By: H. Quincy Long
How would you like to have tax free income when you retire? Would you like to have the ability to leave a legacy of tax free income to your heirs when you die? The great news is that there is a way to achieve these goals – it is through a Roth IRA.
Historically, because of income limits for contributions to a Roth IRA and for converting a Traditional IRA into a Roth IRA, high income earners have not been able to utilize this incredible wealth building tool. Fortunately, the conversion rules are changing so that almost anyone, regardless of their income level, can have a Roth IRA. But is it really worth converting your Traditional IRA into a Roth IRA and paying taxes on the amount of your conversion if you are in a high tax bracket? For me, the answer is a resounding yes. I firmly believe it is worth the pain of conversion for the tremendous benefits of a large Roth IRA, especially given the flexibility of investing through a self-directed IRA.
For Traditional to Roth IRA conversions in tax year 2009, the Modified Adjusted Gross Income (MAGI) limit for converting to a Roth IRA is $100,000, whether you are single or married filing jointly. However, the Tax Increase Prevention and Reconciliation Act (TIPRA) removed the $100,000 MAGI limit for converting to a Roth IRA for tax years after 2009. This means that beginning in 2010 virtually anyone who either has a Traditional IRA or a former employer’s retirement plan or who is eligible to contribute to a Traditional IRA will be entitled to convert that pre-tax account into a Roth IRA, regardless of income level.
Even better, for conversions done in tax year 2010 only you are given the choice of paying all of the taxes in tax year 2010 or dividing the conversion income into tax years 2011 and 2012. If you convert on January 2, 2010, you would not have to finish paying the taxes on your conversion until you filed your 2012 tax return in 2013 – more than 3 years after you converted your Traditional IRA! One consideration in deciding whether to pay taxes on the conversion in 2010 or dividing the conversion income into 2011 and 2012 is that 2010 is the last tax year in which the tax rates are at a maximum of 35%. Tax rates are scheduled to return to a maximum tax rate of 39.6% in 2011, and other tax brackets are scheduled to increase as well, so delaying the payment of taxes on the conversion will cost you some additional taxes in 2011 and 2012. The benefit of delaying payment of the taxes is that you have longer to invest the money before the taxes need to be paid, whether the payment comes from the Roth IRA or from funds outside of the Roth IRA.
The analysis of whether or not to convert your Traditional IRA to a Roth IRA is a complex one for most people, because it depends so much on your personal tax situation and your assumptions about what might happen in the future to your income and to tax rates, as well as how you invest your money. From my own personal perspective, I make the simple assumption that tax free income in retirement is better than taxable income. I can afford to pay my taxes now (not that I like it), and I would like to worry less about taxes when I retire. I also don’t believe that tax rates will be going down in the future. For me, the decision comes down to whether I want to pay taxes on the “acorn” (my Traditional IRA balance now) or the “oak tree” (my much higher IRA balance years in the future as I make withdrawals).
The way I analyze whether or not to convert to a Roth IRA is to calculate my “recovery period” – that is, the time it takes before my overall wealth recovers from the additional taxes I have to pay on the conversion. If I can recover the cost of the taxes on the conversion before I might need the money in the Roth IRA, then I say it is worth doing, especially since the gains after the conversion are tax free forever. Fortunately, with a self-directed IRA you are in total control of your investments, and the recovery period can be quite short. There may also be a benefit if you are able to convert an asset now that may have a substantial increase in value later.
Using my own situation as an example, I have been planning on doing a conversion in 2010 ever since the passage of TIPRA was announced in 2006. My first step was to immediately begin making non-deductible Traditional IRA contributions. Even though I am covered by a 401(k) plan at my company and earn more than the limits for making a deductible Traditional IRA contribution, this does not prevent me from making a non-deductible contribution since I am under age 70 ½. The main reason I have been making non-deductible contributions to my Traditional IRA is to have more money to convert into a Roth IRA in 2010. The best thing about this plan is that only the gains I make on the non-deductible contributions to the Traditional IRA will be taxed when I convert to a Roth IRA, since I have already paid taxes on that amount by not taking the deduction.
I plan on converting approximately $100,000 in pre-tax Traditional IRA money in 2010. The actual amount converted will be more like $150,000, but as I noted above my wife and I have been making non-deductible contributions to our Traditional IRAs since 2006, so the actual amount we pay taxes on will be less than the total conversion amount. This means that my tax bill on the conversion will be $35,000 if I pay it all in tax year 2010 or $39,600 divided evenly between tax years 2011 and 2012, assuming I remain in the same tax bracket and Congress doesn’t make other changes to the tax code.
To help analyze the conversion, I made some calculations of how long it would take me to recover the money I had to pay out in taxes at various rates of return, assuming a taxable conversion of $100,000 and a tax bite of $35,000. I calculated my recovery period based on paying the taxes with funds outside of the IRA (which is my preference) and by paying taxes from funds withdrawn from the Roth IRA, including the early withdrawal penalty I would have to pay since I am under age 59 ½.
If I pay taxes with funds outside of my Roth IRA and can achieve a 12% return compounded monthly, my Roth IRA will grow to $135,000 in only 30 months, at which point I will have fully recovered the cost of the conversion. A 6% yield on my investments will cause my recovery period to stretch to 60 months, while an 18% yield will result in a recovery period of only 20 months! Of course paying taxes with funds outside of the IRA reduces my ability to invest that money in other assets for current income or to spend it on living expenses. But if I have to withdraw the money from the Roth IRA to pay taxes and the early withdrawal penalty, the recovery period for my Roth IRA to achieve a $39,000 increase ($35,000 in taxes and a $3,900 premature distribution penalty) increases to 50 months at a 12% yield and 99 months for a 6% yield. Paying the taxes from funds outside of my Roth IRA will result in a much larger account in the future also since the full $100,000 can be invested if taxes are paid with outside funds, while only $61,000 remains in the Roth IRA after withdrawal of sufficient funds to pay the taxes and penalties.
I believe that since my IRAs are all self-directed I can easily recover the cost of the conversion (i.e. the taxes paid) in less than 3 years based on my investment strategy. From that point forward I am building tax free wealth for me and my heirs. How can I recover the taxes so quickly? It’s easy! Self-directed IRAs can invest in all types of non-traditional investments, including real estate, notes (both secured and unsecured), options, LLCs, limited partnerships and non-publicly traded stock in C corporations. With a self-directed IRA you can take control of your retirement assets and invest in what you know best.
In my retirement plan I invest in a lot of real estate secured notes, mostly at 12% interest with anywhere from 2-6% up front in points and fees. I also own some stock in a 2 year old start up bank in Houston, Texas which is doing very well, and a small amount of stock in a Colorado bank. As the notes mature I plan on purchasing real estate with my accounts, because I believe now is the best time to buy. In some cases I may purchase the real estate itself and in other cases I will probably just purchase an option on real estate. The bank stock will be converted at the market price in 2010, but when the banks sell in a few years I expect to receive a substantial boost in my retirement savings since banks most often sell at a multiple of their book value. In the meantime, the notes and the real estate will produce cash flow for the IRA, and if I have done my investing correctly the real estate will also result in a substantial increase in my Roth IRA when it sells in a few years.
