I’ve spoken a lot about income diversification, using various investment strategies to create the income. One of the things that bugs be about these types of income, however, is that I had to do a lot of it with taxable money. And since I’m still working a full time job, in a high marginal tax bracket, this money was getting taxed at a rate that was really eating into my effective profits. I knew I could shelter basic dividend income inside my IRA, but what about real estate investments and other income generating investments?
Then I learned about Self-Directed IRAs (SDIRA). An SDIRA allows anyone with an IRA to get greater asset diversification by allowing for investments other than traditional stocks and bonds, including but not limited to real estate invesments, private tax liens, peer-to-peer loans, and private businesses. Normally the income in all these investments are taxed at your marginal tax rate, which if you are currently working a good job, is very high. Far higher than the current rate on dividends and capital gains found in stocks and bonds. But by keeping the investment in your IRA, taxes are deferred until your income reduces in retirement.
How it works:
First, you open an account at a bank and trust company. You should be able to find a local one, which I highly recommend. Not only because it supports local business, but also because you do need to fill out quite a bit of paperwork for any transaction and it’s a whole lot easier to go in to an office than do it all over mail. Also, because there are a lot of rules around SDIRA’s (see below) it’s nice to have a person you can meet with and have your questions answered.
Next, you transfer money into the SDIRA from your current IRA brokerage. For me, this was as simple as filling out some pre-arranged paperwork at my SDIRA bank. The documents basically tell your IRA brokerage firm to sell a certain amount of shares of a specific holding and transfer the resulting cash into your SDIRA. (By the way, eTrade takes about 3 weeks to release the money – a lot longer than it takes for them to accept money…)
Once the money is in the SDIRA, you are no longer allowed to do any direct transactions with the money. At this point, you have a custodian who is your primary contact at the bank. Anytime you want to move money around or purchase a new investment you have the custodian write up the paperwork and you simply sign it.
For any new investments, the custodian presents the investment proposal to the firm’s investment committee for approval. I look at this as a way for them to keep me out of trouble with the rigid laws for SDIRA’s. This may be particular to my firm, but if you plan on opening an SDIRA you may want to find out your bank’s process.
Things you need to know:
Having an SDIRA isn’t cheap. For example, my bank is charging me 1% per year, or a minimum of $600. Since I have started out by moving $40000, I will be charged $600 – which equates to 1.5%. I would never pay 1.5% for someone to manage an index fund, but in this case it’s a fee that is allowing me to save quite a bit in taxes. Eventually, I will invest more into my SDIRA and drive the fees down to 1%. (There may be lower fee options out there, but I was referred to this bank by someone I trust, so I was willing to pay for that confidence.)
There are a lot of laws you should be aware of. For instance, you can buy a business with an SDIRA, but not from a close relative. You can buy a vacation home that you rent out, but the so-called “self-dealing” rules mean that you can never stay there yourself – not even for a weekend. There are many other rules, and this is why I like the idea of a local bank with a custodian I can call up at any time and ask her for advice on what is legal and what is not. Not that I’m doing shady business, but I can imagine that getting into any IRS issues after the fact would be plenty painful and expensive.
So what’s next for me? I have just moved $40K into my SDIRA and I just finalized my first SDIRA investment to buy into a private placement company specializing in private lending for Colorado real estate rehabilitation projects. Expected returns are between 10%-12%, with pretty low risk. Unlike an REIC, the payout will not drop if/when interest rates rise. More on that investment soon…