Making Investments with Retirement Funds
The Internal Revenue Code & ERISA does not describe what a retirement plan can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions.Unknown to most, one is permitted to use their retirement funds to make almost any type of investment on their own without requiring the consent of any custodian or person. The IRS only describes the type of investments that are prohibited, which are very few.
The following are some examples of types of investments that can be made with your retirement accounts:
- Residential or commercial real estate
- Domestic or Foreign real estate
- Raw land
- Foreclosure property
- Mortgage pools
- Private loans
- Tax liens
- Private businesses
- Limited Liability Companies
- Limited Liability Partnerships
- Private placements
- Precious metals and certain coins
- Stocks, bonds, mutual funds
- Foreign currencies
Using a retirement account to make investments offers the investor the ability to make traditional as well as non-traditional investments, such as real estate, in a tax-efficient manner.
The concept of tax deferral is premised on the notion that all income and gains generated by the pre-tax retirement account investment would generally flow back into the retirement account tax-free. Instead of paying tax on the returns of a retirement account investment, such as real estate, tax is paid only at a later date, leaving the investment to grow unhindered. For example, if an IRA investor invested $100,000 into a Self-Directed IRA LLC or Solo 401(k) plan in 2019 and the account earns $10,000 in 2019, the investor would not owe tax on that $10,000 in 2019. Instead, the Self-Directed IRA or Solo 401(k) plan investor would be required to pay the taxes when he or she withdraws the money from the retirement account, which could be many years later. For example purposes, assuming the retirement account investor mentioned above is in a 33% federal income tax bracket, she would have had to pay $3,333 in federal income taxes on the $10,000 earned on the IRA in 2019. That would have left $6,667 in the account. At a 8% annual return, those earnings would go on to produce $533.36 in 2019. However, because retirement accounts are tax deferred, the retirement account investor is able to earn a return on the full $10,000 rather than the $533.36 she would have had if she had to pay taxes that year. At an 8% annual return, she'd earn $800 in 2019. The beauty of tax deferral is that the deferral compounds each year.
Tax deferral is one of the last great legal tax shelters available to the U.S. taxpayer. Take the of example Joe the consultant. Assume Joe is thirty years old decided to start a retirement accouny. Joe had a current retirement account balance of balance at zero at that time. Assume Joe decided to make annual retirement account contributions of just $3500 each year until he reached the retirement age of 70. Further assume that Joe was able to generate an average annualized rate of return of 9% and the prevailing tax rate was 25%, at age 70, Joe would have $1,289.022 of tax-deferred income in his retirement account. In contrast, if invested outside of a retirement account (personal funds), assuming a 25% tax rate, Joe would have just $699,475.
Tax deferred investments though a self-directed IRA LLC or Solo 401(k) plan generally help investors generate higher returns. That's because the money that would normally be used for tax payments is instead allowed to remain in the account and earn a return.
The IRS permits one to use retirement funds to purchase real estate or raw land. Real estate is the most popular non-traditional investment made with a Self-Directed IRA LLC or Solo 401(k) plan. Making a real estate investment is as simple as writing a check. As the manager of your Self-Directed IRA LLC or trustee of the Solo 401(k) plan, you have the authority to make investment decisions on behalf of your retirement account. One major advantage of purchasing real estate with a retirement account is that all gains are tax-deferred until a distribution is taken (Traditional IRA distributions are not required until the IRA owner turns 70 1/2). In the case of a Self-Directed Roth IRA LLC or Roth Solo 401(k) Plan, all gains are tax-free.
For example, if you purchased a piece of property with your retirement account for $75,000 and later sold the property for $150,000, the $75,000 of gain would generally be tax-free. Whereas, if you purchased the property using personal funds (non-retirement funds), the gain would be subject to federal income taxes and in most cases state income tax.
The IRS permits the purchase of tax liens and tax deeds with a retirement account. By using a retirement account to purchase tax-liens or tax deeds, your profits are tax-deferred back into your retirement account until a distribution is taken (pre-tax retirement account distributions are not required until the retirement account owner turns 70 1/2). In the case of an after-tax retirement account, all income and gains received would be tax-free.
More importantly, As the manager of the IRA LLC or trustee of your Solo 401(k) plan, will have "checkbook control" over your retirement funds allowing you to make purchases on the spot without custodian consent. In other words, purchasing a tax-lien or tax deed is as easy as writing a check!
Loans & Notes
The IRS permits the use of retirement account funds to make loans or purchase notes from third parties. By using a Self-Directed IRA LLC to make loans or purchase notes from third parties, all interest payments received would be tax-deferred until a distribution is taken (Traditional IRA distributions are not required until the IRA owner turns 70 1/2). In the case of a Self-Directed Roth IRA LLC, all interest received would be tax-free.