Note that I have written this article from the perspective of someone who is in a high tax bracket. A lower tax bracket will reduce the recovery period and is an even better bargain, especially if you can afford to pay the taxes from funds outside of the Roth IRA. If you take advantage of the opportunities afforded to you by investing in non-traditional assets with your self-directed Roth IRA, you can truly retire wealthy with a pot of tax free gold at the end of the rainbow.
H. Quincy Long is Certified IRA Services Professional (CISP) and an attorney and is President of Entrust Retirement Services, Inc., with offices in Houston and Dallas, Texas. He may be reached by email at QLong@EntrustTexas.com. Nothing in this article is intended as tax, legal or investment advice.
Can I Have a Roth Too, Please? Yes, You Can!!!
By · CommentsBy H. Quincy Long
Most people want a Roth IRA once they understand the tremendous tax benefits. You do not receive a tax deduction for contributing money to a Roth IRA, but qualified distributions are TAX FREE FOREVER. Essentially the concept of a Roth IRA is that you pay taxes on the “acorn” (the initial contribution) instead of the “oak tree” (the potentially large amount in the Roth IRA after many years of tax deferred accumulation). This is especially beneficial in a truly self-directed IRA, which can invest in real estate, notes, options, private company stock, LLCs, limited partnerships and other non-traditional asset
Unfortunately, there are income limits for contributing to a Roth IRA or converting money from a Traditional IRA to a Roth IRA. For contributions, a married couple filing jointly may not contribute if they have Modified Adjusted Gross Income (MAGI) of more than $176,000 for 2009. For single individuals the MAGI limit is no more than $120,000 for 2009 to be able to contribute to a Roth IRA. The news is even worse if you want to convert assets from a Traditional IRA to a Roth IRA. Whether married or single, you are not eligible to do a Roth conversion if your MAGI is more than $100,000.
For people who exceed these income limits, it might at first appear that they are left out in the cold when it comes to Roth IRAs. Fortunately, this is not actually true. There are at least 3 ways in which a person who exceeds the income limits may end up with a Roth IRA. The key phrase is “end up with” in the preceding statement.
The first method of acquiring a Roth IRA if you exceed the income limits is to inherit one. There is no age discrimination for contributing to a Roth IRA, unlike the Traditional IRA. Anyone with earned income within the limits can contribute. Earned income is generally income on which you must pay Social Security and Medicare taxes. Passive or investment income, including rents, interest and dividends do not count as earned income, but it is not that hard to create earned income. An elderly relative or friend may be able to help in your business in some way, for example, and your payment to them for their assistance would be earned income. They may even be predisposed to name you as their beneficiary in the event of their death.
When a Roth IRA is inherited, the new account owner must take required minimum distributions from the IRA, unless the inheritor is a spouse. Required minimum distributions are not required for the original account owner. However, this does not mean that the balance in the account cannot be invested, and it is easy, at least with a self-directed IRA, to create income which exceeds the yearly required minimum distributions. Even better, if the person who died had a Roth IRA for at least 5 tax years, distributions from the account are tax free, even if the inheritor is under age 59 ½. There is never a 10% premature distribution penalty either, since the distribution is due to death.
A second method to acquire a Roth IRA has to do with excess contributions. Many people do not really know whether their income will exceed the limits when they make their Roth IRA contribution, especially if they contribute early in the year. This is certainly true of self-employed persons. So what happens if you make a mistake by contributing early and it turns out your income exceeded the MAGI limit for the year?
If you take action before your tax filing deadline, including extensions (generally October 15), you can recharacterize the contribution to a traditional IRA as long as you are under age 70 1/2, along with all of the net income attributable (NIA) to the contribution. You may also remove the contribution from the Roth IRA, along with any net income attributable. In this case the only penalty which you might have to pay is on the income attributed to the contribution, not on the contribution itself. If you remove the contribution after your tax filing deadline plus extensions, it is unclear from the regulations whether you must also remove the net income attributable from the Roth IRA. A third choice is to leave the contribution in the Roth IRA and pay a penalty on the excess contribution. In many circumstances this may be the wisest choice.
If you leave the money in your Roth IRA, you are required to pay a penalty of 6% of the amount of the excess contribution for each year that the excess remains in the Roth IRA. For example, if you make an excess contribution $4,000 to a Roth IRA and your MAGI exceeds the limit, your penalty is only $240 for each year the excess remains in the account. This is the penalty regardless of how much money you make in the Roth! Since the penalty only applies for as long as the excess contribution remains in the Roth IRA, you will no longer have to pay the penalty if you qualify for a Roth in a future year and do not contribute or if you remove the contribution. Once you have a Roth IRA, the account may continue to be invested regardless of your current year income.
Finally, in 2010 the $100,000 MAGI limit for converting assets from a Traditional IRA to a Roth IRA is eliminated. Although a person who exceeds the MAGI limit will still not be able to contribute to a Roth IRA, in 2010 and future years anyone may convert assets in a Traditional IRA to a Roth IRA, no matter what their income level. The amount converted is generally added to your taxable income for the year of conversion to extent it exceeds any non-deductible contributions in the account. For conversions in the year 2010 only, however, the person converting has the choice of paying 50% of the taxes on the conversion in 2011 and the other 50% in 2012. You have 3 years to pay taxes on Roth conversions done in 2010!
As I always say, there are worse things than not qualifying for a Roth IRA, such as qualifying for a Roth IRA! Whether by inheriting a Roth IRA, through an inadvertent excess contribution, or by conversion in 2010, even those who are fortunate enough not to qualify for a Roth IRA due to income exceeding the MAGI limit may end up with a Roth IRA. Even a small Roth IRA can be built into a large IRA with careful investing, which means that even the wealthy can have a substantial amount of tax free retirement income.
By H. Quincy Long
Many people probably don’t think too much about how important it is to name a beneficiary for their IRAs. However, as my family recently found out, ignoring this important detail when setting up your IRA can be costly from a tax perspective.
I recently received a distribution check from an IRA of my father, who passed away last year. My father was a very careful planner, so I was quite shocked at his lack of tax planning with his IRA. When setting up his IRA he named his estate as the beneficiary of the IRA (this is equivalent to not naming a beneficiary at all). This meant that when he passed away the estate had to be probated, even though the IRAs were the only assets requiring probate in his estate. IRAs that have named beneficiaries are generally non-probate assets, meaning that they pass directly to the beneficiaries instead of passing through a will. That was the first problem.
The larger problem came because of the lack of choices he left us by naming his estate as beneficiary. In a Traditional IRA, required minimum distributions must begin no later than April 1 of the year after the IRA owner turns age 70 ½. This is known as the required beginning date. My father died before his required beginning date. Since his estate is a non-individual beneficiary, the IRA had to be distributed within 5 years, or by December 31, 2011. If my father had died after his required beginning date without having a named individual beneficiary, the yearly required minimum distributions would have been based on his remaining life expectancy in the year of his death reduced by one for each year following the year of his death.
