How To Use "Lazy" Retirement Funds to Invest in Higher Yielding, Alternative Investments
Disclaimer, we are not Certified Public Accountants or legal retirement fund advisors. Any and all content herein is based on personal experience, knowledge and opinions. If you seek legal advice, please speak with your CPA or retirement fund professional.
Last week, we posted a question asking, “Should I use my retirement funds to invest in real estate and other alternative investments such as notes and other funds?” From reading that article, you can understand more about my opinions on the limitations and opportunities with these asset classes. If you missed it, here is the link to the first article in our three-part series.
After tossing and turning all night, thinking about your savings, you have decided that it is a good idea to tap into your lazy retirement fund cash to make your money potentially work harder for you. In this article, we’ll discover what type of retirement funds are the best for you to use for investments.
Here are the types of retirement funds covered in this article.
Self Directed IRA
Solo 401K (including EQRPs)
Each of these has Traditional and Roth qualities which will be explored at the end.
Mainstream financial advice talks about rolling over your old 401K into a traditional IRA when switching jobs. At that point, if you wish to have control of your money and how it's invested, you may want to consider rolling over your old 401K account into an alternative retirement plan instead.
If you’re in a situation where you just chose to perform a rollover, no big deal. You can still convert into the alternative retirement plans available to you.
Self Directed IRA
The biggest advantage of Self Directed IRA is that everyone qualifies. This is one of the reasons why the retirement fund service providers love pitching these accounts to their clients.
Funding The Account
If someone were to fund a Self Directed IRA via “contribution,” the limit is the same as other IRA accounts and shared across all IRA accounts. This means that if someone has qualified and funded a Roth IRA account or Traditional IRA account to the limit for the year, they can no longer contribute to this account until a new year begins. At the time this article was written, the annual limit is $6,000 in 2020 through 2021 for people under 50. For anyone older than 50, the contribution limit is $7,000. Any amount of funds can rollover from an old 401K into a Self Directed IRA just like rolling over to a Traditional IRA.
Old 401K accounts can be rolled over into a Traditional IRA because both receive pre-tax contributions unless backdoor conversions are happening. (That is an entire different article for later.) Hence, someone can also roll their old 401K into a Self Directed Traditional IRA account. These accounts are more common and thus, when people talk about Self Directed IRA, it means Self Directed Traditional IRA.
If someone has a Roth IRA account, it could be rolled into a Self Directed Roth IRA because both are after-tax contributions.
Account Management
Typically a Self Directed IRA has a third party custodian who manages the account. They sign on behalf of the account owner and review investment documents to make sure all procedures are conducted correctly. This way, the owner of the account will not accidentally fund an investment that is not allowed by the Self Directed IRA rules. The custodian will also make sure that annual reviews are performed to the account to ensure compliance with ever-changing IRS regulations. Proper tax-related forms and investment forms are managed by the custodian to ensure proper IRS reporting. The custodians do not advise on the soundness of investments that are made with Self Directed IRA funds, they will make sure account owners are compliant with rules and regulations, which is a preventive measure for misuse. Often custodians will need to sign on behalf of the account owner to ensure transactions are “arms-length” transactions. The custodian will also be responsible for releasing and receiving funds for the investments.
The downside to having a custodian is that there are typically fees associated with each service and transaction. They can add up if the account is being used for active investments. Understanding how SDIRA service providers operate and what their associated fees are is key.
UDFI/UBIT
A big disadvantage of using a Self Directed IRA (Roth or Traditional) is that investments using leverage such as real estate could be subject to UBIT(Unrelated Business Income Tax)/UDFI (Unrelated Debt Financing Tax). UDFI is a tax that the IRS has posted on IRA accounts if they are using leverage to profit. The portion of income in the IRA related to the indebtedness may be subject to taxation. At the time of sale, the capital gain tax rate on the leveraged portion may be 20% on profits subject to UDFI. It could be higher based on personal situation and tax brackets. The tax is likely paid by the IRA account instead of individual money. We highly encourage a conversation with your CPA when considering Self Directed IRAs for investing into leveraged assets. More details on this tax code are inside IRS Article 598.
Pros
Anyone can qualify
Account custodians ensure compliance
Cons
UDFI tax on capital gains and possible UBIT tax
The associated fees of a custodian can add up depending on the company and frequency of transactions
Slower in funding deals as there are documents involved when investing in private investments such as real estate syndications.
Annual contribution limit is very low.
