Category Archives: Self-Directed Roth IRA

Top Ten Mistakes

Top Ten Mistakes I See People Make With Their Self-Directed IRAs

1) Not understanding the “self-directed” part of self-directed IRAs.

Unlike more traditional brokerage style IRAs, self-directed IRAs do not come with any tax, legal or investment advice, nor do self-directed custodians and third party administrators offer or endorse investment products.  Self-directed means just that – it is self-directed and you must find your own investments and decide how you want to structure those investments.  If you make a million dollars in your self-directed IRA all the glory belongs to you, but if you lose everything you have there is no one to blame but yourself.

2) Not investing in what they know best, but rather investing in something they know nothing whatsoever about.

One of the primary benefits of a self-directed IRA is that it allows you to invest in what you know best, especially if that is not the more traditional IRA investments like stocks, bonds, mutual funds or annuities.  Some people get very excited about the idea of self-direction and invest in something they know nothing about, which often leads to an investment disaster.  Most of my mistakes in investing have been because I have strayed from what I know how to do best.

3) Not understanding the disqualified persons and prohibited transaction rules.

Disqualified persons are those persons who are deemed to be too close to make a transaction within your IRA an arms-length transaction, which means these persons cannot enter into transactions with your IRA nor can they benefit from those transactions, either directly or indirectly.  Prohibited transactions are what your IRA cannot do with any disqualified person.  The penalty for entering into a prohibited transaction is DEATH (of the IRA that is) along with taxes and penalties.  If you have a self-directed IRA you must have a good basic understanding of these rules as they apply to your investing strategy.

4) Not vesting assets correctly – all assets in self-directed IRAs should be vested as follows:  “Quest IRA, Inc. FBO Your Name IRA #Your IRA Number.”

A lot of time is spent in attempting to get clients, title companies, and investment providers to understand that all assets must be vested in a specific way in order to be held within a self-directed IRA.  Common errors include failing to vest in the name of the custodian or administrator at all, or only putting the client name after the “FBO” so that it appears we are holding the asset on behalf of the individual instead of the individual’s IRA.  Another common mistake is where the client attempts to use their own Social Security Number instead of that of the IRA or the administrator or custodian’s trust tax identification number.

5) Failing to submit proper paperwork to allow smooth opening of IRAs and processing of transactions.

Another large time waster is chasing down paperwork from improperly completed documents for opening the IRAs, for transferring money into the IRAs and for transactions.  This leads to a frustrated client and frustrated staff.  Taking the time to learn how to properly submit paperwork and allowing yourself enough time to do so is critical in successfully navigating the self-directed IRA world.  Remember, it is better to ask questions in advance than to submit incorrect paperwork and cause a delay.

6) Not understanding what they are investing in.

This is a big one.  It is almost incomprehensible to me how some people don’t have any understanding of what they are investing in at all.  For example, a person called the other day and thought she had a note and an option agreement.  Instead, she had a simple option where she had paid $28,000 for an option to buy 50% of the property for $10.  This was meant to help the owner out of foreclosure. The homeowner had the right to buy back the option at a profit to the IRA of about $5,000. The good news is that it worked for a time period and the homeowner got to stay in the house for an extra two years.  The bad news is that the homeowner still wasn’t fiscally responsible and the IRA lost every dime when the lien holder foreclosed. Since all the IRA had was an option (not a note as she thought) she could not even sue to recover some of her money, and even if she had exercised her option her IRA would have only owned half of the house.

7) Not understanding Unrelated Business Income Tax and how it may affect your IRA.

IRAs may be taxed in three circumstances.  First, if it runs a business, either directly in the IRA or indirectly through a non-taxed entity such as a partnership or LLC.  Second, if the IRA owns and rents out personal property (rents from real property are exempt from this tax).  Third, if the IRA owns debt-financed property, again either directly in the IRA or indirectly through a non-taxed entity such as a partnership or LLC.  Just to be clear, it is not necessarily all bad to make investments which cause your IRA to pay tax, especially within a Roth IRA or other tax free account, but it is something you should understand up front.

8) Trusting someone with your hard earned IRA money without doing proper due diligence and proper paperwork.

Let me give you a hint – con men are very good at what they do.  Make sure you understand what you are investing in, and do your due diligence on the investment and on the person you are investing with before making an investment decision.  Also, make sure you have proper paperwork.  I wouldn’t loan money to my own mother without proper documentation!  Proper paperwork protects both your IRA and the person your IRA is investing with.  Think about what would happen if either you died or the person you invested with died.  Would either party’s heirs understand what the investment was all about?  Even if you trusted the person you invested with absolutely, would their heirs know about your handshake deal and honor it?  Probably not!  An excellent rule of thumb in investing is that if it sounds too good to be true it probably is.  Also, a common thread in scams is that it must be done NOW or you will miss out on this incredible opportunity!  This is an attempt to draw you in without allowing you time to think about or due diligence on the investment.

9) Failing to follow proper strategy when loaning your IRA to other investors.

There are at least 10 simple rules to follow when lending your IRA money out (or even your personal money).  They are:

a)         Do not loan on something you wouldn’t be excited to own if the borrower defaults.

b)         Generally, do not advance money for repairs until the repairs are done, and then inspect the repairs before advancing the funds.

c)         Do not loan to someone you would feel uncomfortable foreclosing on!

d)         If the loan goes into default, do not delay – take action immediately!

e)         Collect interest monthly so you will know if the borrower is getting into trouble.

f)          If you are unsure about a loan, hire a professional to help you evaluate the deal (at the borrower’s cost, of course!).

g)         Get title insurance on your loan.  If done at closing the incremental cost to the borrower is very small.

h)        Verify that hazard and, if necessary, flood and wind insurance are in place naming your IRA as an additional insured.

i)          Insist on evidence that taxes, homeowners association dues and hazard insurance are paid when they come due during the term of the loan.

j)          Get a personal guarantee when lending to a non-individual borrower or a weak borrower.

10) Attempting to figure out how to get around the rules to get a benefit for themselves or other disqualified persons rather than simply investing within the rules.

It seems to be very tempting for people to want to use their own IRAs to make money or obtain some other benefit for themselves or other disqualified persons right now instead of letting all the benefits go to the IRA so that they have a nice retirement.  To make matters worse, a lot of gurus are teaching how to hide the fact that you are violating the rules instead of teaching people how to use the rules properly to their advantage.  My personal motto is, use the law to your advantage but don’t abuse the law.  After all, the “R” in IRA stands for Retirement. It is not an INA (or Individual NOW Account)!  To make money now, use OPI (Other People’s IRAs), and to make money for your retirement, use your own self-directed IRA.

11) Attempting to use a “checkbook control LLC” to get their hands on their IRA funds without having to deal with all that pesky paperwork and those silly prohibited transaction rules without understanding the extreme danger involved.

This is popular but is not wise.  However, to explain it fully would take a full weekend with me, Dyches Boddiford and CPA David Worley.  Come to think of it, we are explaining it all in August in Atlanta, Georgia if anyone is interested.

Top 10 Things You Need to Know About Self-Directed IRAs

By: H. Quincy Long

There is a lot of confusion over self-directed IRAs and what is and is not possible.  In this article I will discuss some of the most important things you need to know about self-directed IRAs.

1)   IRAs Can Purchase Almost Anything.  A common misconception about IRAs is that purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA.  This is false.  The only prohibitions contained in the Internal Revenue Code for IRAs are investments in life insurance contracts and in “collectibles.”  Since there are so few restrictions contained in the law, almost anything else which can be documented can be purchased in your IRA.  A “self-directed” IRA allows any investment not expressly prohibited by law.  Common investment choices include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, limited liability companies, limited partnerships, trusts and a whole lot more.

2) Seven Types of Accounts Can Be Self-Directed, Not Just Roth IRAs.  There are seven different types of accounts which can be self-directed.  They are the 1) Roth IRA, 2) the Traditional IRA, 3) the SEP IRA, 4) the SIMPLE IRA, 5) the Individual 401(k), including the Roth 401(k), 6) the Coverdell Education Savings Account (ESA, formerly known as the Education IRA), and 7) the Health Savings Account (HSA).  Not only can all of these accounts invest in non-traditional investments as indicated above, but they can be combined together to purchase a single investment.