In contrast, the choices available to our family had my father simply named beneficiaries would have been much more favorable. Assuming my father wanted his wife and 3 sons to split the IRA in the same percentages he listed in the will, he could have named us specifically instead of requiring the distribution to be made through his estate. If the IRA was not split into separate IRAs by September 30 of the year following the year of his death, then required minimum distributions would have been based on the remaining life expectancy of the oldest beneficiary, which was of course his wife. As his wife is a few years younger than he was, this certainly would have been a large improvement over taking the entire IRA over the next 5 years.
Had my father named the 4 of us as beneficiaries specifically, an even better plan would have been to separate the IRAs into 4 beneficiary IRAs with each of us as the sole beneficiary prior to September 30 of 2007 (the year following his death). In his wife’s case this would mean that she could choose to take all the money out within 5 tax years, leave the IRA as a beneficiary IRA, thereby allowing her to take distributions without penalty even if she was under age 59 1/2, or she could have elected to treat the IRA as her own. In the case of his sons, we could have
taken the IRA over 5 years or we could have stretched the distributions over our life expectancy. For example, in my case I could have elected to take the distributions over the next 39 years instead of all at once!
Since I expected nothing from my father’s estate and have no critical need for the funds, I would have taken the longer distribution period. Instead I must add the distribution check to my taxable income for this year, which in my tax bracket means a substantial bite out of the money for taxes. Since I am reasonably good at investing in my self-directed IRAs, having the ability to stretch the distributions out over 39 years would have meant an inheritance of many times what I will end up with after taxes because I had to take it all within 5 years.
The problem is even worse for my father’s wife, who will have an extraordinarily large tax burden this year, since she chose to take her share of the IRA out all at once instead of over a 5 year period. While I am certainly grateful that my father thought of me in his will, simply naming specific beneficiaries would have made his legacy worth so much more to his family.
Don’t let it happen to your family! Review your IRA beneficiary designations, and if you haven’t already done so, name your beneficiaries. Your family will be glad you did.
By H. Quincy Long
Self-directed IRAs and 401(k) plans have been around for more than 25 years, but many people are just now becoming aware of how powerful this idea can be. There are currently trillions of dollars in retirement plans. Do you know how to unlock your own retirement funds as well as the retirement funds of those within your circle of influence for real estate related and other non-traditional investments? Your knowledge of self-directed retirement plans can help make you money now as well as ensuring that you retire in style.
Plans available for self-direction. A lot of retirement wealth is in traditional IRAs and employer sponsored plans. If you leave an employer, the funds in the employer plan can be moved into a self-directed traditional IRA. This includes money rolled over from 401(k) plans, 403(b) plans, 457 deferred compensation plans, and the federal thrift savings plan. Self-employed people may have their own Individual 401(k) plan, which may even include the new Roth 401(k), no matter what their income level. Other employer sponsored plans which can be self-directed are SEP IRAs and SIMPLE IRAs.
The king of all IRAs when it comes to building tax free wealth is the Roth IRA. Even if you do not qualify for a Roth IRA due to income limitations currently, in 2010 the income limitation for conversions from a traditional IRA to a Roth IRA will be eliminated. At that point even the very wealthy will be entitled to have a Roth IRA. This is a great planning opportunity.
How does paying for your child’s education or your health care expenses with tax free income sound? You can even self-direct a Coverdell Education Savings Account (ESA) or a Health Savings Account (HSA), and as long as distributions are for qualified education or health care expenses they are TAX FREE FOREVER. With an HSA you even get a tax deduction for putting the money in!
Perhaps the best news of all is that you may combine your IRAs and other self-directed plans to make non-traditional investments. Even better, you can invest your IRAs with other people’s IRAs or even non-IRA money of people you know. The key element is that you must have your plans administered at a self-directed IRA company like Entrust Retirement Services, Inc.
Make money now. We have all heard that knowledge is power. Your knowledge of self-directed retirement plans can translate into money in your pocket today. How? It’s easy! While it is true that you may not derive a current benefit from your own IRA’s investments, this does not mean that you cannot benefit right now from Other People’s IRAs (OPI). Simply become knowledgeable about self-directed plans by reading books and attending seminars or workshops, then spread the good news!
Entrust has many seminars and workshops to help you and those whose IRAs you want to use to make money for yourself. There are also numerous books on the market explaining the power of self-directed retirement plans, such as Hubert Bromma’s “Investing in Real Estate With Your IRA and 401(k)” which are selling quickly. For more information on seminars and workshops in your area, visit the Entrust website at www.EntrustTexas.com. Even if you don’t have a dime of retirement funds yourself, you can use your knowledge to:
* Borrow other people’s IRA money to do your deals today
* Sell real estate, notes or other non-traditional assets to people’s IRAs
* Make others aware of an opportunity to invest in your business (always be aware of securities laws when raising money)
Anytime you go to a gathering of people, there are most likely millions of dollars available for non-traditional investments in their retirement plans. It is up to you to let people know about this powerful tool, and how they can take some or all of that anemic money and put it to work in a way that benefits both you and them. You will look highly intelligent and will inspire confidence with your advanced knowledge. You owe it to yourself to learn more today. Entrust can help.
Invest your own IRA in what you know best. With all your knowledge of self-directed IRAs, you will most likely want to invest your own retirement funds in non-traditional investments as well. What investments do you know the most about? Almost without exception, you can invest in what you know best with your own IRA. The law contains very few investment restrictions for retirement plans, but most custodians refuse to allow IRAs to invest in non-traditional investments such as real estate simply because they are not set up to handle them. Not true with Entrust!
Entrust self-directed retirement plans are under the same laws as plans at any other custodian or administrator. We are simply more flexible when it comes to administering non-traditional investments in your IRA or other self-directed plan. Entrust clients have used their retirement plans to purchase all of the following and much more: real estate, both foreign and domestic, including debt leveraged real estate, real estate options, loans secured by real estate, unsecured loans, limited partnership interests, limited liability company shares, stock in non-publicly traded corporations, land trusts, factored invoices (including factored real estate commissions), tax lien certificates, foreclosure property, joint ventures, oil and gas interests and even race horse colts! You are limited only by your imagination.
Ignorance may be bliss, but it will not make you wealthy. Use your knowledge of self-directed IRAs to make money now, to help others build their retirement wealth as well as your own, and to retire in the style and comfort in which you would like to become accustomed. Contact Entrust today!
Either a Lender or Borrower Be
By · CommentsBy: H. Quincy Long
Personally, I think Shakespeare had it wrong when he penned this advice in Hamlet: “Neither a borrower nor a lender be; For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry.” Perhaps he may be forgiven for his error, however, since Shakespeare suffered from a lack of the tremendous benefits of a truly self-directed IRA.
Money in self-directed IRAs can be loaned out to any person who is not a “disqualified person.” While this means that you cannot loan yourself or other related disqualified persons money from your self-directed IRA, you can loan the money to anyone else. Loans can be secured by real estate, mobile homes, equipment or anything you like. If you are really a trusting soul, you can even make a loan from your IRA unsecured (although in that case I personally would tend to support Shakespeare’s advice).
