A self-directed IRA allows you to invest in private, hard and “alternative” assets without
sacrificing the plan’s tax advantages.
The 2018 tax filing deadline has come and gone. Last year was hopefully a prosperous one for you and yours, but a lucrative year for you can also mean a lucrative April for the Internal Revenue Service. A higher tax bill often coincides with a strong period of company earnings, so it’s prudent to consider ways to diminish your tax responsibilities.
Tax-advantaged savings accounts such as IRAs, 401(k)sand health savings accounts have always helped individuals save for retirement. They have also been commonly associated with stocks, mutual funds and other publicly traded equities. In many cases, a person’s retirement account is employer-sponsored and managed by a third-party firm in a manner that prevents the account holder from dictating how their contributions are invested. Others may have the ability to choose their stock positions, but that is where the flexibility ends. By limiting investors to a narrow suite of asset options, some IRA providers expose their clients—and their prospects of a timely retirement—to the dramatic ups and downs of Wall Street.
Many people are unaware that the assets allowed in a retirement plan are decided by the trustee or custodian that holds the plan. The IRS and the Department of Labor have not applied blanket limitations regarding permissible assets (with exceptions, such as restrictions placed on life insurance, collectibles, etc.), but IRA custodians may determine, as individual businesses with the freedom to do so, which assets their investors may purchase with their accounts.
This is where self-directed retirement sets itself apart. Instead of hoping everything goes well on the stock ticker, a self-directed IRA empowers you to invest in private, hard and “alternative” assets as you see fit without sacrificing the tax advantages of your retirement plan. This includes the ability to originate private loans with your retirement dollars through a process similar to that which you may already utilize. As a self-directed IRA holder, you can qualify your potential borrowers and make final decisions on loan durations and interest rates. All payments would be subsequently deposited into your account. Account earnings would be tax-deferred, so you can build a key facet of your financial future without having to oblige the tax man every year.
Whether you choose to issue loans with a self-directed IRA, stick with the stock market or diversify your portfolio to include both strategies, the tax benefits retirement accounts offer are certainly worth thinking about.
Let’s explore some of the more common retirement account types and highlight the nuances that may appeal to you.
Traditional IRAs allow you to defer contributions from your income for tax purposes. You may contribute up to $6,000 in 2019 if you are below the age of 50 and an additional $1,000 if you’re age 50 and above. Keep in mind that you can have multiple accounts of the same or different types. You can also consolidate your retirement accounts via transfer (a movement of funds between similar account types, such as Traditional IRA to Traditional IRA) or rollover (a movement of funds between dissimilar account types with the same tax statuses, such as 401(k) to Traditional IRA).
In exchange for the near term tax benefit that Traditional IRA holders enjoy when making contributions and the long-term advantage of tax-deferred earnings, the IRS will eventually collect taxes on distributions (withdrawals). However, these are designed to occur at retirement age, when the account holder is presumably in a lower income tax bracket. For instance, let’s say you open a self-directed Traditional IRA and make a $6,000 contribution. Let’s also assume you earn $75,000 a year. Your contribution provides an immediate tax advantage by enabling you to deduct the $6,000 from your income, so you would pay income taxes on only $69,000 instead of the full $75,000.
Now let’s say you issue a short-term loan of the $6,000 at 10% interest on behalf of your Traditional IRA. Your account would have $6,600 at the end of the loan, and you would not have to pay any taxes on the $600 because you used a self-directed retirement account. You would only pay taxes down the road when you begin taking distributions. Again, remember that Traditional IRA distributions are meant to be taken when you are older, possibly earning less per year, and theoretically paying taxes at a lower percentage rate.
Unlike Traditional IRAs, Roth IRA holders may not deduct their contributions from their income. They must pay taxes on that money as if it were still cash in their pockets. Their rewards come later in life when they begin taking distributions. Withdrawals of Roth IRA earnings can be 100%
tax-free if the account holder is at least 59 ½ years old and it has been at least five years since his or her first Roth contribution. No such stipulations exist for distributing Roth contributions, as you would have already paid taxes on that money in the year you made the deposit. Annual contribution limits for Roth IRAs are the same as those of Traditional IRAs ($6,000 for those below the age of 50 with an added $1,000 for those age 50 and above). You may also consolidate Roth IRAs via transfer, roll funds from a Roth 401(k), or convert a Traditional IRA to a Roth status via Roth conversion.
Let’s say you make your $6,000 contribution and originate a loan at 10% interest with a Roth IRA. You would have to pay income taxes on the $6,000 even though it has been deposited into your IRA, but you will have an opportunity for significant tax savings once your account grows to $6,600 at the loan’s maturity. If you wait five years from when you made your contribution and turn 59 ½ in the meantime, the full $6,600 balance ($6,000 contribution plus $600 in earnings) can be distributed without paying another penny to the IRS.
SEP IRAs and Solo 401(k)s
SEP IRAs and Solo 401(k)s offer the same tax-deferred contribution benefit as Traditional IRAs, but they cater to the needs and earning potential of business owners. Solo 401(k)s can even incorporate a Roth component, allowing you to live in the best of both worlds with a single retirement account.
These accounts have higher annual contribution limits. The ability to contribute more means increased growth possibilities.
SEP IRA holders may contribute the lessor of $56,000 or 25% of compensation in 2019, a near-tenfold increase over Traditional and Roth IRA contribution limits. In most cases, retirement plan holders have until the tax filing deadline (usually April 15 or thereabouts) of a given year to make a contribution for that year, but SEP IRA holders may contribute up until their business’s tax filing deadline. This deadline generally lies well beyond the mid-April cutoff for individuals.
Solo 401(k) holders, as the sole employees of their own businesses, can simultaneously make employee and employer contributions to their individual plans. As employees, those under the age of 50 may contribute 100% of their compensation up to $19,000 in 2019; those age 50 and above may contribute 100% of their compensation up to $25,000. Employer contributions may equal the lesser of 25% of compensation or $37,000 in 2019, bringing the total contribution potential for 2019 Solo 401(k) investors to $56,000 ($62,000 for those age 50 and above).
As with Traditional and Roth IRAs, account holders may transfer or roll funds from other retirement accounts into their SEP IRAs or Solo 401(k)s. Due to their like tax statuses, you may directly transfer cash or assets between SEP IRAs and Traditional IRAs without limitation. In the same manner as a 401(k)-to-Traditional IRA rollover, you may roll funds from a Traditional IRA or another such pretax account into a Solo 401(k).
Further, Solo 401(k) holders can act as trustees of their accounts. While investor participation characterizes self-directed retirement, 401(k) trustees can exercise an even greater degree of control. Instead of coordinating investment initiations through an IRA custodian, 401(k) trustees can exert “checkbook control” over their tax-advantaged retirement funds and execute investments themselves. A retirement plan custodian would still have to hold the account, and the holder may not commingle retirement money with personal money. SEP IRA holders can create “checkbook control” by opening and funding a limited liability company or a similar business entity within the account.
Tax day may have passed, but it is never too late to start thinking about new strategies for saving for the future while potentially cutting next year’s tax bill. By entrusting your retirement to a method you know and trust, you can hedge your bets in the long run and garner tax benefits.