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How do you picture your retirement? In our mind’s eye, most of us probably imagine getting rid of all of our debt and being able to cover our daily expenses with passive income.
A vast majority of Americans are struggling to achieve that goal, however. According to a report from the National Institute on Retirement Security, the average American household approaching retirement has a median retirement account balance of $14,500, barely enough to live on for a few months, let alone years of retirement.
Most people know of the traditional investment plans, such as workplace 401(k) plans, and IRA and Roth IRA plans. All of these plans offer various tax advantages, but in each case the account holder — you — doesn’t have much control over which investments are made. A financial institution typically manages the plan, choosing from among mutual funds, stocks and bonds.
Often, people nearing retirement are looking for investment options that give them freedom to invest in other areas. One option that may be appropriate for some people is the self-directed IRA. This type of plan, which can be set up as a traditional IRA or a Roth IRA, is also overseen by a financial custodian, but in a more passive way — the custodian simply executes the wishes of the account owner. Under this setup, the account owner can make decisions about where to invest from a greater array of options, such as real estate, trust deeds, precious metals, private limited liability companies, private banking, corporate debt and more.
Direct control over a checking account
My firm serves this role for clients, offering self-directed retirement plans for a fee and allowing our clients to choose the assets they want to invest in. As an example, two of my clients, Debra and Tim, used a self-directed IRA plan to purchase a property in Belize. Using a setup called a “checkbook” IRA, they receive direct control over a checking account with retirement funds. They can write a check or make a wire transfer from the account on behalf of the IRA.
A regular self-directed IRA, without checkbook control, also provides the account owner with investment freedom, but in that case plan owners must wait for the custodian to process transactions.
Debra and Tim were able to establish their account and roll over their existing retirement funds into a checkbook IRA. They bought two adjacent pieces of land in Placencia, Belize, a place they first visited and fell in love with in 2009 on a sailing trip. With the checkbook feature, Debra was able to wire the funds directly to their real estate agent’s escrow account.
The couple plan to construct a simple vacation home on one of the pieces of land, and they plan to rent it out until their retirement. Considering a high vacation rental demand in Belize, the couple expect decent returns on the investment and a low vacancy rate.
Keep an eye on the rules
Here are a few things to keep in mind before investing in real estate through a self-directed checkbook IRA:
The self-directed checkbook IRA holds title: Your retirement plan will hold the title of the property, and you may sign on behalf of the plan. Taking title in your personal name would disqualify the IRA.
All expenses are paid by the account: Per the rules governing self-directed checkbook IRAs, any expenses incurred during the transaction should come from the retirement account only. You cannot use your personal funds for regular maintenance, repairs or any other expenses associated with the property.
Rental income goes back to the account: If you purchase an income-generating property, any income out of the property should flow back into the retirement account only. This is the same as with conventional IRAs that are invested in mutual funds or stocks — dividends are paid back to the account, not to the account owner individually.
The account owner cannot receive any personal benefits from the investment property while it is owned by the IRA until retirement age. At that time, the account owner can start taking distributions from the account or distributing the entire property out of the IRA (which is known as in-service distribution) and converting it to a personal residence.
You may not live in a property owned by your IRA. That would disqualify the IRA as a qualified retirement plan, making the entire IRA treated as distribution. You would be hit with taxes and penalties on the entire amount, plus the IRS might assess additional penalties for violating the rules.
Tim and Debra plan to distribute the property to themselves and pay taxes on the property upon retirement. Until then, the couple will collect extra income from renting the house to another tenant. The key is to make sure that any rental income earned from the property must find its way back to the self-directed checkbook IRA only.
Weigh the pluses and minuses
This kind of retirement strategy is not for everyone — real estate purchases are long-term investments and take time to liquidate. It must be calculated into your overall investment and retirement planning strategy to make sure that you have other income sources that are liquid.
While there are many benefits to investing with a checkbook IRA, plan owners need to do their research. The rules and guidelines mentioned above can result in tax consequences if violated. Plan owners should consult a tax professional when in doubt.