First, let’s look at it from the borrower’s perspective. At our office we offer a seminar entitled “Make Money Now With Self-Directed IRAs.” One of the ways you can make money for yourself right now with your knowledge of self-directed IRAs is by creating your own “private bank.” To do this, simply share the news that an IRA can be a private lender, refer people with IRA money to Entrust to open a self-directed IRA, and then borrow their IRA money for your own financing needs.
With private financing the loan terms can be whatever the borrower and the lender agree to within the legal limits. If you know a person who is getting 5% in a “safe” IRA at a bank, and you can offer them 9% secured by a first lien on real estate with only a 70% loan to value, would they be happy with that? Even with a higher interest rate, private financing can work for you. IRA loans can be done quickly and without a lot of fees or fuss, which may mean you can get a deal which might be lost if you had to wait on the bank. This is especially true in distressed sale situations, such as a pre-foreclosure purchase.
From a lending perspective, your IRA can grow at a nice rate while someone else does all the work. In a typical hard money loan, the borrower even pays all of Entrust’s modest fees as well as any legal fees for preparation of the loan documents. True, you won’t hit a home run with lending, unless you are fortunate enough to foreclose on the collateral. But the returns can be quite solid. For example, by making very conservative hard money loans my Mom’s IRA has grown by about 10.5% in one year. This is much better than the amount she was earning in her money market fund before she moved her IRA to an Entrust self-directed IRA.
Even small IRAs can combine with other self-directed accounts to make a hard money loan. My brother recently combined his Roth IRA, his traditional IRA, his wife’s Roth IRA, his son’s Roth IRA, his Health Savings Account (HSA), and 5 other IRAs to make a hard money loan. The smallest IRA participating in this loan was for $1,827.00! Each IRA made 2% up front and 12% interest on an 18 month loan, secured by a first lien on real estate with no more than 70% loan to value.
One thing to avoid in hard money lending is usury. Usury is defined as contracting for or receiving interest above the legal limit. The usury limit varies from state to state, with a few lucky states having no usury limit at all on commercial loans. Some people have the theory of “What’s a little usury among friends?” However, if the investment goes bad and your IRA has made a usurious loan, the consequences of the borrower making a claim of usury could include the loss of all the principal of the loan plus damages equal to 3 times the interest. Some states even have criminal usury statutes. It is best to consult with a competent attorney prior to making a hard money loan to make sure your IRA does not violate any usury laws.
To see how well hard money lending can work, let me give you an actual example. One of our clients made a hard money loan from his IRA to an investor who purchased a property needing rehab. The terms of the loan were 15% interest with no points or other fees except for the attorney who drew up the loan documents. The loan included not only the purchase price but also the estimated rehab costs. The minimum interest due on the loan was 3 months, or 3.75%. The investor began the rehab by having the slab repaired, and before he could take the next step in the rehab process, a person offered him a fair price for the property as is. The investor accepted the offer, and they closed about 6 weeks after the loan was initiated.
From the investor’s perspective, was this a good deal? Yes, it certainly was! True, he was paying a relatively high interest rate for the time he borrowed the money. However, he was able to purchase a property with substantial equity which a bank most likely would not have loaned him money to buy due to the condition of the property. Also, while the interest rate was high, the cost of financing was actually comparatively low. With a normal bank or mortgage company there are fees and expenses incurred in obtaining the loan. Common fees include origination fees, discount points, processing fees, underwriting fees, appraisal fees and various other expenses relating to the loan. On the surface an interest rate may be 8%, but the cost of the financing is actually higher than 8% since a borrower has to pay the lender’s fees in addition to the interest on the loan. Spread out over a lengthy loan term these additional fees do not add much to the cost of the financing. However, if an investor has to pay all of these fees up front and then pays the loan off in only 6 weeks, the cost of the financing goes way up.
In this case the investor’s total loan costs were limited to 3 months minimum interest at 3.75% plus $300 in attorney’s fees for preparing the loan documents. Best of all, the investor walked away from closing with $20,000 profit and no money out of his pocket! Far from “dulling the edge of husbandry” this loan actually made the “husbandry” (ie. the purchase and resale of the property) possible. Incidentally, the purchaser of the property was absolutely thrilled to get the property at less than full market value so that they could fix it up the way that they wanted it.
What about the lender in this case? The lender was also quite happy with this loan. His IRA received 3 months of interest at 15% while only having his money loaned out for 6 weeks. For the 6 week period of the investment, his IRA grew at a rate of approximately 30% per annum! Although his yield was above the legal limit for interest in Texas on loans secured by real estate, prepayment penalties are generally not included in the calculation of usury here, so there was no problem. The investor was happy, the new homeowner was happy, and the lender was happy. Anytime you can create an investment opportunity with a win-win-win scenario, you should.
When I lecture about hard money lending, I ask the audience what they think is the worst thing that happens if you are a hard money lender. Invariably, most people in the audience answer that you have to foreclose on the property. Nonsense! If you are doing hard money lending correctly, the worst thing that can happen is that the borrower pays you back! Unfortunately, this is a common risk of hard money lending. Most hard money loans are made at 70% or less of the fair market value of the property. If you are fortunate enough to foreclose on a hard money loan, your IRA will have acquired a property with substantial equity while the investor did all the work of finding and rehabbing the property!
While it is true that foreclosing on a property owned by a friend may cause an end to that friendship, a properly secured hard money loan will at least not “lose itself” as Shakespeare asserts. In fact, it may lead to substantial profit for your IRA! To avoid losing a friend, simply don’t loan money from your IRA to someone you would feel bad foreclosing on. In order to be a successful hard money lender, you do have to be prepared to foreclose on the property if necessary.
In modern times I believe the proper advice, at least in the right circumstances, is “Either a lender or a borrower be!” You can make more money for yourself right now by borrowing OPI (Other People’s IRAs). Borrowing from someone else’s IRA can even lower the total cost of your financing compared to a conventional loan from a bank or mortgage company, especially on short term financing. From a lending perspective, your IRA can make great returns by being a hard money lender, either through higher than average interest rates or, better yet, through foreclosing on property with equity. You may find that hard money lending from your self-directed IRA is a great way to boost your retirement savings without a lot of time and energy invested on your part.
How the Richer Family Grows Richer
By · CommentsH. Quincy Long
Ira N. Richer, a 56 year old self-employed consultant, his wife, Hope Tobe Richer, Ira’s 51 year old stay at home wife, and their 17 year old son, Will B. Richer are interested in saving money in self-directed accounts at Entrust. How much money can they contribute based on Ira’s $30,000 net earnings from his consulting practice?
