How Much Retirement Income Can You Generate With Real Estate Investments?

Why do you save for retirement? At the most basic level, you probably save so that you’ll be able to pay for your living expenses once you reach your desired retirement age (whatever that age may be). One of the best ways to plan for your retirement finances is to have the goal of putting together a nest egg that generates enough income every year to cover some or all of those living expenses. This will often be preferable to having to liquidate your investments in order to pay your living expenses, and be at risk of depleting your account too quickly, and effectively outliving the usefulness and value of your retirement savings.

Unfortunately, individuals who aren’t familiar with self-directed IRAs, and the additional investment opportunities that those accounts can provide as compared to IRAs with traditional custodians, might take an overly narrow view of the types of investments that can generate meaningful income.

More specifically, many would consider an “income investment” to be something like a municipal bond or U.S. government bond, or a corporate debenture, or perhaps even publicly traded stocks that pay quarterly dividends. While these are certainly income generating investments, they only scratch the surface of what’s available to a retirement saver who has a self-directed IRA.

Private Debt Investments. Self-directed IRAs are authorized to invest in private debt instruments. This can include not only personally guaranteed notes (lending money directly to an individual), but also borrowings from businesses, and even private mortgages. That’s right, with a self-directed IRA you can make loans to people who are looking to buy a home, and use the home as your security for repayment — just like a traditional mortgage lender would do.

These types of investments have the potential to generate a significant income stream, and the more risk you’re willing to take with respect to repayment, the greater that income can be.

Real Estate. Speaking of home buyers, you can use a self-directed IRA to invest in real estate directly, and generate income from renting the properties you buy. In the residential marketplace, stagnant incomes have combined with increasing real estate prices and tighter lending standards to create a huge demand for rentals. In some areas the growth in prevailing rents has actually exceeded the rate of growth for home prices.

And you’re not limited to residential properties when you invest with a self-directed IRA. You can use your account to purchase commercial properties, including office, retail, and industrial properties. These types of investments can provide exposure to a different type of risk if you’re looking to diversify your retirement investment portfolio, but they can still generate a healthy level of periodic income.

Obviously, making these types of investments is a significantly more complicated process than simply buying a corporate bond. When considering these types of investments with your self-directed IRA, be sure to seek out qualified professional assistance to help you as necessary.

Broaden Your Investment Horizon With a Self-Directed IRA

What’s your current level of investment experience? If you’ve done any investing at all, then congratulations! Across the broader U.S. population, things don’t look particularly bright. Over the past few years, various surveys have concluded that approximately one-third of American adults don’t have any savings at all, and nearly half of American adults only have an emergency fund that would cover less than 90 days of their living expenses. The statistics for retirement savings are equally as dismal.

And even among those who have begun saving for retirement, many limit their savings activities to just a few types of assets, the most popular of which include broad market mutual funds and short term U.S. government bonds. And some, concerned with the preservation of capital beyond all other concerns, use their funds to invest in things like bank CDs.

Even amongst those who have actually invested for growth or income, many have limited their activities to mutual funds or whatever other options were available within or promoted by their discount broker or 401(k) plan administrator.

There’s certainly nothing inherently wrong with those types of investments. Mutual funds can make the process easy for individuals who don’t have the time, inclination or confidence to do a lot of research or make more specific investment decisions. But the problem with simply investing in broad market investments like mutual funds is that you’re limiting your long term growth potential, particularly during down market times.

Fortunately, you can use a self-directed IRA to invest in a wide range of assets that can broaden your portfolio so that you can take advantage of various market conditions.

For example, you can use a self-directed IRA to invest in real estate and precious metals, two asset classes that have historically performed well when the stock market has underperformed. You can use your account to invest in a number of different types of real estate, including single-family and multi-family residential properties, commercial properties, farmland, industrial properties, and even undeveloped properties.

In order to gain exposure to precious metals, you can use your self-directed IRA to invest by purchasing metals in their physical form (pure bullion or government issued coins, but not collectible coins), or in precious metals mining and exploration companies. If you choose to invest in physical metals, it’s important to plan for the costs of hiring a professional custodian to hold those metals. If you were to hold that type of precious metals investment yourself, doing so would be considered taking a distribution from your account, which would potentially subject you to an early withdrawal penalty, as well as any taxes that would otherwise be due.

Furthermore, you can use a self-directed IRA to invest in private companies by taking either equity or debt positions. Depending on the nature of the investment, the performance of these types of investments can provide you with the opportunity to improve the return on your portfolio when your other investment types aren’t performing quite as well.

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.