GDNIP Ep2: IRA 101 Everything You Need To Know About Self-Directed IRA

Our topic is regarding self-directed IRAs or Individual Retirement Accounts.

We should call it IRAs 101.

We’ll be discussing holistically what an IRA is and some methods of how it can be used in investing, including investing in mortgage notes. Gail, I’ll let you take it away.

This is IRAs 101. IRAs in our business have been routinely called the single best instrument for building wealth. I hope by the end of this episode, you’ll understand the reasons why. First, a little disclaimer. Chris and I are not financial experts. We are going to talk about our understanding of IRAs. Our experience managing our own IRAs. What people have told us about IRAs but of course, as with anything else, we don’t know your particular situation and we might not know exactly what we’re talking about. Be sure to take what we say as a suggestion that you will then take to your financial professional and get real advice about your specific situation and needs. With that said, let’s talk from the very beginning. IRAs came out when I was a very young working person. We were all gathered into a conference room one day. We were told we should have IRAs. At the age of 22, I had no idea what they were talking about. I did not understand the point at all, but I’m glad I took their advice and started one. Those were the traditional IRAs. Shortly after, there were other IRAs introduced.

Let’s start with the basics. An IRA is a retirement account that allows you to put away money tax-free. Money that you can take out in retirement. It lets you reduce your taxes on your current income by taking some of your income out of the equation and putting it over here into an account. A traditional IRA hopefully if you keep adding to it and you have good investments, it grows. You’ll have a nice pile of money by the time you retire. When you retire and take it out, that’s when you pay the income tax. The big advantage is that you’re saving on taxes now by taking some of your income out of the equation and off your tax return. You’re stashing it in this account and then when you’re retired and in theory your tax rate is much lower, you pay taxes when you take it out then. You save a lot on taxes because your income is lower.

People may be wondering this. They may have a job with 401(k) and maybe thinking, “I’ve got a 401(k) that’s my retirement plan.” They can also have an IRA, correct?

I don’t know and I’m going to let you talk about 401(k)s because the funny thing about you and me is we are in some ways opposites. You have a real job. I’m a freelancer. You have access and you have corporate experience where you’ve dealt with a company about an IRA or a 401(k). I’ve never had that. I’ve always just been out here on my own. I want you to do a whole riff on 401(k)s. I want to learn about it too.

Self-Directed IRA: With IRA, you pay taxes when you take your money out during retirement. You save a lot on taxes because your income is lower.

For our audience, if you do have a 401(k) with your employer, it doesn’t stop you from having an IRA as well. I want to throw that out there so people that are thinking, “I don’t need to learn about IRAs because I have a 401(k).” IRAs are allowed to happen.

The next thing that happened in the IRA, the great history of IRAs is that Roth IRA came out. There was a certain amount of excitement, “We have an IRA where you don’t get to put the money in tax-free. You pay the taxes and put it in an account.” All of us who were sold on the first concept regarded that as like, “What is the benefit of that?” The way Roth IRAs work is that you pay the taxes when you put the money in. Then you never pay taxes again on that money. The reason it didn’t ring any excitement bells with me is because at the time I was like everybody else I was just, “My money was in mutual funds.” Things were fairly quiet and the growth was very slow and not much happened.

It didn’t seem like there was any benefit to be paying taxes now at my higher tax rate when I’m working versus paying them later when I’m retired. A funny thing happened to me. It dawned on me that the real beauty and perfection of a Roth IRA is that in the real estate world, where you can have fast growth in the value of your account, you can start with a small amount of money. By being clever, grow it into a lot larger pile of money. Anybody who has a strategy that will let them exponentially grow their money in an IRA should absolutely be in a Roth IRA because you’re going to pay taxes on the relatively small amounts of money that you put in. Then when it grows, no taxes on all that growth.

I remember seeing a chart that floats out on the internet that shows money invested at a taxable income versus tax-free growth. The exponential growth of not having to pay taxes on money is insane. The overall growth with not paying your tax bracket is money continues to compounding interest it gains. It’s mind-blowing when you actually look at it.