Roth and Traditional IRAs
Roth IRA – Anytime from January 1, 2008 through April 15, 2009, Ira and Hope can both contribute to a Roth IRA for 2008. Even though Hope does not earn wages, she can still contribute to a Roth IRA based on Ira’s income, assuming they are married filing jointly for federal tax purposes. Even if he doesn’t claim net earnings from self-employment of over $30,000, Ira can contribute $6,000 into each Roth for 2008 ($5,000 base contribution plus a $1,000 catch up contribution since they were both at least 50 years of age by December 31, 2008). Assuming their son Will has compensation of at least the amount of his contribution, he may also contribute $5,000 to his own Roth IRA for 2008.
Traditional IRA – Ira and Hope could have contributed the amounts described under the Roth IRA into Traditional IRAs, but their total contributions to both their Traditional IRAs and their Roth IRAs cannot exceed the annual contribution limit of $6,000 per person over the age of 50. In this case they elected to put the entire contribution into their Roth IRAs. If neither Ira nor Hope were covered by a retirement plan at work, their contributions to a Traditional IRA would be fully deductible, no matter how much income they earned.
Roth Conversion – If Ira or Hope has money in a Traditional IRA (including a SEP IRA), that money can be converted into a Roth IRA provided that their Modified Adjusted Gross Income (MAGI) is $100,000 or less in the year they do the conversion. Any amount they convert is added to their taxable income for the year, but no penalties are assessed for doing a Roth conversion. Important Note: in 2010 the amount of modified adjusted gross income made by Ira and Hope will not affect their ability to do a Roth conversion. Also, they may split the taxes from the 2010 conversion and pay 50% in 2011 and 50% in 2012. For conversions in 2011 and after, taxes must be paid on the conversion income in the year the Traditional IRA was converted to the Roth.
Work Plans
Ira can also have an employer plan based on his self-employment consulting income. With any of the work plans discussed below, Ira must also cover any other employees under the plan. This may affect which of the plans he chooses for his business. We will assume that Ira has no employees. Having any of the work plans discussed below does not affect Ira’s or Hope’s ability to contribute to a Traditional or Roth IRA, but above certain income levels it will affect the deductibility of a Traditional IRA contribution.
SEP IRA – Ira can choose to have a SEP IRA plan into which he can contribute up to a maximum of 20% of his net earnings from self-employment, or 25% of his W-2 wages if he is paid through a company. Net earnings from self-employment are calculated for SEP IRA purposes by deducting one-half of his self-employment tax from his net profits as shown on Schedule C. The plan can be set up and funded at any time prior to Ira’s tax filing deadline, including extensions (ie. October 15, 2009 if Ira files for an extension). Since Ira’s net earnings from self-employment were $30,000 in our scenario, he can contribute up to $6,000 into his SEP IRA at Entrust (the contribution limit would be $7,500 if Ira were paid W-2 wages from a company instead of reporting his income on Schedule C as self-employment income). If he wants to, in January of 2009 Ira can begin making contributions for 2009 to his SEP IRA.
SIMPLE IRA – Another alternative is for Ira to have a SIMPLE IRA for his consulting business. This type of plan is appropriate for those with lower income levels or for those who have employees and who don’t want to contribute an equal percent into their employees’ retirement plans as they do for themselves. Assuming he had the plan set up by October 1, 2008, Ira can contribute $10,500 of his net earnings from self-employment for 2008, plus an additional $2,500 catch up because he is over age 50 by December 31, 2008. The $13,000 is considered salary deferral and must be contributed by January 30, 2009. Ira can also contribute an additional $900 as an employer contribution by his tax filing deadline, including extensions (ie. October 15, 2009). For SIMPLE IRA purposes, net earnings from self-employment are calculated based on 92.35% of Ira’s net Schedule C income. Ira is considered both the employer and the employee since he is self-employed. The total 2008 SIMPLE IRA contribution is $13,000 in salary deferral and $900 in employer contribution for a total of $13,900. This is an improvement over what he can contribute to a SEP IRA at his income level, but at income levels above around $60,000 (or around $48,000 if under age 50) the SEP is more advantageous, absent other factors.
Profit Sharing/401(k) Plan – The plan into which Ira can put the most money is an Individual 401(k)/Profit Sharing plan. An Individual 401(k)/Profit Sharing plan must be set up by December 31, 2008 if Ira wants to contribute or defer compensation for 2008. In this plan Ira can defer $15,500 plus $5,000 catch up for 2008 out of his $30,000 net earnings from self-employment. Net earnings from self-employment is calculated for Individual 401(k)/Profit Sharing plan purposes by deducting one-half of his self-employment tax from his net profits as shown on Schedule C. In addition, Ira can contribute up to 20% of Ira’s net earnings or 25% of his wages if he is paid by a company into the plan, or $6,000. These contributions must be made by Ira’s tax filing deadline, including extensions. This means that for 2008, Ira can contribute $26,500 into his Individual 401(k) plan with only $30,000 in earned income!
Even better, starting in 2006, Ira’s salary deferral can be a Roth 401(k), which means that he will pay taxes on his salary deferral when he contributes, but will pay NO TAXES when the funds are distributed to him, provided they are qualified distributions. What an opportunity! Although Ira qualifies for a Roth IRA because of his income level, even if he makes too much money to qualify for a Roth IRA he can defer salary into a Roth 401(k). The employer contribution ($6,000 in Ira’s case) is pre-tax, so part of Ira’s withdrawals from the plan will be taxable and the portion relating to the Roth 401(k) will be tax free.
Additional Choices
Besides Traditional or Roth IRAs and an Individual 401(k) plan, SEP IRA or SIMPLE IRA for Ira’s consulting business, the Richer family can also have two other types of accounts. These are the Health Savings Account (HSA) and the Coverdell Education Savings Account (ESA). Like the other accounts they have at Entrust, the HSA and the ESA can be self-directed. Neither of these types of accounts is directly related to how much money Ira earns, although above certain income levels Ira and Hope could not contribute to Will’s Coverdell Education Savings Account.
Health Savings Accounts – Ira and Hope can save on taxes for 2008 by opening a Health Savings Account, or HSA. In order to do this, they have to have a special type of insurance plan, called a High Deductible Health Plan, or HDHP. Just having a plan with a high deductible does not necessarily qualify you for an HSA. Assuming Ira and Hope have a family plan, they can contribute up to $5,800 for 2008 up until April 15, 2009. Because Ira is over 55 years old, he can add a $900 catch up contribution for 2008 in addition to the regular contribution. Ira and Hope can split the contribution into 2 separate accounts or put all of it into one account. Starting in 2007 contributions are no longer limited by the deductible amount, as they were in years past. Even if Ira and Hope have the minimum deductible of $2,200 for a family plan, they can contribute the maximum of $5,800 for the year plus the catch up contribution. Contributions to HSA accounts are tax deductible, and there is no tax on the distributions if the money is used for qualified medical expenses. This truly is the best of both worlds!
Coverdell Education Savings Accounts (formerly Education IRA) – Since Will is under age 18, Ira can put up to $2,000 into a Coverdell ESA for 2008. Ira will receive no deduction for the contribution, but any earnings which are withdrawn for qualified education expenses are tax free. Qualified education expenses include certain expenses for grade school and high school as well as for college.
