Private Lender Consider an IRA for your Financial Risk Management Tool Belt

Consider an IRA for your Financial Risk Management Tool Belt

By |2019-01-07T17:53:26+00:00January 7th, 2019|IRA Approach, Private Lender|0 Comments

Originating loans from a self-directed retirement plan can earn tax-advantaged income for your golden years.

Incorporating familiar private lending practices into an individual retirement account (IRA), 401(k) or other tax-advantaged savings vehicles can give you true control over your retirement, while limiting your exposure to undue dangers.

The same origination practices you use for your day-to-day income or personal savings can be adopted by your retirement plan. For example, on behalf of your individual retirement account, you may qualify potential borrowers, make final decisions on terms such as interest rates or loan duration, and oversee the generation of final paperwork in virtually the same way you normally would. The beauty of lending your individual retirement account money lies in your ability to adopt your tried-and-true lending model and maintain the tax benefits of your retirement account, all without incurring additional risk for the privilege.

With pretax accounts like traditional IRAs, SEP IRAs or 401(k)s (in some cases), plan holders can defer contributions from income for tax purposes and, hopefully, pay lower taxes on distributions down the road. Post-tax accounts such as Roth IRAs task holders with paying full income taxes on their contributions, but qualified distributions at retirement time can be 100 percent tax-free. In the meantime, year-to-year earnings within either account type would be completely tax-deferred.

Exploring a new edge in your investment approach would seemingly open you up to other challenges or threats, especially when navigating IRS regulations in pursuit of tax benefits. Reward tends to come at the expense of risk, but that’s generally not the case when lending your retirement money as compared to lending your non-retirement money. Your individual retirement account can enjoy tax-deferred or tax-free earnings by originating private loans, produce a model for your long-term financial well-being, and do it all without carrying additional risk.

IRA Tool Belt

Collateral Treatment

The risks involved with a “private lending IRA” are consistent with those inherent to note investing in general. Securing a loan with collateral is a common security mechanism available to individual retirement account and non-IRA investors alike, though doing so with an individual retirement account would involve a few nuances:

  • Any collected collateral would belong to your individual retirement account. // If your borrower defaults on a loan issued by your IRA, any collateral involved in the transaction becomes the property of the individual retirement account (as the individual retirement account would be the “lender” and wronged party in this instance) and not of you personally. In addition to private notes, self-directed retirement plans can hold real estate, equity positions (public or private) and any other such property. They can even hold physical precious metals if they meet purity requirements set by the IRS. Gold must be at least 99.5 percent pure (except for American Eagle coins, which are IRA-eligible but don’t meet the minimum), silver must be at least 99.9 percent pure, and platinum or palladium must be at least 99.95 percent pure. Any such assets may be requested as collateral, and if received, would be titled in the name of your account in the same manner as the original note.
  • IRAs cannot hold collectibles. // Artwork, non-precious metals items (in this context, “precious” applies only to the four metals listed previously), older precious metals items that don’t meet their respective purity minimums, old or rare bottles of alcohol, sports or celebrity memorabilia and other such commodities whose values are determined strictly within a collector’s market are among the limited holdings that a self-directed retirement plan cannot accept. This would not, however, bar you from securing an IRA-owned note with a collectible asset. If you choose to accept prohibited property as collateral on behalf of your account, you would need to arrange for its liquidation so that your individual retirement account could receive the cash balance in its place.

The use of collateral in an IRA-owned transaction demonstrates the key benefit of directing your own retirement—you can tailor the lending relationship to suit your risk tolerance and due diligence requirements. If your primary retirement account is sponsored by your employer or otherwise managed by a third-party financial entity, you’re hoping they have the expertise to assess your needs and mitigate risk on your behalf. Without a personal or direct relationship with your broker or plan manager, this can be difficult to achieve. Some plan managers may be more inclined to disregard risk considerations altogether if they collect commissions, regardless of how your account performs.