3) Almost Anyone Can Have a Self-Directed Account of Some Type.  Although there are income limits for contributing to a Roth IRA, having a retirement plan at work does not affect your ability to contribute to a Roth IRA, and there is no age limit either.  With a Traditional IRA, the fact that you or your spouse has a retirement plan at work may affect the deductibility of your contribution, but anyone with earned income who is under age 70 1/2 can contribute to a Traditional IRA.  There are no upper income limits for contributing to a Traditional IRA.  A Traditional IRA can also receive funds from a prior employer’s 401(k) or other qualified plan.  Additionally, you may be able to contribute to a Coverdell ESA for your children or grandchildren, nieces, nephews or even my children, if you are so inclined.  If you have the right type of health insurance, called a High Deductible Health Plan, you can contribute to an HSA regardless of your income level.  With an HSA, you may deduct your contributions to the account and qualified distributions are tax free forever!  All of this is in addition to any retirement plan you have at your job or for your self-employed business, including a SEP IRA, a SIMPLE IRA or a qualified plan such as a 401(k) plan or a 403(b) plan.

4) Even Small Balance Accounts Can Participate in Non-Traditional Investing.  There are at least 4 ways you can participate in real estate investment even with a small IRA.  First, you can wholesale property.  You simply put the contract in the name of your IRA instead of your name.  The earnest money comes from the IRA.  When you assign the contract, the assignment fee goes back into your IRA.  If using a Roth IRA, a Roth 401(k), an HSA, or a Coverdell ESA, this profit can be tax-free forever as long as you take the money out as a qualified distribution.  Second, you can purchase an option on real estate, which then can be either exercised, assigned to a third party, or canceled for a fee.  Third, you can purchase property in your IRA subject to existing financing or with a non-recourse loan from a bank, a hard money lender, a financial friend or a motivated seller.  Profits from debt-financed property in your IRA may incur unrelated business income tax (UBIT), however.  Finally, your IRA can be a partner with other IRA or non-IRA investors.  For example, one recent hard money loan we funded had 10 different accounts participating.  The smallest account to participate was for only $1,827.00!

5) Caution:  There Are Restrictions on What You Can Do With Your IRA.  Although as noted above in paragraph 1 the Internal Revenue Code lists very few investment restrictions, certain transactions (as opposed to investments) are considered to be prohibited.  If your IRA enters into a prohibited transaction, there are severe consequences, so it is important to understand what constitutes a prohibited transaction.  Essentially, the prohibited transaction rules were made to discourage certain persons, called disqualified persons, from dealing with the income and assets of the plan in a self-dealing manner.  As a result, disqualified persons are prohibited from directly or indirectly entering into or benefitting from your IRA’s investments. The assets of a plan are to be invested in a manner which benefits the plan itself and not the IRA owner (other than as a beneficiary of the IRA) or any other disqualified person.  Investment transactions are supposed to be on an arms-length basis.  Disqualified persons to your IRA include, among others, yourself, your spouse, your parents and other lineal ascendants, your kids and other lineal descendants and their spouses, and any corporation, partnership trust or estate which is owned or controlled by any combination of these persons.  It is essential when choosing a custodian or administrator that the company you choose is very knowledgeable in this area.  Even though no self-directed IRA custodian or administrator will give you tax, legal or investment advice, the education they provide will be critical to your success as a self-directed IRA investor.

6) Some IRA Investments May Cause Your IRA to Owe Taxes – But That May Be Okay.  Normally an IRA’s income and profits are exempt from taxation until a distribution is taken (or not at all, if it is a qualifying distribution from a Roth IRA).  However, there are three circumstances when an IRA may owe tax on its profits.  First, if the IRA is engaged in an unrelated trade or business, either directly or indirectly through a non-taxable entity such as an LLC or a limited partnership, the IRA will owe tax on its share of Unrelated Business Income (UBI).  Second, the IRA will owe taxes if it has rental income from personal property, such as a mobile home not treated as real estate under state law (but rents from real property are exempt from tax if the property is debt-free).  Finally, if the IRA owns, either directly or indirectly, property subject to debt, it will owe tax only on the portion of its income derived from the debt, which is sometimes referred to as Unrelated Debt Financed Income (UDFI).  This may sound like something you never would want to do, but a more careful analysis may lead you to the conclusion that paying tax now in your IRA may be the way to financial freedom in your retirement.  For example, one client made a net gain of over 1,000% in less than four months after her IRA paid this tax.  This is definitely a topic you will want to learn more about, but it is not something you should shut your mind to before investigating whether the after tax returns on your investment would exceed the return you might otherwise be able to achieve in your IRA.

7) An Inherited Roth IRA Can Give You Tax Free Income Now No Matter What Your Age.  Many people know that a qualified distribution from a Roth IRA is tax free.  To make the distribution qualify as tax free, it must be distributed after the IRA owner has had a Roth IRA for at least 5 tax years and after one of four events occurs – 1) the IRA owner is over age 59 ½, 2) the IRA owner becomes disabled, 3) the IRA owner dies and the distribution is to his or her beneficiary, or 4) the distribution is for a first-time home purchase, either for the IRA owner or certain close family members.  Although the neither the original Roth IRA owner nor his or her spouse has to take a distribution (assuming the spouse elects to treat the IRA as their own), non-spouse beneficiaries of a Roth IRA do have to take distributions, normally over their expected lifetimes.  However, once the five year test is met, those distributions are tax free, regardless of the age of the IRA beneficiary!  Even a $100,000 Roth IRA left to a 6 year old beneficiary may generate as much as $80,496,367 in lifetime tax free distributions if the IRA can sustain a yield of 12%, which is very possible with a self-directed IRA.

8) 2010 Brings an Incredible Gift From Your Government.  Most people who understand the benefits of a Roth IRA really want one, but many people have not been able to qualify for this incredible wealth building tool because of income limitations which restrict the eligibility of a person to contribute to a Roth IRA or to convert pre-tax accounts like Traditional IRAs into a Roth IRA.  In 2010 the rules for conversions will change so that anyone, regardless of income level, will be eligible to do a Roth conversion.  Beginning in 2010 anyone who has a Traditional IRA (including a SEP IRA), a SIMPLE IRA which has been in existence for at least two years, or a former employer retirement plan such as a 401(k) or a 403(b) can convert those into a Roth IRA and can then begin to create tax free wealth for their retirement.  Even if you do not currently have an IRA but are eligible to contribute to a Traditional IRA, the contribution can be made and immediately converted into a Roth IRA.  This truly is one of the most exciting tax planning opportunities to come along in a very long time!

9) There Are Millions of Dollars Available to Finance Your Real Estate Deals Right Now.  We are in a very exciting time for wise real estate investors.  There are a lot of super real estate bargains out there right now, but it can be very difficult for investors to get financing – unless they know the secret of private financing.  There are billions of dollars of lazy IRA money sitting on the sidelines waiting for the right investment, because many people are very afraid of the stock market.  Included among the many things people can invest in with a self-directed IRA are real estate secured loans or even unsecured loans.  Shakespeare wrote in his play Hamlet, “Neither a lender nor a borrower be, for a loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.”  I believe Shakespeare was wrong, but he might be forgiven since he did not have the advantage of knowing about self-directed IRAs.  You can benefit from your knowledge of self-directed IRAs either by having your IRA be a private lender or by borrowing OPI – Other People’s IRAs – for your real estate transactions.  Networking is the key to success in the area of private lending or borrowing, but there are things you must know to do it properly.

10) Use Options to Dramatically Boost Your Small IRA.  Options are one of the most powerful and under-utilized tools in real estate investing today, and they work beautifully within a self-directed IRA.  The consideration for the option and the property being optioned can be almost anything, not just real estate.  Once an IRA owns an option, it can 1) let the option lapse (which at times is the right answer), 2) exercise the option and acquire the property, 3) assign the option for a fee (assuming the option agreement allows for assignment) or 4) agree to cancel the option for a fee with the property owner, thereby getting paid not to buy the property!  Options are very flexible and can be designed to fit almost any situation.  One client paid $5,000 from his Roth IRA for an option which he later canceled for a fee of over $35,000.   Then he took that money, bought a property at a foreclosure auction for cash, and later sold the property for $70,000 with $5,000 down and a $65,000 seller-financed note.  By using the option he was able to take his $5,000 Roth IRA and turn it into a $70,000 Roth in less than a year!

Truthfully there are many more things that you should know about self-directed IRAs.  To learn more, attend one or more of Quest IRAs many free networking and educational events.  You can get the entire schedule of events in addition to playing pre-recorded webinars by going to our website at www.QuestIRA.com.  Happy investing!

H. Quincy Long is an attorney who holds the designation of Certified IRA Services Professional (CISP) and is President of Quest IRA, Inc., a third party administrator of self-directed IRAs serving clients in the State of Texas and throughout the nation with offices in Houston and Dallas.  He may be reached by email at Quincy@QuestIRA.com, Nothing in this article is intended as tax, legal or investment advice.
© Copyright 2009 H. Quincy Long.  All rights reserved.