Summary
For the tax year of 2008, here is the maximum amount of money that the Richer family can put into self-directed accounts at Entrust:
Maximum Contribution
For Richer Family
Ira’s Roth IRA $ 6,000
Hope’s Roth IRA $ 6,000
Will’s Roth IRA $ 5,000
Ira’s Individual (k) $26,500
Ira’s HSA $ 6,700
Will’s ESA $ 2,000
Total $52,200
Assuming all distributions are qualified distributions, the earnings from the Roth IRAs, the Roth 401(k), the HSA and the ESA are tax free forever! This means that the Richers can get richer by investing as much as $46,200 tax free and the balance on a tax deferred basis. All of these accounts can invest in real estate, real estate options, promissory notes, both secured and unsecured, LLCs, limited partnerships, private stock and much more. They can invest individually or in combination with each other. To find out more about these accounts, contact your local Entrust office today!
The Truth About Self-Directed IRAs and Other Accounts
By · CommentsBy H. Quincy Long
There is a lot of confusion over self-directed IRAs and what is and is not possible. In this article we will disprove some of the more common self-directed IRA myths.
Myth #1 – Purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA.
Truth: The only prohibitions contained in the Internal Revenue Code for IRAs are investments in life insurance contracts and in “collectibles”, which are defined to include any work of art, any rug or antique, any metal or gem (with certain exceptions for gold, silver, platinum or palladium bullion), any stamp or coin (with certain exceptions for gold, silver, or platinum coins issued by the United States or under the laws of any State), any alcoholic beverage, or any other tangible personal property specified by the Secretary of the Treasury (no other property has been specified as of this date).
Since there are so few restrictions contained in the law, almost anything else which can be documented can be purchased in your IRA. A “self-directed” IRA allows any investment not expressly prohibited by law. Common investment choices include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, limited liability companies, limited partnerships, trusts and a whole lot more.
Myth #2 – Only Roth IRAs can be self-directed.
Truth: Because of the power of tax free wealth accumulation in a self-directed Roth IRA, many articles are written on how to use a Roth IRA to invest in non-traditional investments. As a result, it is a surprisingly common misconception that a Roth IRA is the only account which can be self-directed. In fact, there are seven different types of accounts which can be self-directed. They are the 1) Roth IRA, 2) the Traditional IRA, 3) the SEP IRA, 4) the SIMPLE IRA, 5) the Individual 401(k), including the Roth 401(k), 6) the Coverdell Education Savings Account (ESA, formerly known as the Education IRA), and 7) the Health Savings Account (HSA). Not only can all of these accounts invest in non-traditional investments as indicated in Myth #1, but they can be combined together to purchase a single investment.
Myth #3 – I don’t qualify for a self-directed Roth or Traditional IRA because I am covered by a retirement plan at work or because I make too much money.
Truth:Almost anyone can have a self-directed account of some type. Although there are income limits for contributing to a Roth IRA (in 2008 the income limits are $169,000 for a married couple filing jointly and $116,000 for a single person or head of household), having a plan at work does not affect your ability to contribute to a Roth IRA, and there is no age limit either. With a Traditional IRA, you or your spouse having a retirement plan at work does affect the deductibility of your contribution, but anyone with earned income who is under age 70 1/2 can contribute to a Traditional IRA. There are no upper income limits for contributing to a Traditional IRA. Also, a Traditional IRA can receive funds from a prior employer’s 401(k) or other qualified plan. Additionally, you may be able to contribute to a Coverdell ESA for your children or grandchildren, nieces, nephews or even my children, if you are so inclined. If you have the right type of health insurance, called a High Deductible Health Plan, you can contribute to an HSA regardless of your income level. With an HSA, you may deduct your contributions to the account and qualified distributions are tax free forever! It’s the best of both worlds. All of this is in addition to any retirement plan you have at your job or for your self-employed business.
Myth #4 – I can’t have a self-directed 401(k) plan for my business because I am self-employed and file a Schedule C for my income.
Truth:You can have a self-directed SEP IRA, a SIMPLE IRA or a 401(k) plan even if you are self-employed and file your income on Schedule C of your personal tax return. With a SEP IRA, you can contribute up to 20% of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C) or 25% of your wages from an employer, up to a maximum of $46,000 for 2008. With the SIMPLE IRA, you can defer up to the first $10,500 of your net earnings from self-employment (calculated by multiplying your net Schedule C income by 0.9235% for SIMPLE IRA purposes), plus an additional $2,500 of your net earnings if you are age 50 by the end of the year, plus you can contribute an additional 3% of your net earnings as an employer contribution. Beginning in 2002 even self-employed persons are entitled to have their own 401(k) plan. Better yet, in 2006 the Roth 401(k) was added, allowing even high income earners to contribute after tax dollars into an account where qualified distributions are tax free forever! With an Individual 401(k) you can defer up to $15,500 (for 2007 and 2008) of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C), plus an additional $5,000 of your net earnings if you reach age 50 by the end of the year, plus you can contribute as much as an additional $30,500 based on up to 20% of your net earnings for2008 (or 25% of your wages from an employer). This means that a 50 plus year old self-employed person can contribute up to $51,000 for 2008!
Myth #5 – Because I have a small IRA and can only contribute $5,000, it’s not worth having a self-directed IRA.
Truth:Even small balance accounts can participate in non-traditional investing. Small balance accounts can be co-invested with larger accounts owned by you or even other people. For example, one recent hard money loan we funded had 10 different accounts participating. The smallest account to participate was for only $1,827.00! There are at least 4 ways you can participate in real estate investment even with a small IRA. First, you can wholesale property. You simply put the contract in the name of your IRA instead of your name. The earnest money comes from the IRA. When you assign the contract, the assignment fee goes back into your IRA. If using a Roth IRA, this profit is tax-free forever! Second, you can purchase an option on real estate, which then can be either exercised, assigned to a third party, or canceled for a fee. Third, you can purchase property in your IRA subject to existing financing or with a non-recourse loan from a bank, a hard money lender, a financial friend or a motivated seller. Profits from debt-financed property in your IRA may incur unrelated business income tax (UBIT), however. Finally, as mentioned above, your IRA can be a partner with other IRA or non-IRA investors.
Myth # 6 – If I want to purchase non-traditional investments in an IRA, I must first establish an LLC which will be owned by my IRA.
Truth:A very popular idea in the marketplace right now is that you can invest your IRA in an LLC where you (the IRA owner) are the manager of the LLC. Effectively you have “checkbook control” of your IRA funds. Providers generally charge thousands of dollars to set up these LLCs and sometimes mislead people into thinking that this is necessary to invest in real estate or other non-traditional investments. This is simply not true. Not only can an IRA hold title to real estate and other non-traditional investments directly with companies such as Entrust Retirement Services, Inc., but having “checkbook control” of your IRA funds through an LLC can lead to many traps for the unwary. Far from protecting your IRA from the prohibited transaction rules, these setups may in fact lead to an inadvertent prohibited transaction, which may cause your IRA to be distributed to you, sometimes with substantial penalties. This is not to say that there are not times when having your IRA make an investment through an LLC is a good idea, especially for asset protection purposes. Nonetheless, you must educate yourself completely as to the rules before deciding on this route. Having a “checkbook control” IRA owned LLC is kind of like skydiving without a parachute – it may be fun on the way down, but eventually you are likely to go SPLAT!