I can tell a story about my own experience that will put this into context for people. I don’t want anyone to feel like that these concepts are too complicated and hard to wrap your mind around. I’ll just talk about the first note I bought. I’ll probably tell this story in more detail. The first note I bought was a little house in Flint, Michigan. I owned the note for nine weeks. I was a novice note investor. We had gotten in touch with the borrower. We had found out she was eager to start paying again. Her husband had been injured at work, but he had just gotten a big settlement from a workman’s compensation case and they were a year behind paying their mortgage. They said to us, “We’re going to bring it up-to-date. We might even pay it off. We might even put a big chunk of money down.” That was exciting. These conversations were happening and then all of a sudden, she goes dark. We have no idea what’s going on. We can’t reach her phone. It rings and nothing’s happening. We find out a little bit after that, that nine weeks after I bought this note, I bought it at the end of December, the last day of the year and this was on March 8th that her house burned to the ground. That was a very sad and terrible situation. It didn’t turn out to be bad because she was very delighted with the outcome in terms of the situation financially that put her in.

What happened to me was I had insurance. I had $25,000 of insurance. I had paid $15,000 for the note and she owed about $40,000. The worst that was going to happen to me was I put down $15,000 and I was going to get $25,000. What turned out was that she had insurance. She had full insurance on her house like twice what I was told the house was worth. I heard the house was worth $55,000. She had $110,000 worth of insurance. The other thing that was funny and strange about it was that she was not paying her mortgage. She was not paying her taxes but she was paying her insurance. Then lo and behold, the house burns down. The insurance company did not seem to think that that was at all strange or something they should think about. We certainly did. What happened was I got a full pay out of the money owed on the mortgage, plus some costs I’d had along the way. I got $42,000. I paid $15,000. In a matter of weeks, I turned a $15,000 investment into a $42,000 gain. $27,000 was the profit. It was in my Roth IRA so I never have to pay taxes on that.

Anybody who has a strategy that will let them exponentially grow their money in an IRA should absolutely be in a Roth.CLICK TO TWEET

If you use the rule of a third, you would end up paying $9,000 in taxes, which you didn’t have to pay that stays. Then that $9,000 that isn’t being paid in taxes, you can reinvest that money to have that continue to grow.

I started out with about $85,000 in my Roth IRA through experiences like this and within fifteen, sixteen months, it’s up to almost $130,000. That shows you that with a good plan and a good Roth IRA and how fast things can happen.

Things can happen quickly and the sun is definitely shining brightly on your plan. There are also some no-noes involved with investing with a self-directed retirement account.

We didn’t talk about self-directing yet. You’ve decided to have an IRA or maybe you already have an IRA. Even if you have a traditional IRA where you get the tax deduction when you put the money in, you can switch it to a Roth IRA. You will have to roll it over and pay the taxes. Then you’re up and running with your Roth IRA. Let’s talk about what happens in the normal world when people have IRAs. People set up IRAs usually because their accountant tells them to, or their company tells them to. They hear on the news that Social Security is not going to keep you going in retirement and you need to have your own money. Typically, people will set up IRAs and the investments they think they can make in it are typically the ones they make without an IRA, mutual funds, stocks, bonds and things like that. Why do people invest in those things, Chris?

I would say for liquidity so you can get in and out if you wanted to. Also most people, because that’s what they’re told to invest in.

They don’t even know that can invest in other things like real estate, all kinds of real estate. You can flip a house in your IRA. You can own an apartment building in your IRA. You can do tons of things in IRA. You cannot invest in stamp and coin collections. You can’t invest in insurance products. I’m not sure why that is.

You also cannot use it for personal use. You also can’t perform any work on the property yourself. You can’t or a family member can’t go put a new roof on it or take an income property and renovate it to make it nice. You can hire people to do that but physically, you can’t be affiliated.

There are prohibited transactions and there are prohibited people. The prohibited people are the people in your up and down family tree; your parents, your grandparents, your children, your grandchildren. The non-prohibited people are your cousins, aunts and uncles, siblings, those people. You can’t do deals with any of those people.

