LetÂ’s face it, whoÂ’s going to care for your money more than you? Nobody, and thatÂ’s why you continue to learn as much as you can about your own personal finances in order to make better choices for your financial future. Thanks to the Employee Retirement Income Savings Act (ERISA) passed in 1974, the 401(k) plan was established and over the last 30 years, millions of so–called “investors†have been born. But our school system has failed to keep up and hasnÂ’t changed since the Agrarian age, which is why we still have summers off for the harvest, and why most people know very little about handling their personal finances. The problem is whether you get straight AÂ’s, straight DÂ’s, go to college or not, everyone has to handle their own finances and plan their retirements. Typically, we are ill equipped to deal with every day money issues. Think back to when you were in school, how many personal finance classes did you have? But who among us says that dissecting frogs in Biology class really came in handy!
So after some school, and clocking in some long hours at a job, youÂ’ve decided to devote your efforts to increasing your own bottom line, and now you are ready to begin investing in real estate. All those years of the company matched 401(k) has built up nicely, and you start eyeing a cash out so you can get your new business off the ground. This is where lack of planning and education can really cost you.
THE CASH OUT NO–NO You can only transfer or cash out your 401(k) when you leave a company and you have no doubt heard of those who cash out their retirement plans, only to be hit with huge penalties and taxes. The IRS levies a 10% penalty and tax liability up to 30% for early withdrawals. ThatÂ’s a hefty 40% off the top that you pay in penalties and fees when going this route. Ouch! But people do it anyway because no one is there to educate and present qualified alternatives.
SELF DIRECTION So how do you control the outcome of your hard earned money without the Tax Man taking a lions share? One answer is rolling your funds over to a Self Directed Individual Retirement Account (SD–IRA). The issues with most brokerages and SD–IRAÂ’s, is they typically only allow you to choose among those investment products that they provide. But in a true SD–IRA, you can invest in many more asset classes than just stock, bonds, and mutual funds.
Using a SD–IRA as an investment vehicle, you can invest in commodities such as silver and gold, private stock offerings, tax lien certificates, commercial paper, Limited Liability Companies (LLC), and real estate, just to name a few. Finding the right IRA administrator or custodian will open these doors for you, just keep in mind that not all brokerages can provide for all asset classes.
WHAT CAN BE DONE? LetÂ’s take a look at a few real–world scenarios:
- Raw land purchased with a direct IRA investment for $50,000 is later divided into building lots and sold on contracts at 12% interest, resulting in monthly tax–deferred profits to the plan that total $350,000.
- Distressed properties can be purchased with rehab costs paid from the retirement plan and can be sold or rented for profit or cashflow.
- Partner with your IRA to create an investment company for real estate projects with an LLC. When the company makes money, you distribute earnings pro–rata and profits go both to you and your IRA. YouÂ’ll need to involve partners because you cannot have 100% ownership of the LLC between you and your IRA.
BUILDING WEALTH TAX FREE Traditional IRAÂ’s allow you to invest pre–tax dollars, and pay taxes on distributions upon retirement. Roth IRAÂ’s allow you to pay taxes now and invest those after tax dollars, and all your earnings are tax free upon retirement. Most of the options are the same within a Self Directed Roth IRA and a SD–IRA. With some good planning it is possible to build a SD–Roth IRA to use as an investment vehicle in real estate, and never pay taxes on your profits.
THE FINE PRINT If you are going to play ball in the big leagues, you need to know what you are doing because proper planning is critical in any business endeavor. Timing is important because transfers and rollovers can take three to six weeks, and LLCÂ’s can also take a few weeks to set up. When directing your retirement plan to invest in Real Estate, you must know which mortgage products are available and when you can use recourse loans and when you can only use non–recourse mortgages. In certain cases, property taxes and related expenses cannot be paid by you and must be paid through the IRA custodian. The IRS also frowns upon prohibited transactions such as direct compensation, use of investment property for personal gain, and transactions with prohibited parties. Investing in real estate or businesses can trigger Unrelated Business Taxable Income (UBTI) and Unrelated Debt Financed Income (UDFI) which have to be accounted for. For these reasons, it is essential to always have a good tax advisor and attorney on your team to consult with on your specific situations.
Taking your financial future into your own hands can be a great opportunity. Just make sure you take the proper steps in educating yourself when you are ready to start building wealth in real estate.