Frequently Asked Questions About Buying Debt Financed Real Estate in an IRA

By:      H. Quincy Long

            Good news!  You can buy real estate in your traditional, Roth, SEP, or SIMPLE IRA, your 401(k), your Coverdell Education Savings Account for the kids, and even in your Health Savings Account.  Even better, your IRA can borrow the money for the purchase or even take over a property subject to existing financing.  What could be better than building your retirement wealth using OPM (Other People’s Money)?  However, there are some restrictions which you must be aware of when using your IRA to purchase debt financed real estate.  Below I answer a series of frequently asked questions regarding the purchase of debt financed real estate in an IRA.

Q.        Is it really legal to buy real estate in an IRA?

A.        Yes.  Even the IRS agrees that real estate is a permitted investment.  In its answer to the question “Are there any restrictions on the things I can invest my IRA in?” the Internal Revenue Service states “IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”

Q.        Can my IRA buy real estate with a loan or take over a property subject to an existing loan?

A.        Yes.  An IRA may borrow money to acquire real estate or take over a property subject to an existing loan, provided that the loan is non-recourse to the IRA and to any “disqualified person.”  This means that typically the lender may only foreclose on the property in the event of a default.  Even if there is a deficiency, the lender cannot come after the rest of the IRA’s assets, nor can the lender come after the IRA owner or any other disqualified person.  Neither the IRA holder nor any other disqualified person is permitted to sign a personal guarantee of the debt.

Q.        Where can I get a non-recourse loan for my IRA?

A.        There are at least four sources for financing which do not violate the non-recourse requirements for IRA’s.  First, there is seller financing.  Most sellers understand that if the loan goes into default they get the property back anyway, so asking for the loan to be non-recourse should not be too difficult to negotiate.  Second, there is private financing from financial friends.  If you cultivate a reputation as a professional real estate investor, there should be no reason that your financial friends would not loan your IRA money on a non-recourse basis, either from their own funds or from their own IRA’s.  I have seen IRA’s borrow the money for both the purchase and the rehab on a non-recourse loan!  Third, there are banks and hard money lenders.  Non-recourse loans are not the norm, so many banks will turn you down.  However, there is at least one bank that lends in all 50 states, and in Houston I have had at least 3 local banks and 2 hard money lenders make non-recourse loans to IRA’s.  Finally, as mentioned above, you could take over a property subject to an existing loan, provided the originator of the loan is not you or another disqualified person.

Q.        Is there any tax effect of having an IRA own debt financed real estate?

A.        Yes.  Income and gains from investments in an IRA, including real estate, are normally not taxed until the income is distributed (unless the distribution is a qualifying distribution from a Roth IRA, a Coverdell Education Savings Account, or a Health Savings Account, in which case the distribution is tax free).  However, if the IRA owns property subject to debt, either directly or indirectly through an LLC or a partnership, it may owe tax on the net income from the property or partnership.

Q.        If the profits from an investment are taxable to an IRA, does that mean it is prohibited?

A.        Absolutely not!  There is nothing prohibited at all about making investments in your IRA which will cause the IRA to owe taxes.

Q.        But if an investment is taxable, why do it in the IRA?

A.        That is a good question.  To figure out if this makes sense, ask yourself the following key questions.  First, what would you pay in taxes if you made the same investment outside of the IRA?  The “penalty” for making the investment inside your IRA, if any, is only the amount of tax your IRA would pay which exceeds what you would pay personally outside of your IRA.  Unlike personal investments, the IRA owes tax only on the portion of the net income related to the debt, so depending on how heavily leveraged the property is the IRA may actually owe less tax than you would personally on the same investment.  Second, does the return you expect from this investment even after paying the tax exceed the return you could achieve in other non-taxable investments within the IRA?  For example, one client was able to grow her Roth IRA from $3,000 to over $33,000 using debt financed real estate in under 4 months even after the IRA paid taxes on the gain!  Third, do you have plans for re-investing the profits from the investment?  If you re-invest your profits from an investment made outside of your IRA you pay taxes again on the profits from the next investment, and the one after that, etc.  At least within the IRA you have the choice of making future investments which will be tax free or tax deferred, depending on the type of account you have.

Q.        If the IRA pays a tax, and then it is distributed to me and taxed again, isn’t that double taxation?

A.        Yes, unless it is a qualified tax free distribution from a Roth IRA, a Health Savings Account (HSA) or a Coverdell Education Savings Account (ESA).  The fact is that you still want your IRA to grow, and sometimes the best way to accomplish that goal is to make investments which will cause the IRA to pay taxes.  Keep in mind that companies which are publicly traded already have paid taxes before dividends are distributed, and the value of the stock takes into consideration the profits after the payment of income taxes.  In that sense, even stock and mutual funds are subject to “double taxation.”

Q.        If the IRA makes an investment subject to tax, who pays the tax?

A.        The IRA must pay the tax.

Q.        What form does the IRA file if it owes taxes?

A.        IRS Form 990-T, Exempt Organization Business Income Tax Return.

Q.        What is the tax rate that IRA’s must pay?

A.        The IRA is taxed at the rate for trusts.  Refer to the instructions for IRS Form 990-T for current rates.  For 2005, the marginal tax rate for ordinary income above $9,750 was 35%.  Capital gain income is taxed according to the usual rules for short term and long term capital gains.

Q.        Is there any way to get around paying this tax?

A.        Yes.  In some ways it may be considered a “voluntary” tax, since investments can often be structured in such a way as to avoid taxation.  Some ways to structure your IRA investment to avoid taxation include loaning money instead of acquiring the real estate directly or purchasing an option on the real estate, then assigning or canceling the option for a fee.  These techniques have a disadvantage in that they may not result in as much profit to the IRA, but will generally be free of tax.  There is also an exemption from this tax for 401(k)’s and other qualified plans in certain circumstances.

Q.        Where can I find out more information?

A.        Visit our website at www.QuestIRA.com for more information.  Also, Unrelated Business Taxable Income and Unrelated Debt Financed Income are covered in IRS

Publication 598, which is freely available on the IRS website at www.irs.gov.  The actual statutes may be found in Internal Revenue Code §511-514.

            There is one general truth that applies both inside and outside of an IRA – you can do more with debt than you can without it.  Despite the increased risk from debt and the taxes due on income from debt financed property, a careful analysis may lead to the conclusion that having your IRA pay taxes now may be the way to financial freedom in your retirement.  Be sure to have your IRA pay the tax if it owes it, though.  As I always say, “Don’t mess with the IRS, because they have what it takes to take what you have!”

Do Roth Conversions Make Sense? How to Analyze the 2010 Roth Conversion Opportunity

By: H. Quincy Long           

            How would you like to have tax free income when you retire?  Would you like to have the ability to leave a legacy of tax free income to your heirs when you die?  The great news is that there is a way to achieve these goals – it is through a Roth IRA.

            Historically, because of income limits for contributions to a Roth IRA and for converting a Traditional IRA into a Roth IRA, high income earners have not been able to utilize this incredible wealth building tool.  Fortunately, the conversion rules are changing so that almost anyone, regardless of their income level, can have a Roth IRA.  But is it really worth converting your Traditional IRA into a Roth IRA and paying taxes on the amount of your conversion if you are in a high tax bracket?  For me, the answer is a resounding yes.  I firmly believe it is worth the pain of conversion for the tremendous benefits of a large Roth IRA, especially given the flexibility of investing through a self-directed IRA.

            For Traditional to Roth IRA conversions in tax year 2009, the Modified Adjusted Gross Income (MAGI) limit for converting to a Roth IRA is $100,000, whether you are single or married filing jointly.  However, the Tax Increase Prevention and Reconciliation Act (TIPRA) removed the $100,000 MAGI limit for converting to a Roth IRA for tax years after 2009.  This means that beginning in 2010 virtually anyone who either has a Traditional IRA or a former employer’s retirement plan or who is eligible to contribute to a Traditional IRA will be entitled to convert that pre-tax account into a Roth IRA, regardless of income level.

            Even better, for conversions done in tax year 2010 only you are given the choice of paying all of the taxes in tax year 2010 or dividing the conversion income into tax years 2011 and 2012.  If you convert on January 2, 2010, you would not have to finish paying the taxes on your conversion until you filed your 2012 tax return in 2013 – more than 3 years after you converted your Traditional IRA!  One consideration in deciding whether to pay taxes on the conversion in 2010 or dividing the conversion income into 2011 and 2012 is that 2010 is the last tax year in which the tax rates are at a maximum of 35%.  Tax rates are scheduled to return to a maximum tax rate of 39.6% in 2011, and other tax brackets are scheduled to increase as well, so delaying the payment of taxes on the conversion will cost you some additional taxes in 2011 and 2012.  The benefit of delaying payment of the taxes is that you have longer to invest the money before the taxes need to be paid, whether the payment comes from the Roth IRA or from funds outside of the Roth IRA.

