Avoiding Income Taxes With Self-Directed IRAs

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…

More on SDIRA’s here.

15 Responses to Avoiding Income Taxes With Self-Directed IRAs

  1. Shawn says:

    Im very interesested in this and happy you brought it up. I have not considered IRAs for a long time because of having a (good) income problem and and being outside the limits for a Roth. I am interested to investigate how this would affect my overall tax base while still working full time versus the reduced income of the immediate future. A Roth may come back into the picture as well.

    • If you’re serious about quitting, and I’m pretty sure you are, then why not defer taxes on some income? You are at a very high rate, which will certainly go down when you and your wife quit working so much.

      Roth is less attractive to me with an early retirement plan. I might be wrong… More assessment is warranted when I have time. I’m curious about your logic on a Roth if you’re in a similar position as me…

    • I know that a SDIRA allows you to invest in different assets,my favourite turned to be precious metals ,I opened a Gold IRA Account with Regal Assets and they helped me to set up an account at zero costs which is very unfamiliar with other custodians,they also helped me rollover my 401k to gold with no penalties,and better yet ,they only charge me a flat annual fee of 150 a year .Looking at how gold and precious metals will perform in the next years if the dolloar keeps inflating,I have great feeling of security that my assets will turn more profitable,and I could have a better ROI upon retiring.

  2. Thanks for the info. Certainly not for the weak of stomache, but it seems that if you have some serious business income, it’s a good investment vehicle and tax strategy.

  3. Paul Salmela says:

    This is a good overview! At the end of last year I moved funds from a traditional IRA and a Roth IRA to a self-directed IRA (similar to what’s described in the article). One thing that isn’t mentioned is that you can structure a LLC that holds your IRA funds and it can be 100% managed by the owner. This means that you can write out a check to purchase a property or to pay for maintenance on the property. The fees listed in the article are higher than what I’m paying. I went through a company and they charged around $2500 to set up the account, draft my LLC, and even paid for some time for me to talk with an independent attorney. The trust company (IRAServices) charges a yearly fee that is between 100-200/year.

    • I talked to the custodian of my SDIRA at my bank, and she said they don’t recommend the IRA path. I thought it looked good too.

      She said that they work closely with the IRS, and the use of an LLC to manage the funds (at $2500 cost) is considered a loophole by the IRS, and that they expect it to be closed within a few years. When it gets closed, they expect that the cost to get out of the LLC loophole will be even more than $2500.

      I’ll admit I don’t know much more than that, and that my SDIRA custodian could be motivated to point me away from the LLC. Still, I didn’t see enough benefit to do this, with so many unanswered questions and such a large upfront cost.

      The main advantage of an LLC that I saw was that you would get a checkbook to manage day to day activities of a business (like a fix and flip). But she gave me several workarounds for this, all that seemed reasonable and not worth paying $2500 for convenience (plus risk).

      I’d be interested in your response, since you’ve already taken the plunge. How much background research did you do?

  4. Mr. Money Mustache says:

    Very fancy and nice to learn about. Did you ever update us readers on the status of the previous real estate investment (the fix ‘n’ flip) ?

    • Short story: I owe you guys an update.

      Slightly longer story: Descent traffic in December but no offers. Meanwhile my partner just sold a different house (with a different financier) for a hardy profit. I visited both houses, and I liked the other better when all was finished, so not surprised.

      I’ll get an update soon, although it may just include pictures of before and after since the house is not yet sold.

  5. […] that I added an income source called Premier Equity Fund.  This is the fund I bought into with my SDIRA.  I bought in at $40,000 and will receive a base return of 8% APR paid out monthly ($267/month) […]

  6. Brandy says:

    I do not qualify for a Roth IRA because of income…so does this strategy work for Traditional IRA’s? I don’t have an IRA at all but I have been investing in the stock market, and if I could pay less taxes that would be great.

  7. John says:

    I don’t believe in other’s restricting my Cash until a certain age or I die. (just like i don’t like AGE LAWS, those Ageist bastards) I know too many people who died before age 65, or at age 65. Hell we all could die before 35, and I may never be Financially independent and enjoy complete freedom!

    When I am financially independent at 35, retire, and start making extra cash from hobbies that i do anyway, AND the Gov decides to increase taxes to 75% like France is debating (if no civil wars or rebellions up spring), then i may put some excess into an IRA. BIG MAYBE!

    Till then they can double tax me as I work for Freedom, which is better than them taking it away til age 60 and seeing if i die (Aka maybe accidently increase the probabilities of all Americans to die by making us obese, offering us free cigarettes, offering us free cocaine and marijuana, making us work 60+ hours/week, “accidently” burning down all the crops….etc.)

    Then when i obtain freedom from working, they will think I am a poor monk and taxes will disappear/go way down from income streams (somewhat, 5% sounds good to me).

  8. Bette says:

    The root cause of the crash is excessive debt. Entire nation cannot borrow non-stop, inflate the money supply and prices with borrowed money and then hope that all will be fine when the pay back time arrives.

  9. Your way of explaining the whole thhing in this
    article is genuinely good, everdy oone cann without difficulty
    understand it, Thanks a lot.

  10. Jpost says:

    Careful investors can use tax liens to make a handsome profit as long as they are patient enough. That’s why many people are choosing to invest using a self-directed IRA (SDIRA).

    Not only are the earnings from the investment tax-deferred, but using a retirement account encourages you to be patient as well.

    SDIRA’s can be used in a wide variety of nontraditional investment.
    Even we can also set up our self-directed IRA for Gold IRA Rollover.

    Thanks for the share :)

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