Self-Directed IRA: The biggest group of people who want to have self-directed IRAs are people who invest in real estate.

If you were, I would still recommend talking to your advisor.

Self-direction. Your next big choice after traditional IRA or Roth IRA is, “Do I want to have it? Do I want to have an IRA at Fidelity or at Vanguard? Do I want to have one that’s under my control?” If you want to where you’re calling all the shots, where you’re saying, “I want to invest. I want to buy whatever.” Someone told me they cashed in their IRA to buy rare books. That does not sound like a great idea. You can’t buy rare books in your IRA. You can buy precious metals. I’m pretty sure you can make private loans to other people. Not anyone, not your parents, grandparents, kids, grandkids, but your siblings, friends, associates. You can make private loans to them to do flips or do real estate. The biggest group of people who want to have their IRAs under their own control, that’s called self-directed, where it’s all up to you what happens with the money. The biggest group of people who want to be self-directed are people who invest in real estate. Would you agree?

I would and most of those people and speaking to custodians who manage these accounts for people likeQuest IRA mentioned that the majority of people who self-direct typically invest in mortgage notes because of how passive it is. You’re the bank or being a hard money lender where you’re lending the money. Because when you have property, if you’ve ever owned property that is a rental, you still have the tenants, toilets and termites to deal with possibly. A lot of people prefer keeping things passive. A big avenue that people go down are the notes.

That’s true because when you do real estate in your IRA, there are very strict rules about what you can and can’t do. If you buy a house with your IRA, you are never allowed to stay in it. You’re not allowed to clean it out when you first buy it. You’re not allowed to decorate it. You can’t hang curtains, you can’t do anything. It’s very strange. You have to act like it’s full of toxic gas. If you go anywhere near it, you will die.

The other component too is when people go to the self-directed route, to acquire real estate can get extremely expensive. To buy a decent property and a decent area, people will look towards alternative investments within real estate as well.

Where you can work with smaller amounts, particularly when you’re young and you don’t have a lot of money in your IRA. As a landlord, you can buy rentals in your IRA. You can’t do any work on them yourself. You can’t manage them yourself. You can collect the rent. You can’t paint, neither can any of your prohibited people. Stay away. If you don’t have enough to buy the apartment building just with your IRA, there are a few lenders who will make loans to people who want to buy real estate with their IRA. Your IRA money can be the downpayment. You can take out a loan to have a mortgage on it, but then there are very specific rules that come into play. One of them is that the rents you get that you have involved alone, which we call leverage. You have a leveraged asset in your IRA, then the income from that so the rents from your apartment building would be taxable. Subject to a tax called UBIT.

As the captain of the ship, you have to be totally aware of everything you're allowed and not allowed to do.CLICK TO TWEET

It gets very complicated. Pensco is the name of a company that does provide those loans. One of the things that are interesting with the loans is they are non-recourse, which means that the lender can’t go back after you personally.

They can’t take any of your IRA.

They just take the property back. Typically, the downpayment requirement is much heavier. Usually, it’s around 40% downpayment and just because they want to make sure if there is a downturn in the market, you still got an equity stake in that and that they’d be covered if it should ever default.

The term is shorter. I don’t think you can get a 30-year non-recourse loan the way you could for a home that you’re buying yourself. Probably the interest rate is higher. They don’t make it easy. I hope this conversation is telling everybody, “If I’m going to consider doing this, I need to talk to somebody about all the details.”

I wouldn’t recommend somebody to get a self-directed IRA in the first investment would be buying a property where you’re also getting financing. It’s similar to starting out as a real estate investor and your first property you’re going to do a fix and flip on is a twelve-unit apartment building.

In the world of self-direction, there are yet more choices to be made. There are a number of very excellent IRA custodians. If you’re not going to have your IRA at Vanguard to buy Vanguard Mutual Funds, which is all you can do with an IRA at Vanguard, then you can go to an independent custodian. The one that we liked best is Quest IRA.

