Why the Self-Directed IRA is the Best Long-Term Savings Vehicle

Being able to save for a financial goal is one of the most valuable skills a person can ever develop. You’ll likely set a variety of savings goals throughout your life, including short-term, medium-term and long-term goals. The ultimate long-term savings goal is saving for your retirement. And the ultimate savings vehicle for retirement is the self-directed IRA.

Let’s look at a few of the reasons why.

Tax-Deferred Growth.

Like other traditional IRAs, the biggest strength of a traditional self-directed IRA is that it provides the opportunity for your investments to grow on a tax-deferred basis. This means that any income you receive from the investments within your account will not be subject to tax for as long as those funds remain in the account. Similarly, any gains from the sale of investments within your account will be free from taxation, provided that those funds (and any investments you make with those funds) remain within your account.

Additional Investment Options.

A self-directed IRA with a custodian such as Quest Trust Company affords the account holder with investment options that traditional IRA custodian will not permit. For example, you can use a self-directed IRA to invest in assets such as private equity and real estate, and to make loans to businesses or even for real estate mortgages. Many of these asset types have long investment timeframes, which allows you make investment choices to precisely match your retirement goals.

The breadth of investment choices you’ll have with a self-directed IRA is even more apparent when you compare them with any 401(k) plan options that you may have through your employer.

Administrative Advantages.

Speaking of 401(k) plans, you’re likely to accumulate multiple 401(k) accounts over the course of your career. Many plan administrators limit your ability to make new investments once you leave the employer, and having to keep track of multiple accounts can reduce your ability to execute on your retirement plan. Having a self-directed IRA as your sole or primary retirement account can lessen your administrative burden.

Additional Roth Self-Directed IRA Advantages.

If the features we’ve discussed above aren’t enough, then consider the additional benefits you receive by structuring your self-directed IRA as a Roth account.

In addition to having your investments grow on a tax-deferred basis as is the case with a traditional IRA, distributions can also be taken from a Roth IRA on a tax-free basis. Furthermore, Roth IRAs are not subject to the rules on required minimum distribution requirements in the same way that traditional IRAs are. These rules require you to take minimum distributions from a traditional IRA once you reach age 70½.

Finally, eligibility to contribute to a Roth IRA does not end at age 70½ as it does with a traditional IRA. This means that if you have other sources of income during retirement you can continue leveraging the various contributions.

The Three Situations Where You Might Consider an Early Withdrawal From Your Self-Directed IRA

It’s important to understand that the default IRS regulations regarding early withdrawals from an IRA. In general, taking a distribution from your account before age 59½ will subject you to a 10% penalty on the amount of the distribution, plus whatever taxes may be due.

In each of the situations below, there are specific requirements that need to be met in order to avoid having to pay the 10% penalty, but in all cases you still may owe taxes on the amount of the distribution. Pay close attention to all the requirements. If you make a mistake in the distribution process it could prove to be quite costly.

  1. To Purchase a First Home. The IRS regulations allow you to take a distribution of up to $10,000 to pay for a down payment on your home if you are a first-time homebuyer (which is defined to mean that you haven’t owned your own home in the past two years). You can also use this penalty free provision to assist a child or grandchild with their down payment, if having access to these additional funds would make the difference between getting a home and not – but it may be worth forgoing future growth of those funds
  2. For Certain Uninsured Medical Expenses. There are actually two situations in which you can use your self-directed IRA in order to pay for some of your medical expenses. The first is in situations where you need to pay for certain unreimbursed medical expenses. The second situation is to pay for medical insurance premiums for you and your family when you are unemployed. one reason taking this type of early withdrawal can be so important is that it eliminates any temptation that might otherwise exist for you to underinsured or yourself or otherwise not seek necessary medical care.
  3. Higher Education Expenses. The third exception we’ll discuss is taking an early withdrawal in order to pay qualified educational expenses. Generally this means paying tuition or room and board for your child, but you can also make such a withdrawal for your own educational expenses, those of your spouse, or those of a grandchild.

There are no limits for how much you can take out of your account early for these purposes. However, given that an early distribution means that you’re losing out on the long-term growth potential of those funds, you may wish to explore other funding options first, including student loans (which in some cases can involve interest and that’s tax-deductible).

In fact, in each of these three situations, it’s always important to consider other alternatives prior to taking an early distribution from your self-directed IRA. Just because you’re authorized to do so doesn’t mean there isn’t a better way.

In addition to losing out on future investment growth, there are other ways in which taking an early distribution can be a bad financial decision. For example if you need to liquidate certain investments early, then the effective loss you experience by taking the early distribution is effectively much greater than the amount of the distribution.

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.

What You Need to Know About Substantially Equal Periodic Payments

You probably know that if you take a distribution from your IRA before you reach age 59½, then in most cases you’ll be subject to a 10% penalty on that amount of the distribution, in addition to any taxes that may be due. (Distributions from a traditional account are generally subject to income tax, while distributions from a Roth account are not.)

You may also know that there are a handful of circumstances in which you can make an early withdrawal from your IRA and avoid the 10% penalty, but not avoid any taxes that are due. These include certain distributions to assist a first-time home buyer in making a down payment, paying for medical expenses, and paying for certain types of higher education expenses.

In certain limited sets of circumstances, these exemptions from the 10% early withdrawal penalty can be useful for certain individuals. But what about IRA owners who find themselves in a extremely serious financial situation that justifies taking money out of their retirement account – is there another option for those individuals?