            The analysis of whether or not to convert your Traditional IRA to a Roth IRA is a complex one for most people, because it depends so much on your personal tax situation and your assumptions about what might happen in the future to your income and to tax rates, as well as how you invest your money.  From my own personal perspective, I make the simple assumption that tax free income in retirement is better than taxable income.  I can afford to pay my taxes now (not that I like it), and I would like to worry less about taxes when I retire.  I also don’t believe that tax rates will be going down in the future.  For me, the decision comes down to whether I want to pay taxes on the “acorn” (my Traditional IRA balance now) or the “oak tree” (my much higher IRA balance years in the future as I make withdrawals). 

            The way I analyze whether or not to convert to a Roth IRA is to calculate my “recovery period” – that is, the time it takes before my overall wealth recovers from the additional taxes I have to pay on the conversion.  If I can recover the cost of the taxes on the conversion before I might need the money in the Roth IRA, then I say it is worth doing, especially since the gains after the conversion are tax free forever.  Fortunately, with a self-directed IRA you are in total control of your investments, and the recovery period can be quite short.  There may also be a benefit if you are able to convert an asset now that may have a substantial increase in value later.

            Using my own situation as an example, I have been planning on doing a conversion in 2010 ever since the passage of TIPRA was announced in 2006.  My first step was to immediately begin making non-deductible Traditional IRA contributions.  Even though I am covered by a 401(k) plan at my company and earn more than the limits for making a deductible Traditional IRA contribution, this does not prevent me from making a non-deductible contribution since I am under age 70 ½.  The main reason I have been making non-deductible contributions to my Traditional IRA is to have more money to convert into a Roth IRA in 2010.  The best thing about this plan is that only the gains I make on the non-deductible contributions to the Traditional IRA will be taxed when I convert to a Roth IRA, since I have already paid taxes on that amount by not taking the deduction.

            I plan on converting approximately $100,000 in pre-tax Traditional IRA money in 2010.  The actual amount converted will be more like $150,000, but as I noted above my wife and I have been making non-deductible contributions to our Traditional IRAs since 2006, so the actual amount we pay taxes on will be less than the total conversion amount.  This means that my tax bill on the conversion will be $35,000 if I pay it all in tax year 2010 or $39,600 divided evenly between tax years 2011 and 2012, assuming I remain in the same tax bracket and Congress doesn’t make other changes to the tax code.

            To help analyze the conversion, I made some calculations of how long it would take me to recover the money I had to pay out in taxes at various rates of return, assuming a taxable conversion of $100,000 and a tax bite of $35,000.  I calculated my recovery period based on paying the taxes with funds outside of the IRA (which is my preference) and by paying taxes from funds withdrawn from the Roth IRA, including the early withdrawal penalty I would have to pay since I am under age 59 ½. 

            If I pay taxes with funds outside of my Roth IRA and can achieve a 12% return compounded monthly, my Roth IRA will grow to $135,000 in only 30 months, at which point I will have fully recovered the cost of the conversion.  A 6% yield on my investments will cause my recovery period to stretch to 60 months, while an 18% yield will result in a recovery period of only 20 months!  Of course paying taxes with funds outside of the IRA reduces my ability to invest that money in other assets for current income or to spend it on living expenses.  But if I have to withdraw the money from the Roth IRA to pay taxes and the early withdrawal penalty, the recovery period for my Roth IRA to achieve a $39,000 increase ($35,000 in taxes and a $3,900 premature distribution penalty) increases to 50 months at a 12% yield and 99 months for a 6% yield.  Paying the taxes from funds outside of my Roth IRA will result in a much larger account in the future also since the full $100,000 can be invested if taxes are paid with outside funds, while only $61,000 remains in the Roth IRA after withdrawal of sufficient funds to pay the taxes and penalties.

            I believe that since my IRAs are all self-directed I can easily recover the cost of the conversion (i.e. the taxes paid) in less than 3 years based on my investment strategy.  From that point forward I am building tax free wealth for me and my heirs.  How can I recover the taxes so quickly?  It’s easy!  Self-directed IRAs can invest in all types of non-traditional investments, including real estate, notes (both secured and unsecured), options, LLCs, limited partnerships and non-publicly traded stock in C corporations.  With a self-directed IRA you can take control of your retirement assets and invest in what you know best.

            In my retirement plan I invest in a lot of real estate secured notes, mostly at 12% interest with anywhere from 2-6% up front in points and fees.  I also own some stock in a 2 year old start up bank in Houston, Texas which is doing very well, and a small amount of stock in a Colorado bank.  As the notes mature I plan on purchasing real estate with my accounts, because I believe now is the best time to buy.  In some cases I may purchase the real estate itself and in other cases I will probably just purchase an option on real estate.  The bank stock will be converted at the market price in 2010, but when the banks sell in a few years I expect to receive a substantial boost in my retirement savings since banks most often sell at a multiple of their book value.  In the meantime, the notes and the real estate will produce cash flow for the IRA, and if I have done my investing correctly the real estate will also result in a substantial increase in my Roth IRA when it sells in a few years.

            Note that I have written this article from the perspective of someone who is in a high tax bracket.  A lower tax bracket will reduce the recovery period and is an even better bargain, especially if you can afford to pay the taxes from funds outside of the Roth IRA.  If you take advantage of the opportunities afforded to you by investing in non-traditional assets with your self-directed Roth IRA, you can truly retire wealthy with a pot of tax free gold at the end of the rainbow.

            H. Quincy Long is Certified IRA Services Professional (CISP) and an attorney and is President of Quest IRA, Inc., with offices in Houston, Austin,  and Dallas, Texas. In addition to Texas, Qunicy has opened an office in Mason, MI this year in December of  2011 and is planning to open an office in Seattle, Washington within the next 12 months.  He may be reached by email at Quincy@QuestIRA.com Nothing in this article is intended as tax, legal or investment advice.

Can I Have a Roth Too, Please? Yes, You Can!!!

By H. Quincy Long

            Most people want a Roth IRA once they understand the tremendous tax benefits.  You do not receive a tax deduction for contributing money to a Roth IRA, but qualified distributions are TAX FREE FOREVER.  Essentially the concept of a Roth IRA is that you pay taxes on the “acorn” (the initial contribution) instead of the “oak tree” (the potentially large amount in the Roth IRA after many years of tax deferred accumulation).  This is especially beneficial in a truly self-directed IRA, which can invest in real estate, notes, options, private company stock, LLCs, limited partnerships and other non-traditional asset

            Unfortunately, there are income limits for contributing to a Roth IRA or converting money from a Traditional IRA to a Roth IRA.  For contributions, a married couple filing jointly may not contribute if they have Modified Adjusted Gross Income (MAGI) of more than $176,000 for 2009.  For single individuals the MAGI limit is no more than $120,000 for 2009 to be able to contribute to a Roth IRA.  The news is even worse if you want to convert assets from a Traditional IRA to a Roth IRA.  Whether married or single, you are not eligible to do a Roth conversion if your MAGI is more than $100,000.

            For people who exceed these income limits, it might at first appear that they are left out in the cold when it comes to Roth IRAs.  Fortunately, this is not actually true.  There are at least 3 ways in which a person who exceeds the income limits may end up with a Roth IRA.  The key phrase is “end up with” in the preceding statement.

            The first method of acquiring a Roth IRA if you exceed the income limits is to inherit one.  There is no age discrimination for contributing to a Roth IRA, unlike the Traditional IRA.  Anyone with earned income within the limits can contribute.  Earned income is generally income on which you must pay Social Security and Medicare taxes.  Passive or investment income, including rents, interest and dividends do not count as earned income, but it is not that hard to create earned income.  An elderly relative or friend may be able to help in your business in some way, for example, and your payment to them for their assistance would be earned income.  They may even be predisposed to name you as their beneficiary in the event of their death.

When a Roth IRA is inherited, the new account owner must take required minimum distributions from the IRA, unless the inheritor is a spouse.  Required minimum distributions are not required for the original account owner.  However, this does not mean that the balance in the account cannot be invested, and it is easy, at least with a self-directed IRA, to create income which exceeds the yearly required minimum distributions.  Even better, if the person who died had a Roth IRA for at least 5 tax years, distributions from the account are tax free, even if the inheritor is under age 59 ½.  There is never a 10% premature distribution penalty either, since the distribution is due to death.

            A second method to acquire a Roth IRA has to do with excess contributions.  Many people do not really know whether their income will exceed the limits when they make their Roth IRA contribution, especially if they contribute early in the year.  This is certainly true of self-employed persons.  So what happens if you make a mistake by contributing early and it turns out your income exceeded the MAGI limit for the year? 

