There are 11 types of IRAs; it’s true Eleven! But do you know the self-directed IRA and what are the benefits?
Most investors mistakenly believe they have a “self-directed IRA” when in fact they have one that limits their choices to a few types of investments. In your plan, you can choose stocks, mutual funds or bonds. And while you may have hundreds, if not thousands, of choices for where to put your money in that account, chances are you won’t be able to invest in non-traditional retirement assets — especially if your rollover IRA or 401( k) is with a traditional brokerage.
So what is a true self-directed IRA? It’s an account that allows you to invest in many other options within your IRA, including:
Fixing rods to resell with profit (flip)
Private loans granted at higher interest rates to other investors
Discounted private tickets
Tax privileges or tax acts
Private companies and startups
Leases and rental options
Simple options (real estate options, no stock options)
These investments receive the same tax treatment as more traditional IRA assets. Any tax due is deferred until withdrawal, usually at age 70.5 when you need to start drawing on your savings, or possibly earlier.
This is an account for active investors with unique knowledge of some of the asset classes on the approved list, not for a “set it and forget it” investor.
By using this type of account, it is possible to make significant returns from a relatively small amount of money. Here is an example :
You have the option of buying a dilapidated house from an estate that wants a quick sale. You determine the house is worth $200,000 – after spending $40,000 on improvements. You agree to buy the property for $120,000. But not having the $160,000 to proceed with the sale, you hire a partner who agrees to provide the full amount, on the condition that you take care of all the details, including closing, renovating and reselling the House.
You further determine that you want your share of the profits to go inside your IRA for the obvious tax benefits. You only have $10,000 inside your IRA to invest. Given these circumstances, the appropriate game is to have your partner buy the property on their behalf or under that of an entity they control, such as a limited liability company. You enter into an option agreement to buy half ownership of this property. You pay $100 from your self-directed IRA, complete the option paperwork, and deliver all paperwork to your plan administrator.
This deal is now moving forward, and the property is renovated and ready for sale in 60 days and sells and closes quickly for $200,000. You have $10,000 in selling and holding expenses, which earns you a profit of $30,000 on this trade in five months. The true owner of title to the property agrees to pay you $15,000 to close out your option. This $15,000 is an optional investment return of $100 and is deposited into your IRA tax-deferred or tax-free (for a Roth IRA).
Your investor invested $160,000 and received $15,000 for a five month investment. That’s an annualized return of over 20% on his money, something that appeals to almost every investor. If he used his IRA money for this investment, his profit would also be tax sheltered.
Here’s another example: A New York investor learned about the self-directed IRA and used a portion of his IRA to acquire four rental units in the Detroit metro area. Each house was purchased for about $55,000 and rented for about $900, and the cash flow goes back to the IRA on a tax-deferred basis. If he sells them for big gains years from now, that profit will also be tax-sheltered.
Be warned: there are also prohibited investments with your IRA (see IRS Publication 590-B):
No lending money to yourself, your spouse or any family member in your direct linear family chain.
No investment in collectibles.
Your IRA cannot personally guarantee any loan in which it borrows money. This means that any money borrowed by your IRA must be a “non-recourse” fund, which means that only the asset can be pledged and can be seized for non-payment. The creditor cannot sue the IRA for any shortfall in the defaulted loan.