Fortunately, there’s another option for taking penalty-free distributions that’s far less known. The holder of an IRA can begin taking distributions from their account as part of a series of what is known as “substantially equal periodic payments.”

The “substantially equal periodic payments” exemption allows the account holder to calculate a yearly amount that they can withdraw from their account every year, for at least five years, or until they reach age 59½, whichever is later.

Given the scope of this exemption, it’s essential for an account holder to be completely sure the withdrawal schedule works for them, and that they’ll be able to maintain and build their overall retirement nest egg to adequate levels. Think about this for a moment, a 25 year old who chooses to take a series of substantially equal periodic payments from their account must do so for more than 32 years. Stopping the withdrawals before they reach that point will subject the account holder to significant IRS penalties.

There are three basic methods for calculating the amount of the periodic payments; the “fixed annuitization method” and the “fixed amortization method.” Under a fixed annuitization approach, the account holder uses a life expectancy table and a “reasonable” interest rate (which will be at least as great as 120% of the federal midterm rate). The fixed amortization method uses a simple amortization approach, and generally yields a lower annual payout amount than the fixed annuitization method. The third approach is to use the same method as that for calculating the required minimum distributions that apply to traditional IRAs for account holders age 70½.

The biggest difference between the third method and the first and second methods is that the amount of the annual payment amount can vary greatly from year to year, depending on the investment activities that occur within the account.

The Biggest Secret to Retirement Saving Success With a Self-Directed IRA

There are certainly a lot of different retirement strategies out there. Regardless of your age, income level, or current level of savings, you’re likely to have access to multiple strategies to try to help you reach your goals.

And there’s no shortage of investment advice on what types of investments are best for you. Just pick up a copy of virtually any personal finance magazine and you’ll read about a wide range of options, some of which may even appear to be in direct conflict with one another.

But perhaps the biggest factor that will contribute to you reaching your retirement goals is common across all of these options. And it remains something of a secret even though it’s so easy to do. The secret?

Be consistent with your retirement savings.

By that we mean that if you save as much as you can each year, and you do so year in and year out, then you stand a very good chance of reaching your goals. When you are more consistent with your retirement savings, your choice of investments becomes less important. You won’t have to chase high yielding investments in an effort to boost the value of your nest egg because your account balance will grow over time merely by choosing investments

When you invest consistently, then over long periods of time your investment choices become less of a factor in determining how much you’ll accumulate. This isn’t to say that you should disregard the process of trying to choose your investments wisely, and select assets that meet your risk tolerance and other financial circumstances. Rather, it simply means that your research and analysis of your various investment possibilities shouldn’t overshadow the priority to put money aside in the first place.

In other words, your primary goal should be to contribute the maximum amount to your self-directed IRA every year, and your efforts should be focused on that first and foremost. After you’ve done the work to save as much as the IRS allows, then you can put the time and effort into figuring out how best to put that money to work.

You’ve probably seen the examples before. Looking at several different case studies of hypothetical investors — one who invests each year at the market low, one who invests at the beginning of the year, and one who is unlucky enough to invest at the top of the market — the results are surprising.

Over a period of several decades, the individual who is unfortunate enough to make their investments at the market peak each year has a smaller nest egg than the other two investors, but not by as great of a margin as you might think. And, more importantly, that bad market timer still has accumulated significantly more than an individual who didn’t save as much, or who simply contributed the same amounts to a bank account or other cash equivalent savings vehicle.

 

Have You Made a Plan for Taking Distributions From Your Retirement Accounts?

When most of us think about retirement planning, we tend to focus on the saving and wealth accumulation aspects of the process. That is, we plan how much we think we need to have accumulated by the time we reach our desired retirement age, in order to be able to lead the retirement lifestyle we want.

But a truly effective retirement plan also gives a significant amount of attention to what happens after you’ve built your nest egg and reached your target retirement age. You also need to plan how you’re going to take distributions from your retirement accounts during retirement.

Why Having a Plan is Important.

In short, having a plan for withdrawing money from your retirement accounts is important because you don’t want to outlive your retirement savings. Since it’s impossible for anyone to know when they’re going to pass, it’s important to have a plan, and to build some cushion into the timing of how long you’re going to need to fund your retirement.

Furthermore, this cushion can be vitally important if some of the assumptions you’re making now about your retirement don’t hold true. For example, you might not be able to work as long as you think. Or you might not have accumulated as much as you would have liked, either due to sub-maximal contributions or poor investment returns.

In any case, you’re not likely to be able to reach your retirement goals without giving careful consideration to all the factors relating to that retirement, and coming up with a plan for how and when you intend to take money out of your account.

Are You Subject to the Rules on Required Minimum Distributions?

If your self-directed IRA is set up as a traditional account, then you’ll be subject to the IRS rules on required minimum distributions. These rules state that once you reach age 70½, you must begin taking minimum distributions for your account every year for the rest of your life.

Having to make withdrawals from your account every year can require some degree of advance planning, particularly if you’ve used your account to invest in assets such as real estate or private equity, as these assets often require a significant lead time to be able to liquidate.

Roth self-directed IRAs are not subject to the rules on required minimum distributions.

Don’t Forget About Social Security.

Even if you haven’t been relying on your Social Security benefits when doing your retirement planning, there are still ways that the government retirement benefits program can impact your decision making. For example, you may choose to delay taking your Social Security benefits until you’re past your full retirement age, in order to increase the monthly check you receive from the government. Doing so may require you to withdraw a greater amount from your self-directed IRA until you start receiving benefits, but the long-term payout could make for a more comfortable retirement.

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.