Self Directed IRA

17 Replies

Good evening,

I recently have been looking to get started in real estate investing and now I am up to the stage of finding financing. My father has enough money to finance my deals in his 401k and he's 60 years old. He would be willing to loan me the money in return for an 8-12% return on his loan. His funds would include all rehab costs.

How does he convert his money from a 401k into a self directed IRA and are there any penalties involved or costs for him?

If anyone can provide knowledge or links to explain how this works would be ideal.

Thanks!

Jason: Your father is considered a disqualified person and it would be a prohibited transaction for his IRA to lend you funds.

You can learn more at our web site or you may contact my office staff for more information.

Jaime Raskulinecz

@Jaime Raskulinecz that really sucks. This was my plan. 

Is there no way he can use his funds which are tied up in 401k to get me started?

Originally posted by @Jason Stephens :

@Jaime Raskulinecz that really sucks. This was my plan. 

Is there no way he can use his funds which are tied up in 401k to get me started?

Well, bounce this off of a qualified professional, but he should be able to use his own self-directed funds to do a deal if you are his partner. Just understand that the gain from the sale MUST be returned to his 401(k) including any earnings - neither of you can benefit directly (that would be a "prohibited transaction").

That said, of course, if he has $100K+ in his 401(k) and if his current SPD allows it, he should be able to borrow out up to $50K (or up to half of the account's current value, which ever is less). Then, you pay him back, he pays his 401(k) back and there's no prohibited transaction issue.

Basically, anyone in your direct line of ascendency / descendency  - father, grandfather, son, grandson, etc. - is a prohibited transaction. However, your Dad can invest his self-directed funds in his brother's business, for example, or an uncle's / aunt's / cousin's, ...

Stated another way, "vertically" = no, "laterally" = yes.

Again, bounce this off of a qualified professional - I'm not one.

@Jason Stephens

You could both look into pooling your respective personal and retirement funds into an LLC whereby by your retirement funds an both of you would be deemed members. Of course, to be a member each party will need to invest. What is more, none of you (e.g., you and your dad) can do any of the work on the properties. Simply put, investing both retirement funds and personal funds in an LLC that then invests directly in real estate is possible but specific rules apply and any deviation from the formula will result in a prohibited transaction.

@Jason Stephens

Jaime is correct, what you describe would be considered a prohibited transaction. If you chose to go self-directed route be sure to consult with an experienced professional who will take the time to understand your situation and provide you proper guidance. 

@Dmitriy Fomichenko On the self directed IRA, I understand that you can not do any of the work on the property yourself. Would any certified contractor be able to perform work on the house?

@Rhett Dantzler

sure, you can hire anyone to do the work on the property, as long as the that person is not considered to be a "disqualified". 

Here is the link to the IRS website for details:

http://www.irs.gov/Retirement-Plans/Plan-Participa...

So here is what I have learned, and tell me if I am wrong and also tell me if my plan sounds insane. 

1.  If my Father uses the money for a disqualified party, he has to pay a 15% tax on the money used.  With a 10% return, that would put him at a -5% return on the money.  This makes lending the money within a 401k prohibitive unless he gets a return of 15% +. 

2.  My father recently retired and has a significant 401k, and also a 400k mortgage left on his home that is appraised at $1,000,000.  He had the idea that he wanted to take the money out of his 401k in order to pay down the remainder of his mortgage so he can live stress free and not have to worry about cashflow in retirement. However, he realized he would have to pay taxes on any money that he took out of the 401k which dashed his dreams. 

I thought of a solution that may solve both of our problems.   If the average tax rate is 30%, we can estimate that he will need to pay $90,000 on $300,000 loan.  So if he takes out $300,000 and lets me use it for a flip he will have a $90,000 tax bill.  If he does this in January 2016, he will not have to pay the tax until April 2017.  This would give me over a year to do enough deals that give him the return he needs to cover his tax bill.  If he loans me money at a 12% rate, he would make $36,000 per deal, meaning it would take 2.5 deals for him to free up $300,000 and essentially wash away any tax bill.  He then can use the money to pay down his home mortgage over 2 years.  

Does this plan seem to make sense, and can anyone else find holes in it?

@Jason Stephens

Your understanding of the implications are severely flawed.

If an IRA engages in a prohibited transaction with a disqualified party, the ENTIRE IRA is viewed as distributed and taxed at regular income rates. There are penalties in addition.

Take your father's retirement savings off the table, please, and insist that before he does anything with that significant savings that he speak with a licensed CPA first.

Brian Eastman I am not saying to use the retirement money while it is in his 401k. I am saying cash out , pay the tax and use the flips to recoup the tax money.

you could find an experienced person in your area doing these flips and then your father could loan him or her the monies and you could be on the sidelines to learn how to do what your looking to do. Once you have some experience then there are ways to go about this such as hard money lenders, other non family members loaning out 401k money, etc..  With a bit of experience or knowledge you would be able to complete a project yourself and then building up. 

I am not a CPA 

I love my son an awful lot.  Perhaps almost as much as your dad loves you.  But if he came to me with such a plan - essentially gambling with MY retirement - I'd kindly but gently tell him to think of something else.

You're asking him to take a HUGE risk on deals you don't even have identified yet - and hope like hell that you can turn 3 deals at $36,000 each in a year.

