Real Estate Investing with a Roth IRA
Buying Property with a Self-Directed IRA
One of the biggest challenges for real estate investors is finding financing. Banks aren’t always willing to lend for real estate investment. Their interest rates will raise the cost of the transaction. Your ability to persuade a financial institution to offer funding will depend on your credit record.
If your credit history has taken a hit, you’ll struggle to borrow the funds you need to make the most of a real estate opportunity.
The solution, though, may be in your own hands. A self-directed IRA can use its funds to invest in property. Instead of putting all of your retirement account in stocks and shares, and hoping that the market performs well enough to deliver the returns you want, you can put at least some of it in real estate and earn the returns you deserve.
What is a Self-Directed IRA?
An IRA, or Individual Retirement Account, is one type of retirement fund. These can be in the form of traditional investments or, in recent years, even cryptocurrency. If you’re employed, it’s likely that your employer will provide a 401(k) plan. The company will automatically put aside part of your salary for the future. It may also offer matching benefits. Agree to contribute more to your 401(k) plan and the company will match some of those funds.
You have no control over the investments in your 401(k). Your employer will have chosen a fund offered by a financial firm. When you retire, you’ll benefit from the fund manager’s investment choices. The growth of your 401(k) investment pot is dependent on the skill of a fund manager chosen by a financial firm selected by your employer.
If you’re self-employed or if you just want to increase your retirement savings, you can also open your own IRA. Like a 401(k) plan, your IRA will let you put money aside for the future. If you’re using a traditional IRA, you’ll only pay income tax on those contributions when you receive them after retirement. If you’re using a Roth IRA, you’ll pay income tax before you make your contributions but the retirement distribution will be tax-free.
A self-directed IRA gives you both those tax options but it also gives you control over your investments. Instead of accepting the basket of stocks, bonds, and ETFs chosen by fund managers and offered by investment companies, you can use the funds in your IRA to invest in a much broader range of assets—including your own choice of real estate opportunities. Real estate is the most popular form of self-directed IRA investment.
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The Benefits of Using a Self-Directed IRA to Finance Real Estate Investments
Using a self-directed IRA to finance real estate investments offers two benefits.
First, you’re in control of your financing. You don’t have to ask a bank to lend you money or pay high rates of interest. You’re using your own money that you’ve already saved. Instead of watching that money grow slowly in line with the performance of the market—and watching fund managers help themselves to a large chunk of those profits in management fees—you can put your retirement funds in the higher-earning real estate opportunities you’ve discovered.
Second, the tax benefits of an IRA mean that you can keep more of the profits. If you invest in a Roth IRA, you’ll pay tax before you make your contributions but you won’t have to pay any tax at all when you receive the distributions.
That means the profits that you make on your real estate investment will be tax-free.
The Limits of Using a Self-Directed IRA to Finance Real Estate Investments
There are some restrictions, though, and like any form of investment, there are some risks.
The biggest restriction is that using an IRA to fund a real estate investment means that you’re investing for the future. The profits from the investment return to the IRA. They don’t go to you directly until you retire. If you withdraw those profits or the capital before the age of 59.5, you could find yourself with a 10 percent tax penalty.
In fact, you can receive no personal benefits at all from the IRA before retirement. You can’t use your self-directed IRA to buy a property, for example, then pay yourself or a family member to renovate it or manage the sale. None of the investments in the IRA, or their profits, are available to you until you reach retirement age.
If you’re looking for a quick flip to enjoy the profits, using the funds in your IRA won’t work.
There’s also a limit to how much you can put in an IRA. In 2021, that’s no more than $6,000 per year, or $7,000 if you’re age 50 or older. The limit is lower if you’re earning more than $125,000 or more than $198,000 for married couples filing joint returns.
On the other hand, there’s no limit to the amount you can rollover to a self-directed Roth IRA from a qualified retirement fund. So depending on your current retirement fund structure, you might be able to make at least some of your retirement pot available for real estate investing by moving it into a self-directed Roth IRA.
Know the Risks
There are risks too, of course. Recognize that if you break a rule—if you pay yourself rent from a property your IRA has purchased, for example—the IRS might decide that you’ve taken an early contribution and levy a penalty. The authorities will be watching to make sure that you don’t self-deal, and that you don’t receive any benefits from the investment until you retire.
Self-directed IRAs will also have fees and they can be complex. Just as you’d check the interest rate at a bank, make sure that you know how much you’re paying for your money.
Liability is an issue. One of the benefits of IRAs is that they’re protected from creditors. That isn’t true, though, of claims made within an IRA’s investments. If a tenant falls in an apartment owned by an IRA, they can sue the fund—and they might also be able to sue you too as the fund’s director. One way to remove that personal liability is first to set up a limited liability company. The IRA invests in the limited liability company which then invests in real estate. The company will be liable but the liability stops with the company.
And of course, you can always lose money in real estate investment. When you fund an investment with an IRA you’re risking your retirement savings. Don’t risk it all. Start small, and make sure that you know what you’re doing.