. That means that if you don’t have enough money outright to purchase a property, you can make a down payment and finance the rest of the purchase with a non-recourse loan that is secured by collateral and there is no recourse against the SDIRA owner or the balance of his retirement account.
Mat also says you can use a non-recourse loan to stretch your buying ability and potentially increase your returns that way. For example, if you have enough money to purchase a property outright using the funds in your SDIRA, you can make that purchase and own one property. Or, you can divide that amount into two down payments and take out a non-recourse loan for the balance on the properties. Now, you own two properties instead of one.
You can’t walk into just any bank and get a loan for your SDIRA, though. You have to get a loan through a company that specializes in non-recourse lending, such as North American Savings Bank, says Allen. He warns that you should be careful not to overstretch your funds since you need to be able to make repairs and cover vacancies with the money in your SDIRA (you can’t use your personal funds to finance any purchase related to your SDIRA).
Is a SDIRA right for you?
SDIRAs are a great way to invest in real estate if you don’t have the funds readily available elsewhere, but they aren’t for everyone, especially if you are considering a non-custodial option such as the checkbook IRA or Solo 401(k). If you don’t have the time to educate yourself on IRS regulations or the time to dedicate to making smart real estate investing decisions, a SDIRA may not be the best option for you.