 

IRA Tool Belt

 

Security Advantages

Even if you can self-direct a retirement account that holds stocks, mutual funds or other publicly traded equities, you may not have access to the same security options as you would with private lending. You may be able to hedge against a downturn in your stock positions with put options or with ETFs that short-sell a particular index or the market in general—both of which provide opportunities to profit when equity prices fall—but these holdings can be just as susceptible to the volatility that occasionally impacts stocks overall.

With a private lending individual retirement account, you may exercise more control over your hedge strategy in the same way you can over the process in general. If you originate a loan and your borrower offers a piece of property as collateral, you can decide to accept it or request something else. If you’re invested in the Standard & Poor’s 500 index during a market correction but would rather not bet against a turnaround, your choices could be somewhat limited (again, assuming you can self-direct your stock-based retirement plan in the first place). Self-directed retirement not only provides the flexibility to buy, sell or exchange the alternative assets that meet your needs, it also provides the flexibility to dictate the specific composition of those assets.

As a private lender, a potential way you could take advantage of this flexibility and mitigate a loss from default is by reducing your interest rates, encouraging borrowers to pay off lower balances, and offsetting your “losses” with individual retirement account tax benefits. You may not be inclined to leave profits on the table by offering lower interest rates, but you may also conclude that a borrower will be more likely to repay a loan in full if their payments are lower.

By favoring the tax advantages of your individual retirement account income over the immediate benefit of additional earnings, you may be able to tread more safely without sacrificing your bottom line. For example, let’s say your borrower needs $5,000, but you’re not entirely confident that he or she will be able to repay a loan at your typical interest rate of 10 percent. Let’s also assume you pay 25 percent in income taxes and have a traditional individual retirement account that allows you to deduct contributions from your annual income.

  • If you loan $5,000 of your non-IRA money, you could charge your usual 10 percent. This would net you $500, but only if your borrower follows through.
  • If you contribute the $5,000 to your individual retirement account, you’ll save 25 percent ($1,250) in taxes before ever lending a dime. This would allow you to tailor the transaction to your borrower, diminish the likelihood of a default and still enjoy a positive margin. By cutting your interest rate to 5 percent, the individual retirement account strategy would net you $1,500 ($1,250 in tax savings plus $250/5% of $5,000 in earnings) in near-term tax savings and retirement income.

Another IRA-specific tool for managing risk is that you won’t owe taxes (assuming qualified distributions) on pretax contributions, and you won’t have to pay the IRS for an uncollectible asset in the event of a default. Despite your best efforts to prevent such an occurrence, you may be out of luck if you find yourself unable to collect some or all of a loan you issue with non-IRA money.

On the other hand, if you lend your individual retirement account money and experience an unfortunate default, the tax deductibility of your retirement contributions would not be affected. This would apply for traditional IRAs and other such pretax accounts. Let’s look at the previous example using the $5,000 contribution. A loss of that principle would have no bearing on your $1,250 tax deduction. As such, lending money from a self-directed retirement plan can at least help soften the blow of a failed lending relationship.

You also wouldn’t have to worry about any tax ramifications from distributing the worthless note from your account. Withdrawals from pretax accounts are taxed as income under normal circumstances, but that wouldn’t apply if you undergo the proper process for zero-valuing the asset. Individual retirement account custodians may have slightly different zero-value requirements, but they all will likely require your written notification of the defunct loan and supporting documentation from a third-party evaluator.

You may not be able to eliminate risk from your business model, but it can pay to evaluate new ways of implementing your proven investment method. This is especially true when you don’t have to worry about taking on added risk for the privilege of doing so. By originating loans from a self-directed retirement plan, you maintain control of your familiar process and earn tax-advantaged income for your golden years—all while minimizing your potential liabilities as much as possible. ∞

By |2019-01-07T17:53:26+00:00January 7th, 2019|IRA Approach, Private Lender|0 Comments

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