Why It’s Important To Coordinate Your Taxable Investments With Your Self-Directed IRA Investments

Your self-directed IRA can save you a lot of money in taxes, both in the short term as well as in the long run. If your IRA is set up as a traditional account, then (depending on certain aspects of your financial position) you may be able to take a tax deduction for those contributions. And contributions in traditional IRAs will grow on a tax-deferred basis, while the investment gains within a Roth IRA will never be subject to taxation. Many individuals are well-versed with the various tax implications on this level.

But there’s another perspective from which you may want to consider your self-directed IRA tax analysis, and this is the way that your taxable investment accounts, and investment decisions, can impact your self-directed IRA investments.

Let’s first examine just how valuable your self-directed IRA can be. Consider two hypothetical portfolios of $100,000, one a taxable account and the other a self-directed IRA. Let’s further assume that each portfolio is comprised of stock that pays dividends at a 3% rate annually (with those dividends being reinvested), and that the stock price appreciates 5% annually.

At the end of 25 years, the value of the taxable account would be approximately $525,000, while the self-directed IRA is worth over $630,000. This difference in value is attributable solely to the fact that the owner of the taxable account has to pay taxes on the dividends they receive, even if they choose to reinvest those dividends.

If the self-directed IRA is a traditional account, then you will have to pay taxes on those gains, but they’re likely to be at a lower tax rate (because you’re in retirement and perhaps no longer working full time), and they’ll only be taxed when you take the distribution. If your account is a Roth IRA, then you’ll realize the full value of the investment gains.

So one common tax optimization strategy is for an individual to place income-generating investments that would otherwise incur a tax liability into an IRA in order to avoid that liability.

On the other side of the equation, it’s important to note that there are certain tax advantages that are actually disallowed within an IRA. For example, investment interest (such as borrowing funds to purchase a stock investment, or taking out a mortgage to buy a piece of real estate) can be used to offset gains in a traditional account. But borrowing funds is considered to be outside the scope of permissible activities for self-directed IRAs, and the tax benefit of those expenses will be lost inside the retirement account.

It’s the same situation for investments that have tax advantages built in, such as municipal bonds. Because these investments would already be tax-advantaged outside of an IRA, there’s no reason (and it’s actually a missed financial opportunity) to keep these types of assets inside a retirement account.

Understanding the interplay between your taxable investment accounts and your self-directed IRA will put you in the best position to make the optimal investment decisions.

The Basic Relationship Between Social Security Benefits And Your Self-Directed IRA

Regardless of whether you envision Social Security to be a significant component of your retirement income, or simply a helpful supplement to your self-directed IRA, it’s important to understand how the two are related. The timing and nature of distributions you take from a self-directed IRA can impact the size of your Social Security benefits, as well as the income taxes you may have to pay on those benefits.

First things first. Under current law, your eligibility to receive Social Security retirement benefits, and the amount of those benefits, is a function of your prior work experience and earnings, not how much you have saved. In other words, having a large self-directed IRA or taking significant distributions from your account during retirement won’t make you ineligible for Social Security benefits.

However, those distributions may impact the taxability of the Social Security benefits you receive. Finally, it’s important to keep in mind when you’re planning your retirement income strategy that you control when you begin receiving Social Security retirement benefits (anywhere between age 62 and age 70), and you control when you begin taking distributions from your self-directed IRA – with no limit for Roth account, and required minimum withdrawals from a traditional account kicking in at age 70½.

Early Retirement Scenarios.

Individuals who choose to retire early and begin taking their Social Security retirement benefits before their full retirement age can see those benefits reduced if their earned income exceeds a certain amount. (For 2015, this amount is $15,720.) In short, the Social Security Administration withholds one dollar in benefits for every two dollars and earnings above the this amount, and even more for earnings that are significantly higher. Distributions you take from your self-directed IRA are not considered “earned income,” and therefore do not count against this limitation.

However, when the IRS determines whether your Social Security benefits are subject to income tax, they look to your “combined income,” which will include distributions you take from any IRA that’s set up as a traditional account.

Roth Self-Directed IRA Benefits.

Significantly, distributions from your Roth IRA will not affect your Social Security benefits in any way. Just as is the case with traditional IRAs, they are not considered earned income by the Social Security administration for purposes of calculating your benefits in an early retirement scenario. In addition, they are excluded from the definition of “combined income” when considering the taxability of those Social Security benefits.

Distribution Strategies.

Given that your Social Security benefits will be increased the longer you wait to take them (with the deferred retirement credits increasing up to age 70), some individuals can maximize their total retirement income by waiting as long as possible to take Social Security, and taking distributions from their self-directed IRA in order to fund retirement living expenses. The analysis is highly individualized, and you’ll have even more options to consider if you are married and your spouse is also eligible for Social Security benefits.

But remember that you’ll only put yourself in a stronger financial position by maxing out your self-directed IRA contributions each and every year, and trying to build the largest account possible.

Increase Your Private Investment Allocation With Your Self-Directed IRA

Individual retirement accounts are perhaps the single most powerful tool you have in your retirement planning arsenal. You have greater control and flexibility over your retirement funds as compared to an employer-sponsored 401(k), and a Roth IRA can provide significant benefits for tax savings and estate planning purposes.

Self-directed IRAs take things a step further. Having an account with a custodian such as Quest Trust Company will allow you to invest in an even wider range of asset types, including a variety of private investments. Here are some ways to increase your portfolio allocation into these investment types by using a self-directed IRA.

Private Mortgages. Regardless of the state of the economy, people are always going to want (or need) to buy and sell homes. The IRS regulations permit you to use a self-directed IRA in order to issue private mortgages. Provided you understand the process fully, follow all legal requirements and evaluate your risks accordingly, you may find this to be a significant boost to your portfolio.

In fact, when prevailing interest rates increase and it becomes more difficult for the average home buyer to get a loan from a bank, you may have even more opportunities for making private mortgages.

Private Equity. Similarly, a self-directed IRA can be used to make private equity investments as well. Depending on the size of your portfolio and your overall financial situation, this can be a way to gain a completely unique risk/reward exposure that wouldn’t be available in any other investment you could make.

Some private equity investments will require that the investor be a so-called “accredited investor”. This is a legal term defined by the SEC to mean a person who either (1) has a net worth of at least $1,000,000 (not including the value of their primary residence), or (2) has an annual income of at least $200,000 over each of the last two years (or has a joint income of $300,000 in each year with their spouse) and a reasonable expectation to achieve the same income this year.

Note that even if you’re looking to invest with your self-directed IRA and your account meets these standards, you’ll still need to meet those standards individually.

Private Partnership Interests. You can use your self-directed IRA to invest in various types of private partnerships. These may include traditional businesses as well as natural resources development opportunities such as those that can be found in the oil and gas industries.

Remember that when you invest your self-directed IRA in a private partnership, you’re prohibited from benefitting from it individually while the investment is still held within your account. So if the partnership invests in vacation real estate properties, neither you nor your family or any other related parties can stay in the property while you’re still invested.

Regardless of the private investments you’re considering making, be sure to do your research and understand all the risks before you commit your account funds.