Quest IRA is out of Texas. With Quest IRA, one of the things that has worked with them in the past, I will say I do not have an IRA with Quest. We’ll talk about my retirement because I have a solo 401(k). With Quest IRA, their management and communication and customer service. When you’re dealing with where you’re going to put your money and when you can get in and out of the accounts because it’s not like a checkbook or a bank account that you just can go write a check and cut a check to send it, there are certain forms you need to fill out and everything has to get fairly clearly detailed of any debits and credits within the account.

What you would do if you were using a Quest IRA or one of the similar things is you would either start a new account or you would roll the money over from an existing account. When you do a rollover, it’s very important that you not take possession of the money. You would go to Quest IRA and you would say, “I want to have an IRA with you. How do we do it?” They would lead you through the process. You should know about an IRA custodian. We’re talking about class because among real estate investors, they are somewhat the gold standard of easy to work with, they do tons of real estates. They understand it. One of the nicest things about using a custodian like that is whenever you come to them to say that you want to do a deal, their paperwork and their process is going to help you stay in compliance. In some cases because they’re very knowledgeable, it’s even going to help you figure out whether it’s a good deal for you or not because they’re going to ask you questions. I don’t think they ever say to you, “This looks like a terrible deal.” I know when I’ve tried to get IRA money in the past from an investor for a flip for example like they would review all the numbers. They be like, “Is this realistic that you can renovate for this? I do think you can get this sales price when you’re done.” It’s very intrusive, but I think at the end we should all be grateful that they pay attention.

Self-Directed IRA: The penalties are very high if you do not document or if, for some reason, you mixed personal funds or did a prohibited transaction with your IRA.

They do help but they will also stipulate that they are also not financial advisors and can tell you where you should or should not invest.

I feel like there’s a little bit of catch before you go off the cliff, not entirely. You can’t count on that. That is one option. You go to a Quest IRA or someone like that. There’s another one near me in Philadelphia called CamaPlan that people like a lot. Your choices go with a custodian like that. Then there’s this other choice over here that you will hear discussed as like a highly speculative, dangerous, crazy-minded thing to do. That is having your own checkbook IRA. Where you have an attorney with experience in the IRA space. Set up an LLC for you. Give you a custodian who is the ongoing watchdog over your account. Then you go open a bank account and your local bank with your LLC paperwork and your EIN which you have, which is your identification number from the IRS for your entity, for your LLC. You open the bank account and then the custodian will take your money from wherever it is and will move it into that bank account.

From that point on, you will also have for the LLC an operating agreement that explains that although this looks like a normal company, it’s a special purpose LLC that is an IRA. You will not need to pay any taxes on anything that happens. At that point, once this is all set up, it’s just you and your checkbook. No one is looking at every deal you’re going to do and saying yes or no. Giving you, making you wait to give you the disbursements of money to buy a note or to buy a property or whatever you want to do. It’s a very interesting situation. I personally have two accounts like that, a Roth and a regular IRA. It’s not for people who aren’t good with the details because you, as the captain of the ship, have to be totally aware of everything you’re allowed and not allowed to do. It’s totally on you.

The penalties are very high from what I’ve heard if you do not document or if for some reason you mixed personal funds or if you did a prohibited transaction within your IRA. It’s my understanding from what I’ve heard and listened to many people that you get whacked. You get taxed on everything and penalties included.

What can happen is tax, penalties and then they can say your IRA is not IRA anymore. It’s gone. You have to pay tax and penalties on everything that’s in it if that’s the way it is. Yes, it’s a big wrist slap. It’s like a whole-body slam, not a wrist slap. I’ve had these accounts for a while and I’ve been very worried about like, “What if I make a mistake?” I made two mistakes on separate occasions. In one, I received an insurance claim check from the insurance company for a property that I own in my checkbook IRA. The insurance company only has my non-IRA entity name in their file. When they sent me the check, they send it in my non-IRA entity name. It being a busy day and me being a little bit of an airhead at that moment, I deposit it in my non-IRA entity. I thought, “I’ve done it.” Years of doing things correctly will all be lost. I called my custodian choking back tears. He was cool about it. He just said, “Don’t worry about it, but you have to create an affidavit saying what happens. I deposited in the wrong account. It should be in this account. I moved it into the right account. End of story.” You take that document to a notary and you sign it and you keep it in your paperwork. In case the IRS wants to review what happened with your account.