Solo 401K
A solo 401(k) is an individual 401(k) designed for a business owner with no employees. The definition of self-employed can be quite broad. If you receive a 1099 tax form, chances are that you may qualify as “self-employed” even with a full-time or part-time W2 job. For individuals reaching financial independence early, chances are there is a side gig creating extra cash. This situation helps someone qualify for a Solo 401(k) account. This is another situation to confirm with a CPA. Just like a Self Directed IRA, someone can use a Solo 401(k) to utilize for alternative investments such as a real estate syndication.
Funding The Account
Unlike a Self Directed IRA, someone can contribute up to $57,000 in 2020 and $58,000 in 2021, with an additional $6,500 catch-up contribution for those who are 50 or older. This is significantly higher. Of course the contribution needs to be income generated through the business that the Solo 401(k) is based.
You can roll over 401(k) accounts from former jobs much like rollovers to a Self Directed IRA. A Solo 401(k) also has a Roth element much like a Roth IRA. It is a less-known investment vehicle. The same rules described in the Self Directed IRA section above applies to funding of a Solo 401(k).
Account Management
Unlike a Self Directed IRA, a Solo 401(k) is managed by the owner of the account as the retirement plan administrator. The account owner usually has “checkbook control” of the funds. As such, there are no fees associated with each transaction. Initially, a Solo 401(k) account broker or policy creator will need to be contacted to open a Solo 401(k). Though there are online brokers, I personally prefer to go with a real person on the phone. With great power comes great responsibility. Since an individual manages this type of account, the possibility of becoming out of compliance increases in likelihood. The “arms-length” rule on transactions still applies. This makes passive investing into other people’s projects, like apartment syndications or notes more acceptable projects to invest in with Solo 401(k) due to their passive nature.
Typically, after opening a Solo 401(k) account, choices will be made on where to keep the funds. Brokages such as Fidelity and Charles Schwab may be used. A typical bank account for a Solo 401(k) trust may also be used. No matter the destination for this 401(k) account, personal accounts and personal funds should never be intermingled to avoid accidental penalties of early withdrawal. Consult with your policy creator and/or CPA before you move funds to ensure compliance.
If someone were to invest in a syndication where there are scheduled ACH distributions, opening a bank account for the 401(k) trust is likely. Very few banks understand this vehicle. Based on personal experience, I had a hard time finding a bank that would open an account for me. I found Solera National Bank to be very friendly with these accounts. (Disclosure: I have no affiliation with Solera National Bank.)
It usually costs a fee to set up a Solo 401(k) and an affordable annual fee after creation. The annual fee is for the policy creator to review and update the policy for compliance with ever-changing IRS rules. The cost of maintaining such an account might be cheaper compared to a Self Directed IRA account.
It is worth it to note that, once the plan is set up, the IRS requires an annual report on Form 5500-SF if the 401(k) plan has $250,000 or more in assets at the end of any given year.
EQRP
Many investors ask me about eQRP accounts. After reviewing this type of policy, I could not tell a huge difference between eQRP and a Solo 401(k) when used for passive apartment syndication investment deals. There may be more asset protection elements when it is used to hold a project such as a personal dwelling single family home. Since I don’t think it is a good idea to use any retirement fund to invest in your own projects to keep compliant with arms-length transaction rules. Even though with care, it can be done, I don’t see much advantage.
UDFI/UBIT
A Solo 401(k) is exempt from UDFI. However, UBIT might apply depending on the asset or investment. For example, if the eQRP is used to invest in a profitable business, UBIT might still apply. Most times, it does not apply to apartment syndication projects.
If you do not qualify for a Solo 401(k), all is not lost. You can start with a Self Directed IRA and then later convert it to a Solo 401(k) account to still avoid the UDFI tax.
Pros
High contribution limit
UDFI is not applicable
Checkbook control of funds
Potentially cheaper compared to a Self Directed IRA with no transaction fees
Projects can be funded quickly with the account holder in control of wiring
Cons
Account holders must remain personally accountable for staying in compliance with transactions and regulations to avoid mixing of funds from personal accounts which ensures no penalties for accidental early access on a 401(k) plan
Property tax forms must be filed each year if the account is bigger than $250,000
Not everyone qualifies. The account holder must be self-employed in some capacity with no employees outside of a spouse.
Conclusion
In general, if someone qualifies for a Solo 401(k), it’s a better vehicle for alternative investments. If someone does not qualify, a Self Directed IRA may be a good start. Someone can always convert a Self Directed IRA into a Solo 401(k) at a later date after qualifying and avoid the UDFI tax. Here is a video I made with John Park, President of PGI Selfdirected, on this topic.
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