What is the Advantage of an IRA LLC?
So, why open an IRA in the first place if you can’t use it? Won’t your money just sit idle for years until you get ready to retire? Well, it depends on you. Most companies who allow their employees to open IRAs, and self-employed individuals who open their own IRAs, are bombarded with advertising from large investment brokers to invest in stocks, stocks and more stocks, and mutual 
funds, which are made up of stocks. Large cap growth funds, mid cap growth funds, value funds, energy funds, utility funds, domestic funds, foreign funds, even “carbon credit” funds. The range of choices is extensive – but they’re all basically investments in stocks. The only aspect of this investment opportunity that is “self-directed” is that you can pick and choose among the range of the investment company’s selection of stocks and mutual funds.
Most investment companies will recommend that you diversify your investment portfolio. However, allocating your portfolio among large cap growth funds, mid cap value funds, energy stocks, utility funds, and index funds is NOT diversification. They are ALL forms of investments in STOCKS. What about real estate, private equity, business ventures, and other investment opportunities? Most of the financial gurus will agree that real estate investing, and investing in private equity and business ventures, although definitely subject to a number of risks, has the potential for large returns. And, it’s perfectly legal. In fact, the only things the IRS will not allow an individual to invest their IRA funds in are collectibles (art and baseball cards for example), life insurance, and Subchapter S corporations. As long as the funds are used for investment purposes, and there is no self-dealing or transactions involving disqualified persons, IRA funds can be invested into just about any type of investment opportunity that exists.
Historically, investing in stocks and mutual funds, over time, will yield a return on investment of around 7 – 10%. Depending on certain factors, the returns will be taxed as ordinary income or will be subject to capital gains tax. In addition, management fees and expenses associated with purchasing and selling stocks and mutual funds could take anywhere from 1.0 – 3.0% of the amount invested. Finally, the investor should consider the effect of inflation, which will further reduce the value of the investment by a factor ranging from 2.5 to 4.5%.
On the other hand, using an IRA to make investments helps you to create wealth two ways. First, since your IRA is funded with pre-tax dollars (there is an exception for Roth IRA accounts, discussed elsewhere), you reduce your taxable income while building your savings. Second, the returns on your investment are returned to the IRA account without any deduction for taxes – until distribution. Now, the decision is whether to invest your IRA into large cap growth mutual funds, energy stocks, overseas stocks, or‚ real estate investments! The choice is up to you. You can purchase Tax Credit Liens which can earn 16%, or you can purchase options on land; you can purchase Trust Deeds; you can invest in start-up companies in Silicon Valley. You can buy real estate investment property, and earn both cash flow from rent payments while your property increases in value over time – a factor known as appreciation. You can also loan money, to friends or fellow investors (so long as they are not “disqualified” persons). In short, you have control over how your funds are invested, and can manage your investment portfolio – within the limits and restrictions imposed by the Government – to earn returns that are tax deferred. Now that is a self-directed IRA.
Let’s look at a hypothetical example: The IRS will allow a 40-year old person to deposit up to $15,500 per year into an IRA. (The employer can match this fund). Let’s assume over a 3 – 5 year period, an employee deposits a total of $100,000. The most immediate benefit is that the employee will have reduced their taxable income, with a corresponding savings of anywhere between $28,000 and $33,000, depending on the individual’s tax bracket. Now, let’s assume a simple investment plan whereby the self-directed IRA funds are loaned to a developer for a year at a simple 10% interest, at the end of which the $100,000 would have earned a total of $10,000. Why would a developer agree to pay 10% interest? The answer is because in many cases, the only available alternative is for the developer to go to a “hard money” lender, who will charge 4 – 5 “points” and upwards of 16% interest. Over a 5-year period, a $100,000 self-directed IRA pension fund will grow to $161,051 at a simple 10% rate of return, and $176,234 at 12%. For the IRA account holder, this would represent a tax-deferred gain. For the borrower, paying 12% is a lot less expensive than the typical “hard money” solution.
Let’s go to the next level. After accumulating over $150,000 in the self-directed IRA account, you may want to consider an investment with slightly higher risk, but potentially with a higher rate of return. For example, you could purchase a real estate investment property. In many states (outside of California), you can purchase a 3 bedroom, 2 bath house in a nice neighborhood for around $100,000 – $120,000, and rent it out for between $1,100 – $1,300 per month. If you factor in an annual 3% increase in rents and another 3% increase in appreciation, the internal rate of return would work out to slightly more than 15% if the property is sold after 5 years. If you were still making regular contributions to your self-directed IRA account, you might be able to add another $200,000 to the Plan. Over the span of ten years, even with fairly conservative returns and regular contributions, you could bring the self-directed IRA account level up to $500,000. At that point, you could probably find some even more profitable investment opportunities, and earn 20 – 25% or more. Over the next 5 years, investing $500,000 at 20% would bring the account level up to $1,240,000 – tax-deferred.
Of course, each person and each situation is different. Each person has a different tolerance for risk, and there is no guarantee that each and every loan would be repaid on time, or that you could, in fact, earn 12% or 15% on every dollar you invest. But, the illustration above shows how, using the contribution limits allowed by the IRS, a 40 year old person could, over a 20-year period, accumulate over a million dollars in their pension plan using a self-directed IRA and taking advantage of tax-deferred returns. Upon reaching the age of 59 , the individual doesn’t have to start taking distributions (they aren’t required until the age of 70), but they have the option. In fact, if the $1,240,000 was invested over the next 10 years at 15%, even without contributing another dollar to the Fund, the self-directed IRA fund would grow to over $5,000,000. If the worst problem you face at the age of 70 years of age is having to deal with paying deferred taxes on mandatory distributions of a $5,000,000 estate, you can count your blessings and your money. However, if you were somehow able to take advantage of a tax-free Roth account while building your self-directed IRA pension plan, not only would you not have any tax liability, but you would not even have to take mandatory distributions at the age of 70 !
To summarize, a self-directed IRA or self-directed 401K, whether a traditional, tax-deferred account or a tax-free Roth account, provides incredible opportunities for an individual to build wealth in several ways; to invest their retirement fund at significantly higher rates of return than generally available in the stock market, and at much lower costs than most investment companies charge for investing in stocks or mutual funds. That said, there is definitely risk involved in real estate investments, but there are ways to reduce that risk and still get a good return on your real estate investment.
