Personal Finance

The Self-Directed IRA: What You Should Know About This Wealth-Building Tool

Expertise: Landlording & Rental Properties, Real Estate Investing Basics, Flipping Houses, Business Management, Personal Development, Mortgages & Creative Financing, Real Estate News & Commentary
208 Articles Written
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Taxes. That simple word makes many of us cringe. We all have a silent partner named Uncle Sam who takes a nice chunk out of every dollar we earn. We have no choice — we have to pay this partner or bad things will happen to us. We can, however, legally shelter some of that income from our silent partner. One way we can do that is to use a self-directed IRA.

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An IRA is an individual retirement account. And almost all of us who have ever worked a regular job have heard of this and at some point had the ability to open an IRA (or a 401K plan, which is similar) through our employer. The IRA was developed as a tool to help people save for retirement. It generally works like this. You deposit a bit of your paycheck every month into an IRA and those funds are then invested and hopefully grow to provide for your later years. To encourage folks to use this tool and save for their retirement, Uncle Sam instituted several IRA income tax incentives. These incentives include the ability to shelter some of your hard earned income and the possibility of tax-free income.

You do not, however, have to be employed in a full-time job or work for a big company to enjoy the benefits of an IRA. Self-employed real estate investors can also get in on the tax benefits of having an IRA. Every individual or small business owner has access to what are called self directed IRAs. And these self-directed IRAs can be a great wealth building tool.

How?

By controlling what the IRA invests in.

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What Exactly is a Self-Directed IRA?

That is the difference between an IRA offered by a large employer and a self-directed IRA that you set up. You control what the IRA invest in. Generally, in an employer-sponsored IRA, you will have a limited number of investment options to choose from. These options usually include stocks, bonds, mutual funds, or even certificates of deposit for the risk averse. Further, your options may even be limited to a particular brand of funds depending on who the custodian of the IRA is. Think Fidelity or Ameritrade here.

Related: How to Grow Your IRA From $5,500 to $204,345 With a Single Rental Property

With a self-directed IRA, however, you direct how the funds are to be invested (hence the name). Thus, the options available to you are wide open (with certain limitations). Not only can you invest in stocks, bonds and mutual funds, but you can also invest in real estate, options and notes to just name a few. In fact, your options are almost unlimited as to what you can invest in. It is up to you and your creativity to find the best and most profitable investments.

And here is the best part; the growth of the investments in your IRA is tax deferred. If you set up a Roth IRA, the growth is tax-free. Think about that. If you invest in a $50,000 property and sell it for $250,000, that growth could be tax-free. If you own a rental property for 20 years and deposit the rental income in your IRA that rental income is not taxed. You can lend hard money and the interest and points you earn may not be taxed. You can also shelter some of your income by depositing the maximum $5,500 ($6,500 if you are over 50) into your account every year.

Sounds great, right? There are, however, some catches.

5 Restrictions of Self-Directed IRAs

There are income limitations.

Uncle Sam will not let high income earners open these accounts. That is usually OK for the average or new real estate investor. But the best advice is set one up now before all of that real estate wealth comes rolling in.

You cannot have material benefit from any of the funds or investments in your self-directed IRA.

That means, for example, if you are a real estate agent and buy a property to put in your IRA, you cannot take a commission. You also cannot pay yourself to manage your IRA’s investments, nor can you live in a property owned by your IRA. Basically, you can’t benefit from the IRA until you retire.

You cannot materially participate in the maintenance of your IRA’s investments.

This can be a tricky one. This means, for example, that you cannot do anything to maintain that rental property in your IRA. You cannot cut the grass. You cannot change a light bulb. You can’t paint, fix up, or repair anything on any property in your IRA. If you do and get caught, you could cause your IRA to lose its status and thus be forces to pay both taxes that would have been owed along with penalties and interest. Instead, you have to hire someone to do anything and everything for you and pay them with funds directly out of your IRA. This can get a bit complicated at times because there are numerous forms to be filled out and time involved in receiving the payments.

You also have to set up the IRA through a proper custodian.

You cannot just go to any bank and open one. There are many custodians out there. They are the folks that will actually hold title to property your IRA buys. They will hold it for your benefit.

You lose the benefits of depreciation.

If you hold real estate in your IRA, you do not get to take the benefits of depreciation to offset other income you may have. However, as I said, you do get the potential benefits of tax-free income and the offset of any IRA contributions.

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Self-Directed IRA Q&As

How much can I contribute per year?

You can contribute up to $5,500 ($6,500 if you are over 50) per year of your earned income. Remember that rental income is passive income, so if that is all of the income you have (as I once did), you cannot contribute anything. This can be a great resource for flippers who get hit with that daunting self-employment tax.