If you take action before your tax filing deadline, including extensions (generally October 15), you can recharacterize the contribution to a traditional IRA as long as you are under age 70 1/2, along with all of the net income attributable (NIA) to the contribution.  You may also remove the contribution from the Roth IRA, along with any net income attributable.  In this case the only penalty which you might have to pay is on the income attributed to the contribution, not on the contribution itself.  If you remove the contribution after your tax filing deadline plus extensions, it is unclear from the regulations whether you must also remove the net income attributable from the Roth IRA.  A third choice is to leave the contribution in the Roth IRA and pay a penalty on the excess contribution.  In many circumstances this may be the wisest choice.

If you leave the money in your Roth IRA, you are required to pay a penalty of 6% of the amount of the excess contribution for each year that the excess remains in the Roth IRA.  For example, if you make an excess contribution $4,000 to a Roth IRA and your MAGI exceeds the limit, your penalty is only $240 for each year the excess remains in the account.  This is the penalty regardless of how much money you make in the Roth!  Since the penalty only applies for as long as the excess contribution remains in the Roth IRA, you will no longer have to pay the penalty if you qualify for a Roth in a future year and do not contribute or if you remove the contribution.  Once you have a Roth IRA, the account may continue to be invested regardless of your current year income. 

            Finally, in 2010 the $100,000 MAGI limit for converting assets from a Traditional IRA to a Roth IRA is eliminated.  Although a person who exceeds the MAGI limit will still not be able to contribute to a Roth IRA, in 2010 and future years anyone may convert assets in a Traditional IRA to a Roth IRA, no matter what their income level.  The amount converted is generally added to your taxable income for the year of conversion to extent it exceeds any non-deductible contributions in the account.  For conversions in the year 2010 only, however, the person converting has the choice of paying 50% of the taxes on the conversion in 2011 and the other 50% in 2012.  You have 3 years to pay taxes on Roth conversions done in 2010!

            As I always say, there are worse things than not qualifying for a Roth IRA, such as qualifying for a Roth IRA!  Whether by inheriting a Roth IRA, through an inadvertent excess contribution, or by conversion in 2010, even those who are fortunate enough not to qualify for a Roth IRA due to income exceeding the MAGI limit may end up with a Roth IRA.  Even a small Roth IRA can be built into a large IRA with careful investing, which means that even the wealthy can have a substantial amount of tax free retirement income.

What’s in a Name? – Why It’s Important to Name a Beneficiary for Your IRA

By H. Quincy Long

             Many people probably don’t think too much about how important it is to name a beneficiary for their IRAs.  However, as my family recently found out, ignoring this important detail when setting up your IRA can be costly from a tax perspective.

             I recently received a distribution check from an IRA of my father, who passed away last year.  My father was a very careful planner, so I was quite shocked at his lack of tax planning with his IRA.  When setting up his IRA he named his estate as the beneficiary of the IRA (this is equivalent to not naming a beneficiary at all).  This meant that when he passed away the estate had to be probated, even though the IRAs were the only assets requiring probate in his estate.  IRAs that have named beneficiaries are generally non-probate assets, meaning that they pass directly to the beneficiaries instead of passing through a will.  That was the first problem. 

The larger problem came because of the lack of choices he left us by naming his estate as beneficiary.  In a Traditional IRA, required minimum distributions must begin no later than April 1 of the year after the IRA owner turns age 70 ½.  This is known as the required beginning date.  My father died before his required beginning date.  Since his estate is a non-individual beneficiary, the IRA had to be distributed within 5 years, or by December 31, 2011.  If my father had died after his required beginning date without having a named individual beneficiary, the yearly required minimum distributions would have been based on his remaining life expectancy in the year of his death reduced by one for each year following the year of his death. 

In contrast, the choices available to our family had my father simply named beneficiaries would have been much more favorable.  Assuming my father wanted his wife and 3 sons to split the IRA in the same percentages he listed in the will, he could have named us specifically instead of requiring the distribution to be made through his estate.  If the IRA was not split into separate IRAs by September 30 of the year following the year of his death, then required minimum distributions would have been based on the remaining life expectancy of the oldest beneficiary, which was of course his wife.  As his wife is a few years younger than he was, this certainly would have been a large improvement over taking the entire IRA over the next 5 years.

Had my father named the 4 of us as beneficiaries specifically, an even better plan would have been to separate the IRAs into 4 beneficiary IRAs with each of us as the sole beneficiary prior to September 30 of 2007 (the year following his death).  In his wife’s case this would mean that she could choose to take all the money out within 5 tax years, leave the IRA as a beneficiary IRA, thereby allowing her to take distributions without penalty even if she was under age 59 1/2, or she could have elected to treat the IRA as her own.  In the case of his sons, we could have

taken the IRA over 5 years or we could have stretched the distributions over our life expectancy.  For example, in my case I could have elected to take the distributions over the next 39 years instead of all at once!

Since I expected nothing from my father’s estate and have no critical need for the funds, I would have taken the longer distribution period.  Instead I must add the distribution check to my taxable income for this year, which in my tax bracket means a substantial bite out of the money for taxes.  Since I am reasonably good at investing in my self-directed IRAs, having the ability to stretch the distributions out over 39 years would have meant an inheritance of many times what I will end up with after taxes because I had to take it all within 5 years.

The problem is even worse for my father’s wife, who will have an extraordinarily large tax burden this year, since she chose to take her share of the IRA out all at once instead of over a 5 year period.  While I am certainly grateful that my father thought of me in his will, simply naming specific beneficiaries would have made his legacy worth so much more to his family. 

Don’t let it happen to your family!  Review your IRA beneficiary designations, and if you haven’t already done so, name your beneficiaries.  Your family will be glad you did.

Either a Lender or Borrower Be

By:  H. Quincy Long         

            Personally, I think Shakespeare had it wrong when he penned this advice in Hamlet:  “Neither a borrower nor a lender be; For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry.”  Perhaps he may be forgiven for his error, however, since Shakespeare suffered from a lack of the tremendous benefits of a truly self-directed IRA. 

            Money in self-directed IRAs can be loaned out to any person who is not a “disqualified person.”  While this means that you cannot loan yourself or other related disqualified persons money from your self-directed IRA, you can loan the money to anyone else.  Loans can be secured by real estate, mobile homes, equipment or anything you like.  If you are really a trusting soul, you can even make a loan from your IRA unsecured (although in that case I personally would tend to support Shakespeare’s advice).

            First, let’s look at it from the borrower’s perspective.  At our office we offer a seminar entitled “Make Money Now With Self-Directed IRAs.”  One of the ways you can make money for yourself right now with your knowledge of self-directed IRAs is by creating your own “private bank.”  To do this, simply share the news that an IRA can be a private lender, refer people with IRA money to Quest IRA, Inc. to open a self-directed IRA, and then borrow their IRA money for your own financing needs.

            With private financing the loan terms can be whatever the borrower and the lender agree to within the legal limits.  If you know a person who is getting 5% in a “safe” IRA at a bank, and you can offer them 9% secured by a first lien on real estate with only a 70% loan to value, would they be happy with that?  Even with a higher interest rate, private financing can work for you. IRA loans can be done quickly and without a lot of fees or fuss, which may mean you can get a deal which might be lost if you had to wait on the bank.  This is especially true in distressed sale situations, such as a pre-foreclosure purchase.

            From a lending perspective, your IRA can grow at a nice rate while someone else does all the work.  In a typical hard money loan, the borrower even pays all of Quest IRA, Inc. modest fees as well as any legal fees for preparation of the loan documents.  True, you won’t hit a home run with lending, unless you are fortunate enough to foreclose on the collateral.  But the returns can be quite solid.  For example, by making very conservative hard money loans my Mom’s IRA has grown by about 10.5% in one year.  This is much better than the amount she was earning in her money market fund before she moved her IRA to an Quest IRA, Inc. self-directed IRA. 

            Even small IRAs can combine with other self-directed accounts to make a hard money loan.  My brother recently combined his Roth IRA, his traditional IRA, his wife’s Roth IRA, his son’s Roth IRA, his Health Savings Account (HSA), and 5 other IRAs to make a hard money loan.  The smallest IRA participating in this loan was for $1,827.00!  Each IRA made 2% up front and 12% interest on an 18 month loan, secured by a first lien on real estate with no more than 70% loan to value.

            One thing to avoid in hard money lending is usury.  Usury is defined as contracting for or receiving interest above the legal limit.  The usury limit varies from state to state, with a few lucky states having no usury limit at all on commercial loans.  Some people have the theory of “What’s a little usury among friends?”  However, if the investment goes bad and your IRA has made a usurious loan, the consequences of the borrower making a claim of usury could include the loss of all the principal of the loan plus damages equal to 3 times the interest.  Some states even have criminal usury statutes.  It is best to consult with a competent attorney prior to making a hard money loan to make sure your IRA does not violate any usury laws.

