LOOKING DIFFERENTLY AT INVESTING IN REAL ESTATE WITH YOUR RETIREMENT IRA
Jerry is a middle-aged progressive man from California; he has a high-paying job that gives him a good income to support him and his family of four. He has always had an interest in real estate; he has bought and resold properties in the past five years. He was at the bar with a colleague from work, blowing off steam and talking about potential money-saving strategies and Jerry’s colleague made mention of retirement IRA.
‘’What does retirement IRA mean Nick?’’ Jerry asked, adjusting his tie.
Nick explained to him how retirement IRA works. How an individual who is into real estate investing can plan towards investing with his retirement IRA.
‘’Okay, that sounds interesting but what does IRA stands for exactly?’’ Jerry asked, the bartender filled up there glasses of beer.
‘’IRA means individual retirement account’’ Nick said.
‘’And how come I haven’t heard about this?’’ Jerry asked, he was being skeptic about this.
‘’It is because it is relatively new and many people haven’t heard about it.’’ Nick replied.
Nick went on and explained to Jerry that retirement IRA is new and there are different kinds of it.
‘’I know you are into real estate investing so this shouldn’t be a new thing to you but the thing is you can actually buy and invest into real estate using your retirement account so you don’t have to just buy mutual funds. Stocks and bonds aren’t the only things you can invest your retirement in; there are a lot of different options.’’ He said and he knew he had caught Jerry’s attention because Jerry began to ask about the basics of IRA real estate investment.
‘’There are two fundamental ways to go about the process. We have the self-directed IRA and the solo 401(k)’’
‘’Okay, explain the first option’’ Jerry said.
A self-directed IRA is the very common way used by people and they are managed by custodians.
‘’Custodians, what do you mean custodians?’’
‘’Well, a custodian is basically a middleman who manages everything including the bank account, concerning your IRA. There are big custodians and there are small custodians.’’
‘’So you’re saying I will give someone access to my bank account?’’ Jerry asked.
‘’Not exactly, you have to own a retirement account – that’s how it works. To set up as self-directed IRA, money must be moved out of your current retirement account if you have one but if you don’t you can always create a new one – this will be handled by the custodians.’’
‘’So what are the functions of these custodians?’’
‘’Custodians give you a go-ahead when you wish to buy a particular property and they also send you the actual money (or checks in some cases) when you wish to buy a particular property.’’ Jerry’s friend explained to him.
‘’So you are saying with a self-directed IRA, I can buy real estate but the custodian handles the rest?’’ Jerry asked for certainty.
‘’Yes and by ‘the rest’’ I mean they handle lots of the guidelines and rules that you have to follow; they give you the green light or the red light.’’ Nick said.
A custodian’s job is mostly like real estate investor’s but only when they use a self-directed IRA. Because they are managed by a custodian, they are highly regulated.’’
‘’Okay, I’m all for rules and regulations but what is the catch of having a custodian handle my retirement IRA?’’ Jerry asked.
‘’It takes a lot of process to be a custodian and a custodian gets paid as a percentage of the total assets. This is very important by the way because you need to know how the custodian handling your bank account gets paid through you.’’
‘’How much percentage of my total assets are we talking about here Nick?’’
‘’A custodian gets paid a percentage of your total assets. Which means if you have $1 million in your retirement account, it is going to be a larger annual fee compared to you having $10000. This is what a self-directed IRA is all about and it is commonly used by people. Most of the better programs charge only a couple hundred dollars a year.’’
Jerry sighed and pushed his glass of beer aside before saying
‘’Tell me about the second option’’
‘’It is called the solo 401(K).’’ Nick said.
‘’It is also called ‘an individual 401(k) account’’’ Nick said.
‘’Okay, tell me about it.’’
‘’A solo 401(K) is suitably ideal for real estate investors. It was set up in 2001 and it is brand new and not many people know about it. A solo 401(k) is the method in which you are the administrator of your own account’’
‘’I am in charge of my own account?’’
‘’Absolutely, the solo 401(k) is a large plan and no employee is full time. You can have them part time and you can have them 10-9 but no full-time employees. Most real estate investors such as me just hire employees as independent contractors.
‘’Solo 401(k) deals with a sole proprietorship business more or less, which means your business can be on a small scale but the important part is that an individual has some earned income activities.
‘’For a real estate investor whose aim is mostly about flipping, buying, fixing and reselling a property, the income earned here has to be more than mere passive investments which only income is from a rental property. Only then can you consider yourself a solo 401(k).
‘’I think I can handle that. I have other sources of income than my rental property. But tell me the benefits of this solo 401(k)’’ Jerry said, he was definitely getting interested.
‘’Okay first of all, there is the benefit of the checkbook power.’’
‘’The checkbook power?’’
‘’Yes, with a solo 401(k) you handle the checkbook. When you have a deal on your hands that requires a money transaction and discretion, you can handle it on your own because the checkbook power is yours – something that isn’t common with a self-directed IRA.’’
‘’Nice, what other benefits are there for me if I choose a solo 401(K)?’’
‘’You can borrow money to help purchase a property. And there are not many tax hits and penalties while borrowing money compared to a self-directed IRA.
‘’With a solo 401(k), if a mistake is made i.e. a prohibited transaction it can be fixed, whereas with a self-directed IRA, it can’t be fixed because they typically liquidate your plan.’’
‘’There is no second chance with a self-directed IRA?’’
‘’No, which is why a custodian avoids mistakes. However, with a solo 401(k) you can fix what you’ve made mistakes on.’’
‘’Wow’’ Jerry simply said.
‘’With a solo 401(k), there is a chance of borrowing up to $50000 out of your plan to do whatever you want. The catch is you have to pay yourself back in five years with interest, or in some cases where buying a personal residence in ten years, still the interest will be yours.’’
‘’That is a win-win for me I guess. All I have to do is work harder to pay back the money I owe myself or I don’t even borrow money at all, right?’’ Jerry asked.
‘’You can avoid borrowing money because having the ‘’checkbook power’’ can push people to lose willpower over their own retirement IRA because there is not a visible control over the account which is why it is advisable not to use your money for personal purposes.
Moreover, many people might be scared at the idea of having a checkbook power, so you can hire a middleman but the bad news is there will not be enough control over your account and the middleman he will charge you more money but the good news is you will not blow away your retirement.
‘’You are right Nick. It is all about balancing and taking extra care on how I spend my retirement money. Still I know there would be some drawbacks though, each option has to have one’’
You are right Jerry. With a solo 401(k) account, there are also some setbacks that can occur. So you have to set the account right at the beginning which can be debatable since most bank officers don’t always know how to set up a solo 401(k) account.
‘’Also, it takes time because as an individual you will have to coach the title company how to put the whole process together when you want to close a transaction.
Not every underwriter in the title company at their title insurer knows how to issue a title insurance. This can pose a problem as well.
‘’Exactly! All these can pose problems. However, aren’t there people who know how to set this thing up? There has to be, right?’’
‘’If you do want to set one of these up, there are very few people out there that really know how to set it up right. I can get set you up on few contacts of mine if you want’’ Nick said.
‘’That will be lovely but you also agree with me that a solo 401(k) is preferable?’’
‘’Well Jerry, the choice is up to you because it is relatively new but a solo 401(k) is an absolute slam dunk compared to the self-directed IRA.’’
‘’Alright then, we will discuss more about this retirement IRA at the office. I have to go home now and discuss it with my partner but I am so glad you told me about this. Now I can work towards my retirement.’’
‘’Excellent Jerry and you’re most welcome.’’ Said Nick.