Related: 3 Solid Strategies for Investing With a Self-Directed IRA

Can I get loans in my IRA?

Yes, you can, but you may have a tough time finding someone who will loan to your IRA. Still, there are companies and people out there who will do it. You may also be faced with something called UBIT or Unrelated Business Income Taxes that may or may not make an investment feasible. Talk to your tax advisor on this issue.

Can anyone set one up?

Yes, as long as you meet the income requirements. Talk with your tax advisor to be sure.

Can you co-mingle IRA funds with other investors?

Yes. My wife and I do this on investments we own.

Can I transfer funds from other IRAs into my self directed IRA?

Yes, as long as you have a qualifying event, which is generally separation from a job. If you quit your job, you can usually transfer IRA funds to your self-directed IRA. Just be careful you follow the rules when doing so, and do not expect it to be easy. Your existing IRA custodians will not want to let you go.

Can I have a checkbook and use an LLC in my self-directed IRA?

I have heard good and bad about these two issues, and honestly, these are gray areas. Some custodians will steer you away from these, and others will help set them up. Thing is, we do not know if they are completely legal, as there have been few if any court cases to clarify the law. So if you set one of these up, please tread carefully.

I have found my self-directed IRA to be a pretty good wealth building tool, especially since I was able to consolidate several smaller IRA and 401K plans into it after I quit my full-time job. I can easily see how having this account is really going to pay great dividends as I get older.

Any questions about self-directed IRAs?

Leave your comments below!

Kevin Perk is co-founder of Kevron Properties, LLC with his wife Terron and has been involved in real estate investing for 10 years. Kevin invests in and manages rental properties in Memphis, TN and is a past president and vice-president of the local REIA group, the Memphis Investors Group.