            To see how well hard money lending can work, let me give you an actual example.  One of our clients made a hard money loan from his IRA to an investor who purchased a property needing rehab.  The terms of the loan were 15% interest with no points or other fees except for the attorney who drew up the loan documents.  The loan included not only the purchase price but also the estimated rehab costs.  The minimum interest due on the loan was 3 months, or 3.75%.  The investor began the rehab by having the slab repaired, and before he could take the next step in the rehab process, a person offered him a fair price for the property as is.  The investor accepted the offer, and they closed about 6 weeks after the loan was initiated.

            From the investor’s perspective, was this a good deal?  Yes, it certainly was!  True, he was paying a relatively high interest rate for the time he borrowed the money.  However, he was able to purchase a property with substantial equity which a bank most likely would not have loaned him money to buy due to the condition of the property.  Also, while the interest rate was high, the cost of financing was actually comparatively low.  With a normal bank or mortgage company there are fees and expenses incurred in obtaining the loan.  Common fees include origination fees, discount points, processing fees, underwriting fees, appraisal fees and various other expenses relating to the loan.  On the surface an interest rate may be 8%, but the cost of the financing is actually higher than 8% since a borrower has to pay the lender’s fees in addition to the interest on the loan.  Spread out over a lengthy loan term these additional fees do not add much to the cost of the financing.  However, if an investor has to pay all of these fees up front and then pays the loan off in only 6 weeks, the cost of the financing goes way up. 

            In this case the investor’s total loan costs were limited to 3 months minimum interest at 3.75% plus $300 in attorney’s fees for preparing the loan documents.  Best of all, the investor walked away from closing with $20,000 profit and no money out of his pocket!  Far from “dulling the edge of husbandry” this loan actually made the “husbandry” (ie. the purchase and resale of the property) possible.  Incidentally, the purchaser of the property was absolutely thrilled to get the property at less than full market value so that they could fix it up the way that they wanted it.

            What about the lender in this case?  The lender was also quite happy with this loan.  His IRA received 3 months of interest at 15% while only having his money loaned out for 6 weeks.  For the 6 week period of the investment, his IRA grew at a rate of approximately 30% per annum!  Although his yield was above the legal limit for interest in Texas on loans secured by real estate, prepayment penalties are generally not included in the calculation of usury here, so there was no problem.  The investor was happy, the new homeowner was happy, and the lender was happy.  Anytime you can create an investment opportunity with a win-win-win scenario, you should.

            When I lecture about hard money lending, I ask the audience what they think is the worst thing that happens if you are a hard money lender.  Invariably, most people in the audience answer that you have to foreclose on the property.  Nonsense!  If you are doing hard money lending correctly, the worst thing that can happen is that the borrower pays you back!  Unfortunately, this is a common risk of hard money lending.  Most hard money loans are made at 70% or less of the fair market value of the property.  If you are fortunate enough to foreclose on a hard money loan, your IRA will have acquired a property with substantial equity while the investor did all the work of finding and rehabbing the property! 

            While it is true that foreclosing on a property owned by a friend may cause an end to that friendship, a properly secured hard money loan will at least not “lose itself” as Shakespeare asserts.  In fact, it may lead to substantial profit for your IRA!  To avoid losing a friend, simply don’t loan money from your IRA to someone you would feel bad foreclosing on.  In order to be a successful hard money lender, you do have to be prepared to foreclose on the property if necessary.

            In modern times I believe the proper advice, at least in the right circumstances, is “Either a lender or a borrower be!”  You can make more money for yourself right now by borrowing OPI (Other People’s IRAs).  Borrowing from someone else’s IRA can even lower the total cost of your financing compared to a conventional loan from a bank or mortgage company, especially on short term financing.  From a lending perspective, your IRA can make great returns by being a hard money lender, either through higher than average interest rates or, better yet, through foreclosing on property with equity.  You may find that hard money lending from your self-directed IRA is a great way to boost your retirement savings without a lot of time and energy invested on your part.

The Truth About Self-Directed IRAs and Other Accounts

By H. Quincy Long

There is a lot of confusion over self-directed IRAs and what is and is not possible.In this article we will disprove some of the more common self-directed IRA myths.

Myth #1 – Purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA.

Truth:The only prohibitions contained in the Internal Revenue Code for IRAs are investments in life insurance contracts and in “collectibles”, which are defined to include any work of art, any rug or antique, any metal or gem (with certain exceptions for gold, silver, platinum or palladium bullion), any stamp or coin (with certain exceptions for gold, silver, or platinum coins issued by the United States or under the laws of any State), any alcoholic beverage, or any other tangible personal property specified by the Secretary of the Treasury (no other property has been specified as of this date).

Since there are so few restrictions contained in the law, almost anything else which can be documented can be purchased in your IRA.A “self-directed” IRA allows any investment not expressly prohibited by law.Common investment choices include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, limited liability companies, limited partnerships, trusts and a whole lot more.

Myth #2 – Only Roth IRAs can be self-directed.

Truth: Because of the power of tax free wealth accumulation in a self-directed Roth IRA, many articles are written on how to use a Roth IRA to invest in non-traditional investments.As a result, it is a surprisingly common misconception that a Roth IRA is the only account which can be self-directed.In fact, there are seven different types of accounts which can be self-directed.They are the 1) Roth IRA, 2) the Traditional IRA, 3) the SEP IRA, 4) the SIMPLE IRA, 5) the Individual 401(k), including the Roth 401(k), 6) the Coverdell Education Savings Account (ESA, formerly known as the Education IRA), and 7) the Health Savings Account (HSA).Not only can all of these accounts invest in non-traditional investments as indicated in Myth #1, but they can be combined together to purchase a single investment.

Myth #3 – I don’t qualify for a self-directed Roth or Traditional IRA because I am covered by a retirement plan at work or because I make too much money.

Truth:Almost anyone can have a self-directed account of some type.Although there are income limits for contributing to a Roth IRA (in 2008 the income limits are $169,000 for a married couple filing jointly and $116,000 for a single person or head of household), having a plan at work does not affect your ability to contribute to a Roth IRA, and there is no age limit either.With a Traditional IRA, you or your spouse having a retirement plan at work does affect the deductibility of your contribution, but anyone with earned income who is under age 70 1/2 can contribute to a Traditional IRA.There are no upper income limits for contributing to a Traditional IRA.Also, a Traditional IRA can receive funds from a prior employer’s 401(k) or other qualified plan.Additionally, you may be able to contribute to a Coverdell ESA for your children or grandchildren, nieces, nephews or even my children, if you are so inclined.If you have the right type of health insurance, called a High Deductible Health Plan, you can contribute to an HSA regardless of your income level.With an HSA, you may deduct your contributions to the account and qualified distributions are tax free forever!It’s the best of both worlds.All of this is in addition to any retirement plan you have at your job or for your self-employed business.

Myth #4 – I can’t have a self-directed 401(k) plan for my business because I am self-employed and file a Schedule C for my income.

Truth:You can have a self-directed SEP IRA, a SIMPLE IRA or a 401(k) plan even if you are self-employed and file your income on Schedule C of your personal tax return.With a SEP IRA, you can contribute up to 20% of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C) or 25% of your wages from an employer, up to a maximum of $46,000 for 2008.With the SIMPLE IRA, you can defer up to the first $10,500 of your net earnings from self-employment (calculated by multiplying your net Schedule C income by 0.9235% for SIMPLE IRA purposes), plus an additional $2,500 of your net earnings if you are age 50 by the end of the year, plus you can contribute an additional 3% of your net earnings as an employer contribution.Beginning in 2002 even self-employed persons are entitled to have their own 401(k) plan.Better yet, in 2006 the Roth 401(k) was added, allowing even high income earners to contribute after tax dollars into an account where qualified distributions are tax free forever!With an Individual 401(k) you can defer up to $15,500 (for 2007 and 2008) of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C), plus an additional $5,000 of your net earnings if you reach age 50 by the end of the year, plus you can contribute as much as an additional $30,500 based on up to 20% of your net earnings for2008 (or 25% of your wages from an employer).This means that a 50 plus year old self-employed person can contribute up to $51,000 for 2008!

Myth #5 – Because I have a small IRA and can only contribute $5,000, it’s not worth having a self-directed IRA.