Myth #7 – I can borrow money from my IRA to purchase a vacation home for myself.
Truth:Although the Internal Revenue Code lists very few investment restrictions, certain transactions (as opposed to investments) are considered to be prohibited. If your IRA enters into a prohibited transaction, there are severe consequences, so it is important to understand what constitutes a prohibited transaction.
Essentially, the prohibited transaction rules were made to discourage disqualified persons from dealing with the assets of the plan in a self-dealing manner, either directly or indirectly. The assets of a plan are to be invested in a manner which benefits the plan itself and not the IRA owner (other than as a beneficiary of the IRA) or any other disqualified person. Investment transactions are supposed to be on an arms length basis.
As a result of these legal restrictions, a loan from your IRA or staying at a vacation home owned by your IRA, even if fair market rates are paid for interest or rent, would be prohibited.
Myth #8 – With a self-directed IRA, I can borrow my IRA funds to purchase real estate and then put all the profits back into the IRA.
Truth:When real estate or any other asset is purchased within a self-directed IRA, the money never leaves the IRA at all. Instead, the IRA exchanges cash for the asset, in the same way that an IRA at a brokerage house exchanges cash for shares of stock or a mutual fund. Therefore, the asset must be held in the name of the IRA. For example, if Max N. Vestor were to purchase an investment house in his self-directed IRA, the title would be held as “Entrust Retirement Services, Inc. FBO Max N. Vestor IRA #12345-11.” Since the IRA owns the asset, all expenses associated with the asset must be paid by the IRA and all profit resulting from that investment belongs to the IRA, including rents received and gains from the sale of the asset.
Myth #9 – If my IRA buys real estate, it must pay all cash for the property. An IRA cannot buy real estate with debt.
Truth:An IRA can own debt-financed property, either directly or indirectly through a non-taxed entity such as an LLC or partnership. Any debt must be non-recourse to the IRA and to any disqualified person. An IRA may have to pay Unrelated Debt Financed Income Tax (UDFIT) on its profits from debt-financed property. In general, taxes must be paid on profits from an IRA-owned property that is debt-financed, including profits from the sale or disposition of the property, in the same proportion that it had debt. For a simplified example, if the IRA puts 50% down, then 50% of its profits above $1,000 will be taxable. Although at first this sounds terrible, in fact leverage can be an extremely powerful tool in building your retirement wealth. The same leverage principle applies inside or outside of your IRA – you can do more with debt-financing than you can without it. One client was able to build her Roth IRA from $3,000 to over $33,000 in less than 4 months even after paying the taxes due by taking over a property subject to a debt and selling the property to another investor!
Myth #10 – An IRA cannot own a business.
Truth:A self-directed IRA is an amazingly flexible wealth building tool and can own almost anything, including a business. However, due to the conflict of interest rules you cannot work for a business owned by your IRA and get paid. Some companies have a plan to start a C corporation, adopt a 401(k) plan, roll an IRA into the 401(k) plan and purchase employer securities to effectively start a new business, but this is not a direct investment by the IRA in the business and is fairly expensive to set up. Also, if your IRA owns an interest in a business, either directly or indirectly through a non-taxed entity such as an LLC or partnership, the IRA may owe Unrelated Business Income Tax (UBIT) on its profits from the business. A solution to this problem may be to have the business owned by a C corporation or another taxable entity.
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How to Pay for Education Expenses With Tax-Free Dollars
By · CommentsMany people are under the mistaken impression that a Roth IRA is the only type of self-directed account from which tax free distributions can be taken. However, distributions from Health Savings Accounts (HSAs) and Coverdell Education Savings Accounts (ESAs) can be tax free if they are for qualified expenses. In this article we will discuss the benefits of the Coverdell Education Savings Account and, more importantly, what investments you can make with a self-directed ESA.
Contributions. Contributions to a Coverdell ESA may be made until the designated beneficiary reaches age 18, unless the beneficiary is a special needs beneficiary. The maximum contribution is $2,000 per year per beneficiary (no matter how many different contributors or accounts) and may be made until the contributor’s tax filing deadline, not including extensions (for individuals, generally April 15 of the following year). The contribution is not tax deductible, but distributions can be tax free, as discussed below. Contributions may be made to both a Coverdell ESA and a Qualified Tuition Program (a 529 plan) in the same year for the same beneficiary without penalty.
To make a full contribution to a Coverdell ESA, the contributor must have Modified Adjusted Gross Income (MAGI) of less than $95,000 for a single individual or $190,000 for a married couple filing jointly. Partial contributions may be made with MAGI as high as $110,000 for an individual and $220,000 for a married couple filing jointly. Since there is no limit on who can contribute to a Coverdell ESA, if your MAGI is too high consider making a gift to an individual whose income is less than the limits, and they can make the contribution. Organizations can make contributions to a Coverdell ESA without any limitation on income.
Tax Free Distributions. The good news is that distributions from a Coverdell ESA for “qualified education expenses” are tax free. Qualified education expenses are broadly defined and include qualified elementary and secondary education expenses (K-12) as well as qualified higher education expenses.
Qualified elementary and secondary education expenses can include tuition, fees, books, supplies, equipment, academic tutoring and special needs services for special needs beneficiaries. If required or provided by the school, it can also include room and board, uniforms, transportation and supplementary items and services, including extended day programs. Even the purchase of computer technology, equipment or internet access and related services are included if they are to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in elementary or secondary school.
Qualified higher education expenses include required expenses for tuition, fees, books, supplies and equipment and special needs services. If the beneficiary is enrolled at least half-time, some room and board may qualify for tax free reimbursement. Most interestingly, a Qualified Tuition Program (a 529 plan) can be considered a qualified education expense. If you believe that contributing to a 529 plan is a good deal, then contributing that money with pre-tax dollars is a great deal!
One thing to be aware of is that the money must be distributed by the time the beneficiary reaches age 30. If not previously distributed for qualified education expenses, distributions from the account may be both taxable and subject to a 10% additional tax. Fortunately, if it looks like the money will not be used up or if the child does not attend an eligible educational institution, the money may be rolled over to a member of the beneficiary’s family who is under age 30. For this purpose, the beneficiary’s family includes, among others, the beneficiary’s spouse, children, parents, brothers or sisters, aunts or uncles, and even first cousins.
Investment Opportunities. Many people question why a Coverdell ESA is so beneficial when so little can be contributed to it. For one thing, the gift of education is a major improvement over typical gifts given by relatives to children. Over a long period of time, investing a Coverdell ESA in mutual funds or similar investments will certainly help towards paying for the beneficiary’s education. However, clearly the best way to pay for your child’s education is through a self-directed Coverdell ESA.
With a self-directed Coverdell ESA, you choose your ESA’s investments. Common investment choices for self-directed accounts of all types include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, limited liability companies, limited partnerships, trusts and much more.