For example, if you used a Self-Directed IRA LLC to loan money to a friend, all interest received would flow back into your IRA tax-free. Whereas, if you lent your friend money from personal funds (non-retirement funds), the interest received would be subject to federal and in most cases state income tax.
With a Self-Directed IRA LLC or Solo 401(k) plan you are permitted to purchase an interest in a privately held business. The business can be established as any entity other than an S Corporation (i.e. limited liability company, C Corporation, partnership, etc.). When investing in a private business using retirement funds, it is important to keep in mind the “Disqualified Person” and “Prohibited Transaction” rules under IRC 4975 and the Unrelated Business Taxable Income rules under IRC 512, which could impose a 37% tax on the profits allocated to the retirement account business investment operated via a passthrough entity.
Precious Metals & Coins
Internal Revenue Code Section 408(m) lists the type of precious metals and coins that are permitted investments using IRA funds:
- One, one-half, one-quarter or one-tenth ounce U.S. gold coins (American Gold Eagle coins are the only gold coins specifically approved for IRAs. Other gold coins, to be eligible as IRA investments, must be at least .995 fine (99.5% pure) and be legal tender coins.
- one ounce silver coins minted by the Treasury Department;
- any coin issued under the laws of any state;
- a platinum coin described in 31 USCS 5112(k) ; and
- gold, silver, platinum or palladium bullion (other than bullion that is made into a coin) of a certain fineness that is in the physical possession of a trustee that meets the requirements for IRA trustees under Code Sec. 408(a).
Hedge Funds, Private Equity Funds, & Venture Capital Funds
When it comes to using retirement funds to invest in a hedge fund, private equity fund, or venture capital fun, it is important to be mindful of the IRS prohibited transaction rules under Internal Revenue Code Section 4975. In general, the IRS has restricted certain transactions between the retirement account and a “disqualified person”. The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the retirement account holder, any ancestors or lineal descendants of the retirement account holder (i.e. parents, children, spouse, daughter-in-law, or son-in-law), and entities in which the retirement account holder or a disqualified person holds a controlling or management interest. Furthermore, Internal Revenue Code Section 4975(c)(1)(D) and (E) outlines rules that relate to self-dealing or conflict of interest transactions that involves an investment that could directly or indirectly personally benefit a disqualified person. The self-dealing or conflict of interest prohibited transaction rules have the broadest application especially when it comes to hedge fund type investments.
The prohibited transactions rules tend to become more of an issue when the person using retirement funds or any disqualified person related to the retirement account owner has a personal interest or relationship with the fund investment. In other words, a retirement account can generally make an investment into a hedge fund in which neither the retirement account holder nor any disqualified person has any personal ownership or relationship with. The issues begin to arise from an IRS prohibited transaction standpoint when the retirement account owner wishes to use retirement funds to invest in a hedge fund where her or she or a disqualified person is either an owner, employee or, in some cases, has a professional relationship with the fund in question.
In general, if structured correctly, there may be a way for one to use their retirement funds to invest in a fund that one has some direct or indirect personal relationship with. The key is to make sure that the retirement account investment into the fund will not directly or indirectly personally benefit the retirement account owner directly or indirectly or any other disqualified person since that type of investment could likely trigger a prohibited transaction.
The IRS does not prevent the use of retirement funds to purchase foreign currencies. Many believe that foreign currency investments offer liquidity advantages to the stock market as well as significant investment opportunities.
Purchasing foreign currency, such as the Iraqi Dinar, with a Self-Directed IRA LLC or Solo 401(k) plan is as easy as writing a check. As manager of the IRA LLC or trustee of the Solo 401(k) plan, you will have “checkbook control” over your retirement funds, providing you with the ability to make investments without requiring custodian consent.
By using retirement funds to purchase foreign currencies, all foreign currency gains generated would be tax-deferred until a distribution is taken (Traditional IRA or Solo 401(k) distributions are not required until the account owner turns 70 1/2). In the case of a Self-Directed Roth IRA LLC or Roth Solo 401(k), all foreign currency gains would be tax-free.
Stocks, Bonds, Mutual Funds, CDs
In addition to non-traditional investments such as real estate, a Self-Directed IRA LLC or Solo 401(k) Plan may purchase stock, bonds, mutual funds, and CDs. The advantage of using retirement funds with “Checkbook Control” is that you are not limited to just making these types of investments. With a Self-Directed IRA LLC with “checkbook control” or trustee directed Solo 401(k) plan you can open a stock trading account with any financial institution as well as purchase real estate, buy tax liens, or lend money to a third-party. Your investment opportunities are endless!
To learn more about making investments, such as real estate, with retirement funds, please contact us at 800-472-0467.