Truth:Even small balance accounts can participate in non-traditional investing.Small balance accounts can be co-invested with larger accounts owned by you or even other people.For example, one recent hard money loan we funded had 10 different accounts participating.The smallest account to participate was for only $1,827.00!There are at least 4 ways you can participate in real estate investment even with a small IRA.First, you can wholesale property.You simply put the contract in the name of your IRA instead of your name.The earnest money comes from the IRA.When you assign the contract, the assignment fee goes back into your IRA.If using a Roth IRA, this profit is tax-free forever!Second, you can purchase an option on real estate, which then can be either exercised, assigned to a third party, or canceled for a fee.Third, you can purchase property in your IRA subject to existing financing or with a non-recourse loan from a bank, a hard money lender, a financial friend or a motivated seller.Profits from debt-financed property in your IRA may incur unrelated business income tax (UBIT), however.Finally, as mentioned above, your IRA can be a partner with other IRA or non-IRA investors.

Myth # 6 – If I want to purchase non-traditional investments in an IRA, I must first establish an LLC which will be owned by my IRA.

Truth:A very popular idea in the marketplace right now is that you can invest your IRA in an LLC where you (the IRA owner) are the manager of the LLC.Effectively you have “checkbook control” of your IRA funds.Providers generally charge thousands of dollars to set up these LLCs and sometimes mislead people into thinking that this is necessary to invest in real estate or other non-traditional investments.This is simply not true.Not only can an IRA hold title to real estate and other non-traditional investments directly with companies such as Quest IRA, Inc., but having “checkbook control” of your IRA funds through an LLC can lead to many traps for the unwary.Far from protecting your IRA from the prohibited transaction rules, these setups may in fact lead to an inadvertent prohibited transaction, which may cause your IRA to be distributed to you, sometimes with substantial penalties.This is not to say that there are not times when having your IRA make an investment through an LLC is a good idea, especially for asset protection purposes.Nonetheless, you must educate yourself completely as to the rules before deciding on this route.Having a “checkbook control” IRA owned LLC is kind of like skydiving without a parachute – it may be fun on the way down, but eventually you are likely to go SPLAT!

Myth #7 – I can borrow money from my IRA to purchase a vacation home for myself.

Truth:Although the Internal Revenue Code lists very few investment restrictions, certain transactions (as opposed to investments) are considered to be prohibited.If your IRA enters into a prohibited transaction, there are severe consequences, so it is important to understand what constitutes a prohibited transaction.

Essentially, the prohibited transaction rules were made to discourage disqualified persons from dealing with the assets of the plan in a self-dealing manner, either directly or indirectly. The assets of a plan are to be invested in a manner which benefits the plan itself and not the IRA owner (other than as a beneficiary of the IRA) or any other disqualified person.Investment transactions are supposed to be on an arms length basis.

As a result of these legal restrictions, a loan from your IRA or staying at a vacation home owned by your IRA, even if fair market rates are paid for interest or rent, would be prohibited.

Myth #8 – With a self-directed IRA, I can borrow my IRA funds to purchase real estate and then put all the profits back into the IRA.

Truth:When real estate or any other asset is purchased within a self-directed IRA, the money never leaves the IRA at all.Instead, the IRA exchanges cash for the asset, in the same way that an IRA at a brokerage house exchanges cash for shares of stock or a mutual fund.Therefore, the asset must be held in the name of the IRA.For example, if Max N. Vestor were to purchase an investment house in his self-directed IRA, the title would be held as “Quest IRA, Inc. FBO Max N. Vestor IRA #12345-11.”Since the IRA owns the asset, all expenses associated with the asset must be paid by the IRA and all profit resulting from that investment belongs to the IRA, including rents received and gains from the sale of the asset.

Myth #9 – If my IRA buys real estate, it must pay all cash for the property.An IRA cannot buy real estate with debt.

Truth:An IRA can own debt-financed property, either directly or indirectly through a non-taxed entity such as an LLC or partnership.Any debt must be non-recourse to the IRA and to any disqualified person.An IRA may have to pay Unrelated Debt Financed Income Tax (UDFIT) on its profits from debt-financed property.In general, taxes must be paid on profits from an IRA-owned property that is debt-financed, including profits from the sale or disposition of the property, in the same proportion that it had debt.For a simplified example, if the IRA puts 50% down, then 50% of its profits above $1,000 will be taxable.Although at first this sounds terrible, in fact leverage can be an extremely powerful tool in building your retirement wealth.The same leverage principle applies inside or outside of your IRA – you can do more with debt-financing than you can without it.One client was able to build her Roth IRA from $3,000 to over $33,000 in less than 4 months even after paying the taxes due by taking over a property subject to a debt and selling the property to another investor!

Myth #10 – An IRA cannot own a business.

Truth:A self-directed IRA is an amazingly flexible wealth building tool and can own almost anything, including a business.However, due to the conflict of interest rules you cannot work for a business owned by your IRA and get paid.Some companies have a plan to start a C corporation, adopt a 401(k) plan, roll an IRA into the 401(k) plan and purchase employer securities to effectively start a new business, but this is not a direct investment by the IRA in the business and is fairly expensive to set up.Also, if your IRA owns an interest in a business, either directly or indirectly through a non-taxed entity such as an LLC or partnership, the IRA may owe Unrelated Business Income Tax (UBIT) on its profits from the business.A solution to this problem may be to have the business owned by a C corporation or another taxable entity.

Preparing for 2010: Converting your Traditional IRA Assets to a Roth

Preparing for 2010:
Converting your Traditional IRA Assets to a Roth
by Hubert Bromma, CEO of Entrust
As we face an ailing U.S. economy bombarded by the subprime crisis, the rising cost of oil and the products that depend on it, and an expensive, ill-advised war, there is the opportunity for investors to profit from long-term gains at the expense of current economic problems. However, in the context of these current economic conditions, IRA holders can look toward the future and can take advantage of a change to the tax law that takes affect in 2010.

In 2010, regardless of your income, you can convert your traditional IRA assets to Roth IRA assets. Under the current law, you cannot convert a traditional IRA to a Roth if your adjusted gross income (AGI) exceeds $100,000. If any of your assets are currently undervalued, 2010 could be a great opportunity to convert your funds. The  assets will be taxed based on their fair market value as of December 31, 2010, and you also have the option of paying your tax bill over two years. You can pay the tax with cash outside of the IRA, which preserves your IRA assets. After the tax is paid, your earnings will never be taxed again.

Roth IRAs offer the added benefit that there are no required distributions. Unlike a traditional IRA, which requires that you begin taking minimum distributions starting at age 70½, with a Roth, you can let your assets sit and continue to grow. In a time when people work longer, you can amass wealth in a non-taxed environment for as long as you want.

Because you can convert as much or as little of your IRA as you want, you can choose to convert only the assets that have a current low value but that you anticipate having more value in the future. For example, if your self-directed IRA has real property that has been decreasing in value in today’s market but you expect a turnaround, that asset may be ideal to convert at the current fair market value.

Fair Market Value
Neither the Internal Revenue Code nor IRS regulations provide a general definition of fair market value for income tax purposes. The IRS regulations, however, use the following definition in connection with specific income tax issues as well as for estate and gift taxes:“The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.”

This is the definition adopted for purposes of valuing charitable contributions of property,pension plan assets,and real property interests disposed of by nonresident aliens and foreign corporations.The courts have also followed this definition when addressing tax issues.

You must determine the fair market value before converting your traditional, pre-taxed assets to Roth, post-taxed assets. This value is used to compute the federal tax, and possibly state tax, that you owe. The best way to establish the fair market value is through a qualified appraiser. The appraiser must have an arms-length relationship with the taxpayer and the asset. The IRS might also accept a recent bona fide offer from a third party who is not considered disqualified under IRS regulations involving IRAs and qualified retirement plans.

Debt-financed assets, such as real estate, must be valued at net asset value. This means that the fair market value subtracts the amount of debt remaining after the date of the appraisal or valuation. Private placements should be assessed by persons or firms qualified to make such appraisals. Cash, stocks and bonds, and publicly traded assets use the established values on the date required for valuation.

Plan Ahead to Minimize Tax and Maximize Gain

The object is to pay as little tax as is legally required and to pay the tax with non-IRA funds, thus preserving the funds that are never be taxed again. If you can, convert as much as possible, concentrating on assets that have the highest potential of future appreciation or income within your time horizon.Tax planning with a professional is always a good idea, but especially so in 2010 if you want to take full advantage of the new law. The amount you convert is added to your income for 2010, and your tax is calculated on your total adjusted gross income. So in 2010, it behooves you to have as little income as possible and plenty of losses. You can also spread the tax burden and pay part in 2011 and 2012.

After you have converted the asset, you can withdraw all or part of it at any time without paying federal taxes if you are at least 59½ years old. However, you may owe state tax. States differ on how assets in IRAs are taxed, and you should make sure that your have adhered to your state’s tax requirements.