With the small contribution limits for Coverdell ESAs, you might wonder how these investments can be made. Often these accounts are combined with other self-directed accounts, including Traditional, Roth, SEP and SIMPLE IRAs, Health Savings Accounts (HSAs) and Individual 401(k) plans, to make a single investment. For example, I combined my daughters’ Coverdell ESAs with our Roth IRAs to fund a hard money loan with 2 points up front and 12% interest per year.
One client supercharged his daughter’s Coverdell ESA by placing a burned down house under contract in the ESA. The contract price was for $5,500 and the earnest money deposit was $100. Since the ESA was the buyer on the contract, the earnest money came from that account. After depositing the contract with the title company, the client located another investor who specialized in rehabbing burned out houses. The new investor agreed to pay $14,000 for the property. At closing approximately one month later, the ESA received a check for $8,500 on its $100 investment. That is an astounding 8,400% return in only one month! How many people have done that well in the stock market or with a mutual fund?
But the story gets even better. Shortly after closing, the client took a TAX FREE distribution of $3,315 to pay for his 10 year old daughter’s private school tuition. Later that same year he took an additional $4,000 distribution. Assuming a marginal tax rate of 28%, this means that the client saved more than $2,048 in taxes. In effect, this is the same thing as achieving a 28% discount on his daughter’s private school tuition which he had to pay anyway!
The Coverdell ESA may be analogized to a Roth IRA, but for qualified education expenses only, in that you receive no tax deduction for contributing the money but qualified distributions are tax free forever. Investing through a Coverdell ESA can significantly reduce the effective cost of your child or grandchild’s education. As education costs continue to skyrocket, using the Coverdell ESA as part of your overall investment strategy can be a wise move. With a self-directed ESA (or a self-directed IRA, 401(k) or HSA for that matter), you don’t have to “think outside the box” when it comes to your ESA’s investments. You just have to realize that the investment box is much larger than you think!
H. Quincy Long is a Certified IRA Services Professional (CISP) and an attorney. He is also President of Entrust Retirement Services, Inc., with offices in Houston and San Antonio, Texas. He may be reached by email at QLong@EntrustTexas.com. Nothing in this article is intended as tax, legal or investment advice.
Option Strategies for Your IRA
By · CommentsMany people would like to buy real estate in their IRAs but have a mistaken belief that they do not have enough money to do so. Nothing could be further from the truth! You may invest in real estate with your IRA without a lot of money in several ways, including partnering with other IRAs or non-IRA money, buying property with debt, or by using one of the most powerful and under utilized tools in real estate investing today – the option.
In this article we will focus on some option basics. First, what is an option? Once consideration for the option is paid, it is the owner’s irrevocable offer to sell the property to a buyer under the terms of the option for a certain period of time. The buyer has the right but not the obligation to buy.
You might wonder why an owner would agree to tie up his property with an option. Advantages to a property owner include: 1) the owner may be able to time his income for tax purposes, since option fees are generally taxable when the option is either exercised or expires (always check with your tax advisor); 2) if the owner needs money, an option may be a way to get money that he doesn’t have to repay, unlike a loan; 3) options are very flexible, and the owner may be able to negotiate an option which allows him to keep the property until a more opportune time – this is especially true of an owner in a pre-foreclosure situation.
Do the paperwork right! Options are extremely powerful and very easy to mess up. Be very specific, clear and complete about all the details. Remember, with options, you have to negotiate for both the option and for the purchase of the property. With a well written option, the following must be, as my old law professor was fond of saying, “patently obvious to the most casual observer”:
a) Who is granting the option? Does it include heirs, successors and assigns?
b) Who is receiving the option? Does it include assignees of the buyer, or is it an exclusive option to purchase by the buyer only?
c) What property is being optioned? Property can be anything, including real estate, a beneficial interest in a land trust, a real estate note or nearly anything else.
d) What is the consideration for the option? Remember, there must be some consideration for the option in the form of money, services or other obligations.
e) How is the option exercised by the buyer? This is one of the easiest things to mess up in an option. If the procedure is not clear for exercising the option, it is an invitation to litigation!
f) What will be the purchase price of the property if the option is exercised?
g) How will the purchase price be paid when the option is exercised? Will it be for cash? Seller financing? Subject to the owner’s existing mortgage?
h) Will the option consideration be credited to the option price or not?
i) When can the option be exercised? For example, does the option holder have the right to exercise the option at any time during the option period, or can the option only be exercised after a specified amount of time?
j) When will the option expire, and under what circumstances? The option should have a definite termination date, but might also include other circumstances under which the option terminates, such as a default under a lease.
k) When it comes time to close, what are each party’s obligations? For example, who pays for title insurance, closing costs, etc? Are taxes prorated?
So what forms do you use? The answer is my favorite as a lawyer – it depends! There is not and cannot be a “standard” option for all purposes. They are simply too flexible. You must decide on a specific use for the option and then, as Shakespeare said, “Get thee to a lawyer!” (Okay, it was “Get thee to a nunnery” but I like it better as revised!).
When you have negotiated an option agreement for your IRA, you have several choices. First, you can let the option expire on its own terms. Sometimes this is the best course of action if the deal is not what you expected, especially if you only paid a small amount for the option.
Another choice is that your IRA could exercise the option and buy the property. Since there are ways to finance property being purchased by your IRA, including seller financing, bank financing, private party financing or even taking over property subject to a loan, this may be a good strategy for your IRA, even if the IRA does not have the cash to complete the purchase. Be aware that if your IRA owns debt financed property, either directly or indirectly through an LLC or partnership, its profits from that investment will be subject to Unrelated Business Income Tax (UBIT). This is not necessarily a bad way to build your retirement wealth, but it does require some understanding of the tax implications.
A third choice which is often employed in the context of self directed retirement accounts is to assign your option to a third party for a fee. Your option agreement should specifically allow for an assignment to make sure that there are no problems with the property owner. This is a great technique for building a small IRA into a large IRA quickly. I had one client who put a contract on a burned house for $100 earnest money in his daughter’s Coverdell Education Savings Account, then sold his contract to a third party who specialized in repairing burned houses for $8,500. In under 1 month the account made a profit of 8,400%, and all parties were happy with the deal! The account holder then immediately took a TAX FREE distribution to pay for his daughter’s private school tuition.
A fourth choice that sometimes is overlooked is the ability to release the option back to the property owner for a cancellation fee. In other words, this is a way for your IRA to get paid not to buy! Let me give you an example of how this might work. Suppose you want to offer the seller what he would consider to be a ridiculously low offer. When the seller balks, you say “I’ll tell you what. You sign this option agreement for my IRA to purchase this property at my price, and we’ll put in the option agreement that I cannot exercise my option for 30 days. If you find a buyer willing to offer you more money within that 30 day period, just reimburse my IRA the option fee plus a cancellation fee of $2,500.” Either way, your IRA wins!
The creative use of options can make your IRA grow astronomically if done correctly. In future articles I will be discussing different types of option strategies.