When we were talking about rollover with the IRAs and stuff, I wanted to make one comment in regard to that. It’s somebody who we mentioned earlier who came from the corporate world when you do ever switch jobs and you have 401(k). One of the things you can also do is because typically you’re told you can leave it in the current plan, which may be a Fidelity or Vanguard or roll it into your new company. You do have the ability to roll it into your own IRA as well and then get it self-directed if you so choose.

What do you mean as your own IRA? What would that be? A company that you created?

If you start saving for retirement at a younger age and let it start compounding and growing, it makes a big difference.CLICK TO TWEET

It would be like self-directed. Say I was working for ABC Company for ten years and I had $50,000 in a 401(k) or a $100,000. Then I switched jobs to go work for XYZ Company. When I did that shift, my retirement plan in that initial company, I could take that and call up Quest and say, “I’ve got $50,000 in a 401(k). I’d like to move it and self-direct it to invest in real estate.” People think that building an IRA, which does have limits on how much you can put per year has its limitations. If you’ve been in the workforce and have money in a 401(k) and you switched jobs, that money could be made available to invest and self-directed. With your current employer, I’ve never seen a plan where they let you take money from that plan to shift it out. When you switch, the first thing the new HR people are going to tell you is put it in our company because there are fees getting paid. I’m not sure if they get a piece of the pie as well or whatnot or if they get a fee. Another avenue for people who are out there thinking, “I can’t have an IRA or get one,” here are many options and ways to get money invested in real estate if we went that self-directed route.

Can you take money out on 401(k) and put it in an IRA or do you have to start an IRA separately from?

You’d have to start one separately. I work for a company and say if I didn’t have an IRA, I could start an IRA along having the current 401(k). If I was to ever leave my current employer, the money that I’ve grown within their 401(k) plan, I could take that and move it into my IRA that I have to grow that. As long as I personally didn’t take the money, I shift it from the retirement plan to the next. It allows people to then take those funds to self-direct versus putting it into your new company’s plan, which is Fidelity or Vanguard, which will give you the mutual funds or whatever their only investments that you can invest in.

I never had a 401(k) but I’m starting to feel like I want one. Is it possible for you to talk about 401(k), the features are compared to an IRA?

There are two types of 401(k) plans. For those who work or an employee of a company that has a sponsored plan 401(k) plan. It’s through the company or sometimes they may give our contribution match. A lot of companies, if you put in 6%, they may give 3% or less. You do get free money from that. Those plans allow for around approximately $18,000 per year. You can put in tax-free within the account so it’s all pretax so you can fill out a form that allows the money to go in pretax. There’s a second type, which most people aren’t familiar with and that’s called a solo 401(k). What a solo 401(k) is for those who have their own company or do work that does produce earned income such as a consultant, a real estate agent, a fix and flipper. If you don’t have any employees outside of your family, you can start what’s called a Solo 401(k) plan. This is what I have through one of my entities. What that allows you to do is not only invest up to that $18,000, which is the limit. If you have two 401(k) plans, which I technically have, let’s say you work for yourself and you need a retirement plan. A Solo 401(k) plan is the gold standard compared to the IRA because not only can you put your earning in, but the profits from the company also can be contributed.

When I mentioned earlier if you work for a company, they may kick in 2% or 3% to give you a little extra into your plan. A Solo 401(k) plan, they can contribute up to 50% of your income up to a total investment. I think low $50,000 per year. If you were putting $50,000 per year into a retirement account that can grow tax-free. That would be awesome. The few other things that’s nice with the Solo 401(k) plan as well as it’s a checkbook control like some of the checkbook control IRAs, it also doesn’t have some of the tax implications that you have with IRAs in borrowing money and stuff. That’s something I’d say is pushed off to the side because it gets very complex from that standpoint. I wanted to let people know that option is out there. If you’re somebody who is self-employed or having earned income, I strongly recommend you talk to an advisor in regards to what availability you have between an IRA and a solo 401(k).