    Paul A. Rental Property Investor from Syracuse NY
    Replied almost 3 years ago
    Another option is the solo 401k- which all the above apply but you can get financing on your property and not pay the UBIT, is that correct?
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied almost 3 years ago
    Paul, you are correct: leveraged real estate inside of a Solo 401k is exempt from UBIT. This, and several other major benefits such as ability to take a personal loan from it, higher contribution limits (up to $59,000/yr), and no need for a custodian and built-in Roth sub-account make it superior to a self-directed IRA.
    Brandon Hall CPA from Raleigh, NC
    Replied almost 3 years ago
    You can contribute up to $53k per year via employer contributions. When you are flipping properties, you are self-employed (i.e. the employer) and can contribute a percentage of your net profits into the IRA for a maximum of $53k.
    Gautam Venkatesan Investor from Dallas, Texas
    Replied almost 3 years ago
    @Brandon Hall, Is that $53K irrespective of the gross income earned that year? For example, if my flipping business grossed $53K this year can all of it go to my IRA effectively meaning I earned $0 from a tax perspective?
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied almost 3 years ago
    No Gautam, there is certain formula you have to apply when calculating your contributions to a Solo 401k. The contributions are based on your net self-employment income and there are two ways you can contribute: 1) Employee Elective Deferrals – up to $18,000 (plus $6,000 catch up for those who are over 50), this can be up to 100% of your earnings. 2) Profit sharing – up to 25% of your compensation. The combine total of two is $53,000 (plus $6,000 catch up for those over 50 or $59,000)
    NA Stevens
    Replied almost 3 years ago
    I thought you can not use SDIRA to fund your own investment? Please clarify.
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied almost 3 years ago
    You can not fund your personal investment, however with self-directed IRA you can make independent investment. If you are making investment in a real property, in this case the owner of the property is not you personally, but your IRA.
    Shan Shan Stevens from Honolulu, HI
    Replied almost 3 years ago
    Thank you for your response. I’m a RN by profession. I’m wanting to open a care home with my friends. I want to transfer my old IRA/401k for the down payment for purchasing a facility. How can I investing without violating the IRS rules or triggering tax liability?
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied almost 3 years ago
    Investing in a business where you are a part owner maybe complicated. Please be sure to consult with an attorney who is practicing in this area of law to ensure that you don’t violate any rules. If you need a referral please PM me.
    Jim Chung from Little Neck, New York
    Replied almost 3 years ago
    thanks
    Julie Schellberg
    Replied almost 3 years ago
    This article doesn’t mention the fees associated with self directed IRA. The fees to hold real estate in one of these account are huge and will eat away your returns (they are a % of the asset).
    Julie Schellberg
    Replied almost 3 years ago
    This article doesn’t mention the fees associated with self directed IRA. The fees to hold real estate in one of these account are huge and will eat away your returns (they are a % of the asset).
    Timothy Friars
    Replied almost 3 years ago
    Julie, would love to see you expand more on this in your own article here. 😉
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied almost 3 years ago
    Julie, some custodians charge a percentage of the total assets they hold for your IRA. Others have flat fees. I suggest you don’t go with a custodian who charges a percentage, you are correct, in this case their fee would continue to increase as you grow your IRA. There are number of custodian who charge a flat fee and are very affordable.
    Frank Sanchez Rental Property Investor from Chicago, IL
    Replied almost 3 years ago
    I’m very curious on the typical fees when using this system. Can someone provide feedback on percentages and annual fees? What other charges are there? Index funds – the best option for equity investments- should remain at 0.20%, retuns could be at 5%/6% pre-inflation including bonds. Thanks
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied almost 3 years ago
    Frank, here is an example of fees from one custodian: https://www.iraservicestrust.com/pdfs/ira-services-fee-schedule-2016.pdf There are many custodians out there and their fees vary significantly. You should contact few different companies and check their fees. What is more important than the fees is the quality of service you can expect to receive and the expert advise. Here is a list of custodian that BP had put together: https://www.biggerpockets.com/rei/self-directed-ira-real-estate/ One other thing to keep in mind, which was not mentioned in the article, is truly self-directed Solo 401k plan. With such setup a custodian is not required so all the custodian and transaction fees are completely eliminated. All of the transactions are done inside of a trust and the account holder has total control over his retirement moneys as plan trustee. The catch is that this plan is not for everyone – only those are are self-employed or own a small business can benefit from it.
    Joan Brown Flipper/Rehabber from Lubbock, Texas (TX)
    Replied over 2 years ago
    Dmitriy, I am interested in setting up a Solo 401K for my Property Management of my rental real estate holdings. As far as I have researched, this is an allowable pathway to getting a Solo 401K – as long as I am actively managing the properties. I am not sure what type of company I need to have, but I think I can have an LLC for the Property Management and the LLC can have a Solo 401K. Am I on the right track? How do I go about getting these entities set up?
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied over 2 years ago
    Joan, in order for you to establish a Solo 401k plan you need to have self-employment income or legitimate business with the earned income. Income from rental properties is considered passive. This link to the IRS website should provide you some clarity: https://www.irs.gov/businesses/small-businesses-self-employed/self-employed-individuals-tax-center Any legitimate business can adopt a Solo 401k plan, it can be an LLC, Partnership, Corporation or just a sole-proprietorship.
    Peter S. Rental Property Investor from Denver, CO
    Replied almost 3 years ago
    How would it work if I have an existing ROTH IRA with Fidelity? Can I purchase RE using that or would I need to convert it somehow to a SDIRA?
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied almost 3 years ago
    Peter, you can not use Fidelity Roth IRA to purchase RE. You need to convert it into self-directed Roth IRA, which will in turn allow you to buy real estate or any other alternative investments in that SD Roth IRA.
    Victor Peluso from Anchorage, Alaska
    Replied almost 3 years ago
    My girlfriend owns a small parcel of unimproved land, in a subdivison with controlled access. The parcels on both sides of hers had cabins built and sold for double and triple what she paid for her land. So would I be able to direct my IRA to loan her the money to build a cabin, with the idea of selling it at a big markup? If so, am I prevented from helping her, furniture staging, minor maintenance, etc, in preparation for sale? Great article, Thanks for sharing Vic
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied almost 3 years ago
    Victor, depending on your relationship and several other factors you may or may not lend to her from your IRA. And if you do – you will be prohibited from personally engaging in the transaction with the activities you mentioned (staging, maintenance, etc.). Feel free to reach out to me and we can chat about this.
    Julie Marquez Investor from Seattle, Washington
    Replied almost 3 years ago
    So with this IRA, or any IRA, you can only gain benefit of the funds when you retire. Is that the government’s retirement age, or my goal of retiring at the age of 48? I want to live off all the passive income of my rental properties, but if they are in an IRA, then I can’t realize the money until I’m 59 1/2? So is this still a good option for me and the goal to live off passive income of rentals?
    Dmitriy Fomichenko Solo 401k Expert from Anaheim Hills, CA
    Replied almost 3 years ago
    Julie, the age at which you can start pulling out distributions from any IRA is 59 1/2, and is set by the IRS. Great goal you have of retiring at 48, to help you achieve that you can’t use tax-deferred accounts for the period from 48 to 60 years of age. But retirement accounts can also be part of your overall wealth building strategy since you will need an income after 60 as well.
    Jeff T. Rental Property Investor from Culver City, CA
    Replied over 2 years ago
    I just wanted to add a note to Dmitriy’s last comment. You can pull distributions from an IRA early but you may have to pay additional tax/penalty (10% I think). The Mad Fientist has a great article about accessing retirement funds early using Roth conversion ladders , SEPP rule 72T equal payments, or just taking the penalty. http://www.madfientist.com/how-to-access-retirement-funds-early/