You're just now getting started, so you have NO track record.  If you go through some of the deal diaries and success stories on BP, you'll find a fair amount that are homeruns out of the park, but an even higher number where people make a whopping $6,000 on a $300,000 investment (just read that one today), barely broke even or, as you might suspect, lost a crapton of money.

Flipping houses is hard.  Doing 3 in your first year...  I'm not saying it's impossible, but it's unlikely that your dad will break even on the tax payment.

Please - don't gamble with your father's retirement.  He worked his butt off for that money, I'm sure.  Let that money go.  Work for your own nest egg, then start your investing career. 

Originally posted by @Brian Eastman :

@Jason Stephens

Your understanding of the implications are severely flawed.

If an IRA engages in a prohibited transaction with a disqualified party, the ENTIRE IRA is viewed as distributed and taxed at regular income rates. There are penalties in addition.

Take your father's retirement savings off the table, please, and insist that before he does anything with that significant savings that he speak with a licensed CPA first.

A 15% penalty in Addition to income tax.

@Jason Stephens I can poke holes in your plan. 

In summary, you and your father need to sit down with a CPA separately and then together to understand your options. This situation seems too risky and doesn't align with your father's risk tolerance, considering he expressed interest in taking a withdrawal to pay down his mortgage and live "stress free."

First off, I want to correct your understanding of how to calculate returns. If a 15% tax hit is incurred, a 10% earnings does NOT result in a -5% return. Example: principal of $100k is taxed at 15% leaving $85k to work with. You have a decent year and earn 10% on that money resulting in a $8.5k gain. Ending principal is $93.5k resulting in a 6.5% loss, not 5%.

Second, if your father takes an early withdrawal in the amount of $300k, he instantly jumps to the 33% tax bracket for 2015 (regardless of whether he's single or MFJ). Depending on his other income, his effective tax rate may be anywhere between 25 and 30%. Since your father is past 59 and a half in age, no early withdrawal penalty will be assessed. So I'd say the minimum expected tax liability on a $300k withdrawal is $75k.

That's a huge and completely unnecessary tax bill fraught with risk for your father. I'm all for for parents helping their kids, but not when it means tapping into a retirement account. Additionally, a 12% return is quite poor when adjusting for the risk your father is taking. You should be considering more like 15-18% or the full intention to pay his tax bill at year end plus some.

My other thought is this - it doesn't sound like you've flipped a property before, so inherently there will be a huge learning curve that will cost you time and money. Your budgets will be inaccurate and your expected returns will be lower than expected. It would be a shame to have an unsuccessful flip and have to go to your father and say "well sorry."

Lastly, since you are having to use your father's money and you have no real estate experience, I naturally assume you haven't managed your finances in a way that allows you the capital to invest yourself, so what makes you think you can handle $300k? It may be harsh, but it's likely a true statement.

It's okay to put your real estate dreams on hold while you build up a savings account. Take a job with a builder to further reduce your risk. Learn on someone else's dime. Invest a significant portion of your capital WITH your father to reduce his risk. His situation is way riskier than yours. He needs to understand that and you need to understand that.

I'm all for taking risks that are well thought out and worth the return. This doesn't seem to be one of those risks. It will be a shame to see you father broke in retirement due to a bad deal and ignorance.

Originally posted by @Jason Stephens :

Good evening,

I recently have been looking to get started in real estate investing and now I am up to the stage of finding financing. My father has enough money to finance my deals in his 401k and he's 60 years old. He would be willing to loan me the money in return for an 8-12% return on his loan. His funds would include all rehab costs.

How does he convert his money from a 401k into a self directed IRA and are there any penalties involved or costs for him?

If anyone can provide knowledge or links to explain how this works would be ideal.

Thanks!

I was always told kids are excluded in self directed IRA. You can do deals with brothers and sisters, but parents and kids cannot.

Originally posted by @Ali Brooks :
Originally posted by @Jason Stephens:

Good evening,

I recently have been looking to get started in real estate investing and now I am up to the stage of finding financing. My father has enough money to finance my deals in his 401k and he's 60 years old. He would be willing to loan me the money in return for an 8-12% return on his loan. His funds would include all rehab costs.

How does he convert his money from a 401k into a self directed IRA and are there any penalties involved or costs for him?

If anyone can provide knowledge or links to explain how this works would be ideal.

Thanks!

I was always told kids are excluded in self directed IRA. You can do deals with brothers and sisters, but parents and kids cannot.

Right. As mentioned in other posts, children of an IRA accountholder are disqualified persons with respect to the IRA, making transactions between the 2 prohibited transactions.

@Jason Stephens - your passion and desire are to be commended...

BUT, without wisdom and understanding they will get you in a lot of trouble.

I hope you've taken the sage advice from others on this post.  Please don't dig into your dads retirement, regardless of how wonderful your intentions may be.  

Lastly, did you know that most first time flippers actually lose money on their first flip - and to break even is a big win.  That fact alone significantly changes your assumed returns.

Keep studying, keep learning, keep asking.  You have the potential to invest wisely and become a successful real estate investor.  And if you make a mistake, do it with your own money, not your dads retirement.  

Join the Largest Real Estate Investing Community

Basic membership is free, forever.

By signing up, you indicate that you agree to the BiggerPockets Terms & Conditions.