Using IRA Funds to Invest in Alternatives
While traditional asset classes, like stocks and bonds, provide a solid return for most retirement portfolios, incorporating alternatives provides a tool to achieve higher yields, greater diversification, protection against inflation and the ability to own hard assets.
As alternative assets grow in popularity, it’s important to understand where and how you can invest. In this blog, we’ll highlight one of the lesser known investment vehicles, self-directed IRAs, and explain when this may be a good choice as a funding source in your next real estate investment.
What are Self-Directed IRAs?
Self-directed IRAs simply mean the investor is choosing what to invest in.
You’re probably wondering, well isn’t that every retirement account? Believe it or not, many custodians (companies that hold your retirement account), only provide a limited menu of options, eliminating the ability to invest in alternative assets.
There are a few, however, that do provide the option to do so, and allow the investor to really be in the driver’s seat. There are also many advantages of using this funding source versus just writing a check from your bank account.
Here are 2 main benefits that come with using IRA funds to invest into private securities:
- Tax advantages: Retirement accounts are tax preferred accounts that allow all of your investments to grow tax deferred so you’re not going to have to do any complicated tax accounting at the end of the year. In addition, they may allow you to invest with pre-tax dollars or even have your investments be tax-free forever on those gains in the case of a Roth.
- Investment horizon: A lot of alternative assets are very long investment horizon opportunities and if you think about locking up funds from your bank account for say, 3, 5, or 7 years, that can be a much more difficult decision than using an account you aren’t touching until you retire for these types of investments.
When is an IRA not the Best Choice as a Funding Source?
The advantages are evident (being able to see your investments grow tax deferred, potentially even tax-free forever, or use pre-tax dollars to invest); however, because it’s a tax-deferred account, that means you’re not paying taxes on the gains as they occur, until you take the money out of the account later on in retirement.
It also means you’re not going to be able to pass through losses nor get the benefit of tax credits if that opportunity provides them. So, it’s important to really think about the tax implications of not being able to pass through losses, like accelerated depreciation for instance or opportunity zone funds, where there are tax credits. In these cases, it is probably not the best use for an IRA account because you will lose those benefits.
Some Rules to Keep in Mind When Investing out of IRAs:
Oftentimes, people think that you can’t use an IRA to invest into alternative assets, legally, because it’s not administratively allowed wherever you have your retirement account. The fact of the matter is that the IRS does allow IRA funds to be used to invest in almost any asset type. There are very few that aren’t allowed, and what comes up more often is that your IRA might not transact with every type of person or entity.
Just to break it down on what assets aren’t allowed, the IRS has a requirement that you can’t use your IRA funds to:
- Own a whole collectible – For example, you can’t go out and buy a painting, put it on your wall and call it an investment. You can invest in securitized collectibles where you own a fraction of an asset that’s a collectible, you just can’t own the entire thing.
- Buy your own life insurance
- S corporations
The IRS wants to ensure that you aren’t circumventing some of the rules and creating undue benefit for yourself.
Regarding transaction limitations, your IRA can’t transact with you directly; you can’t buy a house using taxable dollars and then sell it to your IRA or buy an investment property and have your family live in it. This also applies to close family members or businesses that you own.
How can you use an IRA to invest into Excelsior Deals?
Due to the complex nature of Self-Directed IRAs, it is helpful to have a custodian that will provide much-needed guidance as you travel through the murky waters of the IRS tax code.
As always, please don’t hesitate to reach out if you have any additional questions.
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