We have covered a lot of great stuff. I think it’s a good place to stop since we’ve had a lot of things so far. I thought it might be fun to finish with a little bit of jeopardy for you, Chris. I thought you might like to test your knowledge of how prepared your fellow Americans are for retirement. I just looked up some statistics about how much we need in retirement and where everyone’s at so far. As you may have heard on the news, it’s not a pretty sight but the general consensus seems to be that $1 million in your retirement fund would be the minimum to live a dignified life. That doesn’t entail eating dog food for dinner. How are Americans doing, Chris? The average retirement savings of an American family is $95,000, $52,000, $15,000 or $8,000?

Self-Directed IRA: People need to start looking at alternative ways to start saving and getting money growing tax-free.

I believe it’s very low. I go with $8,000. It’s scary from what I’ve heard.

It’s $95,000. This is the average savings. This is putting everybody’s money together. It’s $95,000 and that’s because of a class of people known as Super Savers. We all know people like this. The people who get up and go to the bathroom right before the check arrives. $95,000 is the average because of the Super Savers but what is the median from now? You take the top number and the bottom number and the middle place where most people are. Is it $80,000, $50,000, $10,000 or $5,000?

I’ll go with $10,000.

It’s $5,000. Even though those Super Savers bring the average up for everybody, in reality almost everybody is down in the below $10,000 range.

If you look at it just from the perspective, if you want to retire at 65, which many people can’t do nowadays and people living to approximately 80 years old, fifteen years. If you had the $95,000, say you had that much over fifteen years, that’s about $6,000 a year. That’s $500 a month. It’s not going to get you very far. If you have $5,000 that’s definitely not getting anywhere. It’s scary. People are starting to realize that when the 401(k) came out, when they started shifting away from pension plans, they thought that would be the next savior. A lot of reports are coming out, including those on 60 Minutes with some of the fees that are paid within these plans and some of the returns that are being provided and what are people putting away. People need to start looking at alternative ways to start saving and getting money growing tax-free in these plans to start building some money to have that safety net.

You said $500 a month, we’ll all be going to the restroom before the check arrives. It’ll be at McDonald’s. How sad is that? I’m determined that you’re going to win one of these, Chris. Your performance is sad so far. Here’s your last chance. What percent of families in America have zero retirement savings? Is it 70%, 50%, 30% or 15%?

It’s 50% or higher. I’m going to say it’s between 50% and 70%. Seeing that 70% is so close to my last name. I’m going to have to go with 70%.

The correct answer is 50%. The recommendation is that starting at age 25, you save 15% of your salary every year. That ship has sailed. I don’t know about you. It didn’t happen for me. I looked at my kids, they’re in their twenties. They’re barely hanging on. They cannot save that.

With student loan debt nowadays with the payments that people are making, 15% is very difficult to achieve. You’re starting to see a lot of younger people living at home to save money. If you start saving for retirement at a younger age and let it start compounding and growing, if you start, if you wait until you’re 40 years old, you’re still young but those lost years and the money that could have been put in and starting growing it at that time, it makes a big difference.

The earlier you start, the less you have to save overall. That’s a good point. If you’re not 25 anymore and you don’t have an IRA, don’t be upset. Don’t feel like you’ve missed the boat. Start now. That’s the most important thing. Call your person tomorrow. It’s important. Thank you so much, Chris. This was a great time. We’ll talk more about IRAs. They’re key to what we do and such a great wealth builder. We should talk a lot about it in our upcoming podcasts. Let’s say goodbye. Thanks for joining us, everyone. Go out there and do some good deeds.

Thank you. See you on the next episode of the Good Deeds Note Investing podcast.