The biggest question you have to think about is how well is your crystal ball working; how well can you and your tax advisors foretell your economic and tax-paying future?
Clearly, the more flexibility that you have and the more time that you have will give you more opportunity for appreciation and improve the possibility of the conversion paying for itself. But if past history and inflationary pressures are any indication, if , for example, your real estate investment is valued at 35% less than when your IRA purchased it, the increase in value over time should not only make up the 35% but even more. So converting now at its lowest fair market value may be a wise investment.

Doing The Numbers

It can be daunting to figure out the tax implications when taking inflation and cost of living indicators into account. If your property is in a traditional IRA, when you take distributions, which remember are required, you pay tax on that property at your ordinary income tax rate. Some pundits suggest that your tax rate will be lower when you are older and retire. This may be, but tax rates have hardly decreased over time.Just to take a simple case, let’s say your property has a fair market value of $100,000 today. If the property appreciates as a result of inflation by 2.5% annually over 20 years, the fair market value will be $163,000. You will be paying tax on an asset valued at least 63% higher just due to inflation. Paying tax in 20 years at 35% leaves you with a property worth about $106,000, without taking into consideration any gain as a result of appreciation.

Your cost of living may also increase at a nominal annual rate of 3.5%, based on current rates. That means you have to make up the difference between the fair market value of the property and what your real cost of living is on the amount that you need to live on, or $199,000. In this scenario, you need the property to appreciate to at least $306,000. Tax on $306,000 is $107,000, leaving you with the $199,000 that you need to just break even with the original fair market value. So in this case, you hope for either better appreciation or lower taxes.

The income on the property also plays a big role over time. Let’s say that your property has a 7% net operating income annually. Over 20 years, that equals about $314,000. You also invest the income in money markets that make 4%, adding another $15,000. So when you add your $329,000 in income over 20 years to the fair market value of $306,000, you end up with an IRA worth $635,000! Tax on a distribution of $635,000 at the rate of 35% is about $222,000, leaving you with $413,000, a little more than twice as much than the IRA had in real dollar terms.

If you had paid the tax with money outside the IRA in 2010, you would pay $35,000 (35%) on the $100,000 fair market value. Taking into account how much you could have made on the tax you paid in 2010 over 20 years-we’re using 14.8% compounded annually, which totals about $553,000-and adding that to the $413,000 in the above scenario, your IRA is valued at nearly $628,000 ($996,000 taxed at 35%) rather than $635,000. But that money does not get taxed on distribution. You end up with $628,000 and not $413,000.

Is It Worth It?

In summary, if you pay tax in 2010 on a low cost basis, the outcome in the long term can be substantially better if your assets earn a good return and they appreciate in value. If you expect very high appreciation and income, converting to a Roth IRA in 2010 could be profitable. Most importantly, do the numbers with the advice and input of competent accounting and tax professionals. And you also need to think about paying taxes 20 years from now. In our example, the tax bite is $338,000 in 20 years, not $35,000 in 2010. Keep in mind that you can spread the tax over two years. If you plan now, you can possibly minimize your tax burden by managing your income and losses. But who knows, the value of dollar may be relatively the same and render the question moot.

How to Pay for Education Expenses With Tax-Free Dollars

Many people are under the mistaken impression that a Roth IRA is the only type of self-directed account from which tax free distributions can be taken.  However, distributions from Health Savings Accounts (HSAs) and Coverdell Education Savings Accounts (ESAs) can be tax free if they are for qualified expenses.  In this article we will discuss the benefits of the Coverdell Education Savings Account and, more importantly, what investments you can make with a self-directed ESA.
Contributions.  Contributions to a Coverdell ESA may be made until the designated beneficiary reaches age 18, unless the beneficiary is a special needs beneficiary.  The maximum contribution is $2,000 per year per beneficiary (no matter how many different contributors or accounts) and may be made until the contributor’s tax filing deadline, not including extensions (for individuals, generally April 15 of the following year).  The contribution is not tax deductible, but distributions can be tax free, as discussed below.  Contributions may be made to both a Coverdell ESA and a Qualified Tuition Program (a 529 plan) in the same year for the same beneficiary without penalty.
To make a full contribution to a Coverdell ESA, the contributor must have Modified Adjusted Gross Income (MAGI) of less than $95,000 for a single individual or $190,000 for a married couple filing jointly.  Partial contributions may be made with MAGI as high as $110,000 for an individual and $220,000 for a married couple filing jointly.  Since there is no limit on who can contribute to a Coverdell ESA, if your MAGI is too high consider making a gift to an individual whose income is less than the limits, and they can make the contribution.  Organizations can make contributions to a Coverdell ESA without any limitation on income.

Tax Free Distributions.  The good news is that distributions from a Coverdell ESA for “qualified education expenses” are tax free.  Qualified education expenses are broadly defined and include qualified elementary and secondary education expenses (K-12) as well as qualified higher education expenses.

Qualified elementary and secondary education expenses can include tuition, fees, books, supplies, equipment, academic tutoring and special needs services for special needs beneficiaries.  If required or provided by the school, it can also include room and board, uniforms, transportation and supplementary items and services, including extended day programs.  Even the purchase of computer technology, equipment or internet access and related services are included if they are to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in elementary or secondary school.

Qualified higher education expenses include required expenses for tuition, fees, books, supplies and equipment and special needs services.  If the beneficiary is enrolled at least half-time, some room and board may qualify for tax free reimbursement.  Most interestingly, a Qualified Tuition Program (a 529 plan) can be considered a qualified education expense.  If you believe that contributing to a 529 plan is a good deal, then contributing that money with pre-tax dollars is a great deal!

One thing to be aware of is that the money must be distributed by the time the beneficiary reaches age 30.  If not previously distributed for qualified education expenses, distributions from the account may be both taxable and subject to a 10% additional tax.  Fortunately, if it looks like the money will not be used up or if the child does not attend an eligible educational institution, the money may be rolled over to a member of the beneficiary’s family who is under age 30.  For this purpose, the beneficiary’s family includes, among others, the beneficiary’s spouse, children, parents, brothers or sisters, aunts or uncles, and even first cousins.

Investment Opportunities.  Many people question why a Coverdell ESA is so beneficial when so little can be contributed to it.  For one thing, the gift of education is a major improvement over typical gifts given by relatives to children.  Over a long period of time, investing a Coverdell ESA in mutual funds or similar investments will certainly help towards paying for the beneficiary’s education.  However, clearly the best way to pay for your child’s education is through a self-directed Coverdell ESA.

With a self-directed Coverdell ESA, you choose your ESA’s investments.  Common investment choices for self-directed accounts of all types include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, limited liability companies, limited partnerships, trusts and much more.

With the small contribution limits for Coverdell ESAs, you might wonder how these investments can be made.  Often these accounts are combined with other self-directed accounts, including Traditional, Roth, SEP and SIMPLE IRAs, Health Savings Accounts (HSAs) and Individual 401(k) plans, to make a single investment.  For example, I combined my daughters’ Coverdell ESAs with our Roth IRAs to fund a hard money loan with 2 points up front and 12% interest per year.

One client supercharged his daughter’s Coverdell ESA by placing a burned down house under contract in the ESA.  The contract price was for $5,500 and the earnest money deposit was $100.  Since the ESA was the buyer on the contract, the earnest money came from that account.  After depositing the contract with the title company, the client located another investor who specialized in rehabbing burned out houses.  The new investor agreed to pay $14,000 for the property.  At closing approximately one month later, the ESA received a check for $8,500 on its $100 investment.  That is an astounding 8,400% return in only one month!  How many people have done that well in the stock market or with a mutual fund?

But the story gets even better.  Shortly after closing, the client took a TAX FREE distribution of $3,315 to pay for his 10 year old daughter’s private school tuition.  Later that same year he took an additional $4,000 distribution.  Assuming a marginal tax rate of 28%, this means that the client saved more than $2,048 in taxes.  In effect, this is the same thing as achieving a 28% discount on his daughter’s private school tuition which he had to pay anyway!

The Coverdell ESA may be analogized to a Roth IRA, but for qualified education expenses only, in that you receive no tax deduction for contributing the money but qualified distributions are tax free forever.  Investing through a Coverdell ESA can significantly reduce the effective cost of your child or grandchild’s education.  As education costs continue to skyrocket, using the Coverdell ESA as part of your overall investment strategy can be a wise move.  With a self-directed ESA (or a self-directed IRA, 401(k) or HSA for that matter), you don’t have to “think outside the box” when it comes to your ESA’s investments.  You just have to realize that the investment box is much larger than you think!

H. Quincy Long is a Certified IRA Services Professional (CISP) and an attorney.  He is also President of Quest IRA, Inc., with offices in Houston Dallas, Texas.  He may be reached by email at Quincy@QuestIRA.com .  Nothing in this article is intended as tax, legal or investment advice.